Let’s face it - managing your inventory can be a monumental task. This is especially true if you are running a retail or wholesale business which requires products to be available as and when customers want to buy them. And it ultimately means having to spend a lot to ensure your warehouse is always well-stocked.
Indeed, some estimates place inventory behind only labor as the biggest cost for small businesses, representing around 17-25 percent of their budget on average. Given this significant liability for your business, then, you are probably wondering whether there are funding solutions out there that can ease this consistently onerous financial burden, particularly if it’s failing to be covered by your working capital.
Thankfully, inventory financing has emerged as a preferred solution among companies with sizeable inventory obligations, particularly small businesses with few alternative routes for obtaining funding.
This type of lending can help you to continue making those necessary stock purchases, but without having to spend excessively up-front. And it helps to protect your cash flow – something which could prove vital if your business suffers from pronounced seasonal dips in sales.
What is Inventory Financing?
A short-term lending facility, inventory financing is typically issued as either a term loan or a revolving line of credit which you use to purchase inventory for your business. This inventory can be anything from raw materials and components to finished goods, all of which can be kept in stock before you sell them on to your customers.
The funding is a form of asset-based lending in which the inventory itself represents collateral for the loan. As such, you don’t have to tap into your personal assets to secure the facility - inventory financing lenders (such as banks, credit unions and online specialists) will instead seize the inventory to repay the loan if you default on the loan.
And while purchasing new inventory might be your prime motivation for seeking out inventory financing, there are also deals that allow you to borrow to smooth over your cash flow, especially if your capital is already mostly tied up in inventory. The funding can additionally be used to prepare for next season’s inventory by stocking up now.
Types of Inventory Financing
Inventory finance is offered in two main forms:
Term Loan – a fixed up-front cash sum that is issued in an amount that’s equivalent to the estimated value of inventory you need to purchase. Such loans are typically granted over a short-term horizon, with repayment usually required in less than 12 months, and done so in fixed monthly installments.
The inventory purchased serves as security for the loan, whereby the lender can sell it to repay the loan’s outstanding balance. Interest is also charged on the loan, with the rate mostly derived from the liquidation value of inventory you intend to purchase - that is, the likely value you can recover in a distressed sale of the inventory, an event that arises should you default on your loan repayments.
Should the lender find it difficult to sell some or most of the goods in such a scenario – and given that the inventory’s value is likely to continue depreciating over time - the higher the interest you will be charged.
That said, there are some term loan agreements available that only require you to make repayments once the inventory starts to be sold, which could be a good option if you have high turnover.
Revolving Line of Credit – a credit facility through which you can continue to access funding as required to purchase inventory. Whereas a term loan requires you to apply for a new facility each time you want more funds, the credit line grants more flexibility by allowing you to draw funds as and when you need.
Much like a credit card, you can withdraw funds up to - but not exceeding - a pre-determined credit limit, with an agreed interest rate that is only charged on the amount of the line that you utilize. You can also keep paying off partial amounts or even the total balance of the amount drawn as is suitable for you, and you can keep borrowing more (and paying interest) until you reach the credit limit.
Again, the inventory you buy serves as security for your borrowing. In this case, however, the interest rate is determined not only by liquidation value of the inventory you intend to purchase, but also by the credit risk posed by your business.
Who is Inventory Financing For?
Given that businesses invoke this funding option explicitly to ease their inventory cost burden, it makes sense to use inventory financing if you consistently require large quantities of inventory and/or require substantial resources to manage your inventory, which in turn ties up a huge chunk of your capital.
This typically means that inventory financing is popular among retailers, wholesalers and seasonal businesses that experience large fluctuations in sales. Automotive dealers, restaurants and convenience stores are just some of the examples of small businesses that need inventory on hand.
It is also a particularly useful funding option for small businesses that might have neither the sufficient operational history nor the assets required to obtain other types of funding (such as business bank loans). Inventory financing can help provide that necessary injection to free up enough capital, protect your cash flow, and allow you to focus on other pressing business needs.
How Does Inventory Financing Work?
To obtain the loan, you must apply to a lender of inventory financing – normally either a bank, a credit union or an online lender. Nevertheless, all inventory financing lenders will require most or all of the following:
1. Your credit score, with a minimum of anything between 500 and 650 deemed sufficient in most cases
2. Your business’ financial statements, including balance sheets, cash flow statements, profit-and-loss statements and bank statements
3. Business tax returns
4. Evidence of your business being in operation for a minimum of 6 months
5. Inventory lists
6. Management records
The lender might also stipulate that a visit is required to your business site at some point during the term of the agreement to appraise the financed inventory. You will usually be charged an additional appraisal fee for this arrangement.
The application process for online lenders is most likely to be the easiest, perhaps even taking a few minutes to complete and upload. Banks and credit unions, however, will have more stringent eligibility requirements and can take weeks or even months to approve. They may also require you to visit their premises as part of the process.
Before you apply for inventory financing, moreover, there are questions you should ask to ensure you are securing the best arrangement for your own inventory situation:
- What are the Terms? Whether it’s the proportion of the inventory value that the lender is willing to finance, the repayment terms, the type of inventory financing, or the eligibility requirements, this funding option can vary significantly between lenders. It is worth taking time to investigate which deal is most suitable for you before signing on the dotted line.
- How is Interest Being Applied? The way interest rates are calculated can also differ between lenders, as well as between types of financing (for example a term loan vs. a line of credit). Some estimates put the interest charged on inventory finance at between 9% and 97% across lenders, so it is worth double- and even triple-checking that you understand how you are being charged.
- Collateral – Understanding the differences in collateral requirements for each lender is crucial. Different types and amounts of collateral will affect the other terms of the financing agreement, so make sure you understand the full implications of what you are being asked to pledge to secure your financing.
Example
Let’s say you’re the owner of a retail spare parts business which provides customers, on-demand, with a vast array of automotive items including motors, gears and belts. Ideally, you want to always have all items in stock to be able to deliver immediately for your customers without ever having to order specific parts from manufacturers and wait for them to be delivered.
But the inventory required for this business eats up a lot of your capital. Indeed, with some parts more frequently purchased than others, ensuring that you are sufficiently stocked in all items – including more exotic parts that have a much slower sales turnover - presents a distinct challenge for your business.
After all, you do not want to be overstocked and end up having a warehouse full of parts that will take months, if not years, to sell. But you also do not want any item to be out of stock when a customer is ready to purchase, as it can incur potentially huge financial losses and a permanent loss of business as customers turn to other, better-stocked retailers.
instead of using your cash to purchase suitable quantities of stock, you instead decide to take out a short-term $30,000 inventory loan. The liquidation value of the parts is $40,000, so the loan is 75 percent of this value. You must also repay the loan at an interest rate of 12%, in fixed monthly amounts over the course of 8 months, with the items you purchase serving as collateral on the funding.
As such, the capital injection provided by inventory financing gives you enough time to sell the inventory whilst sufficiently protecting your cash flow across the term of the loan.
The Pros of Inventory Financing
Burdensome Inventory Costs Eased – with inventory often being a huge obligation that can tie up most of your capital, inventory financing can be a lifesaver for your business. By tying your inventory purchases to the security of the funding, you can turn into an asset what would otherwise have been a significant liability.
Seasonal Businesses Can Benefit – if you are running a restaurant, you will know that some of the food you sell (such as fruit and vegetables) are in hot demand in the summer months when conditions are ideal for their growth. This means you should have more inventory on hand during these months, although you may not have made enough money during the low-season winter months to sufficiently add to your stock.
As such, inventory loans can provide the needed boost to your working capital to acquire the additional inventory needed for high season.
Flexibility – by allowing you to draw funds as and when you need below your agreed credit limit, the revolving line of credit is a more flexible inventory financing solution than a term loan. And if your business is growing, this option can be ideal for acquiring successfully greater quantities of inventory as you can continue to access capital and repay funds (with interest) whenever it is suitable for you to do so.
Relaxed Credit Requirements – given that the inventory being financed is used to secure the financing facility, lenders will not usually require a high level of creditworthiness for your application to be approved. Indeed, a credit score of 500 is sufficient for some online lenders, although the minimum threshold for banks and credit unions is likely to be higher.
The Cons of Inventory Financing
Affordability – to completely mitigate potential risks, lenders will typically implement high rates for inventory financing deals compared with both up-front cash inventory purchases and equivalent standard term loans. Rates can range from 10% to almost 100% depending on the credit and financial history of your business, the quality of the inventory you are financing, the ease with which the inventory can be resold, and the type of lender providing the financing.
Should the inventory itself be insufficient to cover the cost of a default event, moreover, the lender may ask you to pledge additional assets as collateral.
Additional Fees – the financing facility may involve additional fees for which you are responsible for paying. For instance, lenders may charge you an Appraisal Fee should they want to visit your warehouse and verify in-person that the inventory being funded is in good condition, is being suitably looked after, and is not being exposed to anything that is making its value quickly depreciate.
Confined Financing Terms – Lenders don’t want to be stuck with outdated inventory that they can’t sell in the event of you defaulting on the loan. This means that inventory financing terms are rarely over 12 months, which in turn will inflate the repayment amount you are obliged to make each month.
It also means that the purchases you can make with the issued funds will typically be restricted by the lender to a pre-determined list of specific inventory items.
Not Universally Accessible – as mentioned above, inventory finance lenders will almost certainly want to see evidence that your business has been in operation for at least 6-12 months, that you have a solid financial history, and perhaps most important of all, that you have been able to consistently sell your inventory without significant delay.
If such criteria cannot be met you may have to pursue an alternative funding option.
