How Inventory Financing Can Unlock Sales Opportunities and Cash Flow
With inventory financing, you borrow money against inventory you either own or would like to own. It’s a popular form of funding for companies that want to make sure they have enough stock to sell to their customers without affecting cash flow.
In this article, we cover:
What inventory financing is and how it works
The seven different types of inventory finance
Where you can get inventory financing from
How Does Inventory Financing Work?
Inventory finance can either be a standard term loan or a line of credit.
It’s a way that retailers, wholesalers, and manufacturers can purchase what they need to meet customer demand without tying up their working capital.
To qualify for inventory financing, you need to meet lenders’ eligibility criteria. Lenders generally want your business to have been operational for six months or more. Many may require a good credit score together with an indication of your annual revenues and profitability.
The main benefits of inventory financing are:
Fast application process: With some types of inventory finance, you can set up an account quickly and have access to the capital you need within one or two business days.
No equity dilution: Some entrepreneurs give away stock to raise capital in order to buy inventory, meaning they own less of the company. Inventory financing lenders make no such request of borrowers.
Better supplier relationships: If your use of inventory finance leads you to order more from your suppliers and pay them faster, you might benefit from lower prices and more generous terms.
Improved business credit: If you manage your account well, this will improve your business credit score, making it easier to apply for other types of finance in the future.
The main drawbacks of inventory financing are:
Limited funding: Lenders don’t offer up to 100% of the value of the inventory you hold or wish to purchase. You may only be offered half of what the stock is worth.
Personal risk: Owners of newer businesses may be required to sign a personal guarantee, which may put at risk any personal assets you pledge as security.
Restrictive covenants: Restrictive covenants limit your ability to borrow money from other lenders and you’ll be required to agree to them with certain types of inventory financing.
Expensive funding: Compared to standard bank loans, interest rates on inventory loans and lines of credit can be much higher.
7 Types of Inventory Financing
There are seven different forms of inventory financing, each one has its own pros and cons to consider when choosing the most suitable loan option for your circumstances.
1. Asset-Based Lending
Asset-based lending is a broader form of business finance, where companies pledge business assets like their inventory, machinery, real estate, and accounts receivable as collateral.
Financial institutions provide two forms of asset-based lending — a line of credit or a standard term loan.
A business line of credit shares many features with credit cards and bank account overdrafts. You have a limit — the maximum amount of money you can borrow. You only pay interest on the amount you actually use. When you make a repayment, you can borrow that amount again.
Alternatively, you may be offered a standard term loan. With a loan, you’ll borrow a set amount of money for a set period of time. The repayment terms of your loan will stipulate how much you have to pay back each month and for how long.
Pros of Asset-Based Lending
You can borrow a higher amount of money because the combined value of the assets you offer as collateral is higher.
Depending on the quality of the assets you offer, you may benefit from lower interest rates on your facility.
Cons of Asset-Based Lending
On longer asset-based loans or lines of credit, your lender may need to revalue your assets periodically, adding to the cost.
The application process is in-depth, and you may have to submit substantial volumes of documentation, including your balance sheet, profit and loss statement, and your tax returns.
2. Inventory Lines of Credit
Inventory lines of credit operate in the same way as asset-based lines of credit, except that they can only be used to purchase stock.
You can use an inventory line of credit to purchase stock to meet unexpected demand spikes or stock up on fast-selling items. It can also help businesses maintain a lean inventory, thereby minimizing the costs of holding onto excess stock.
Pros of an Inventory Line of Credit
With access to an agreed sum of money arranged in advance, you can react quickly to changes in market demand.
Unlike with a trade account you have with a supplier, you’re not restricted to which companies you do business with using an inventory line of credit.
Cons of an Inventory Line of Credit
If you order stock but the demand you expected doesn’t materialize, you’ll still need to make repayments on your line of credit, which may negatively impact your cash flow.
Unlike a small business loan, what you can use an inventory line of credit for is restricted, so you can’t use it to meet other business expenses.
3. Purchase Order Financing
This type of inventory financing is best for businesses that have received a large order from a client but don’t have the funds required to fulfill the order.
In these cases, you might apply for purchase order financing. With this type of loan, the finance company pays your supplier the value of the inventory you’re buying.
When you sell all your new inventory to your client, you then repay your lender. An example of the type of business that purchase order financing would work for is a small office-furniture supplier that receives a very large order to furnish a corporate client’s substantial office space.
Pros of Purchase Order Financing
You can take on large orders that you couldn’t manage otherwise.
Many lenders consider the creditworthiness of your clients when coming to a decision rather than your company’s credit history.
Cons of Purchase Order Financing
The fees on this type of inventory loan are high, which will reduce your profit margin.
You can only fund orders for the specified client, so this is not a long-term financing option.
4. Consignment Arrangements
Consignment arrangements are an ideal funding option for newer businesses with no credit history and little working capital on hand.
With this arrangement, you don’t actually purchase inventory. Instead, your supplier sends it to you free of charge — so there’s no upfront financial risk to you. You only pay your supplier when you’ve sold their stock to customers.
Consignment arrangements work well for startups with very tight cash flows. They’re also suitable for businesses that want to try out new lines or suppliers without having to commit any money upfront.
Pros of Consignment Arrangements
You don’t pay for inventory until you’ve sold it, reducing initial costs and your financial risk.
Your cash flow remains unaffected, so you can continue to buy in stock from other suppliers and meet your ongoing business expenses.
Cons of Consignment Arrangements
Your supplier may charge you higher prices for consignment stock to reflect the risk they’re taking, cutting into your profit.
As you don’t own the inventory, you may have to return unsold stock on demand. You may also have less control over pricing.
5. Warehouse Financing
Many wholesalers and manufacturers use warehouse financing as part of their inventory management strategy.
With this type of finance, you use your existing inventory as collateral to create a line of credit. You can draw down from your credit line as needed to purchase new stock. When you sell your inventory, you can either repay the full amount you’ve borrowed or make installments, depending on your agreement with the lender.
Warehouse financing is a way to pay for inventory purchases without draining working capital. Larger retailers often use warehouse financing to stock up during busy seasons.
Pros of Warehouse Financing
You have the funding to pay for inventory you need to meet customer demand without having to offload existing inventory at a discount to bring in cash.
Many lenders offer flexible repayment schedules so you can repay your loan without affecting working capital levels.
Cons of Warehouse Financing
Some businesses have over-purchased inventory using warehouse financing, which reduces storage space and can lead to incorrect purchasing decisions.
As the amount borrowed can be high, many lenders impose covenants on stock quality as well as company debt-to-equity and liquidity ratios.
6. Loans for Inventory
Loans for inventory (or inventory loans) are short-term loans that retailers, in particular, use to buy stock for their stores.
Inventory loans are best-suited to businesses that have predictable sales volumes where historic trading patterns suggest that they’ll be able to make the repayments with ease, assuming no unexpected downturn.
They can be used to take advantage of temporary offers too, like when wholesalers and manufacturers offer volume discounts to shift their own inventory. Retailers can take advantage of the discount, get the stock in and sell it, and then repay the loan with the cash they’ve been paid by their customers.
Pros of Loans for Inventory
You can obtain the funding you need upfront to purchase stock without adversely affecting cash flow.
Monthly repayments and interest rates are usually fixed so they’re easier to budget for.
Cons of Loans for Inventory
If your business has a less-than-ideal credit score, you’ll pay higher interest rates, which will affect cash flow and profitability.
Depending on your lender, you may be charged a prepayment penalty if you settle your loan early.
7. Loans Against Inventory
With a loan against inventory, you use your existing stock as collateral for the loan. This type of loan is aimed at helping companies manage their inventory turnover better by freeing up cash currently tied up in stock.
Like inventory loans, loans against inventory are short-term loans. You receive a lump-sum payment upfront and repay it in monthly installments over an agreed time period.
Loans against inventory are useful for businesses that stock high-ticket items where the turnaround time on stock may be slow. They’re also often used as working capital loans to meet costs like payroll or rent.
Pros of Loans Against Inventory
Payouts on loans against inventory are quick because you offer lenders collateral.
You can keep your current inventory instead of selling it at a discount, which would hurt your profit margins.
Cons of Loans Against Inventory
The amount you can borrow is based on the current value of your inventory. Items you bought may not be worth what you paid for them anymore.
There may be a delay in getting access to the finance you need because many lenders will want an independent valuation.
Where Can You Get Inventory Financing?
Inventory financing is available from many sources, including traditional banks and online lenders. Sometimes, suppliers team up with financial institutions to offer their own branded service.
Each lender has their own criteria, lending terms, and interest rates. Banks and credit unions generally provide higher loan amounts and lower interest rates, but they have strict eligibility standards, and it takes them longer to make decisions.
Online lenders, on the other hand, offer much faster turnarounds on decisions but may charge higher interest rates.
Is Inventory Financing Right for Your Business?
Inventory financing is a popular way for companies to purchase the inventory they need without adversely affecting cash flow. You can take out financing on inventory you already own or to pay for inventory you need to meet customer demand.
With at least seven different and established forms of funding, you can choose which type of inventory financing loan works best for your business. There’s plenty of competition in the market, meaning you have the freedom to shop around for the best deal for your company.
If you’re looking to purchase inventory, there are other funding options available too. With Backd, you can get a working capital advance of up to $2 million or a business line of credit of up to $750,000 — without the need for collateral like many inventory financing options require.
It only takes a few minutes to apply, and you can get your decision in less than 24 hours. Apply with Backd today.
