What Is Inventory Financing?
Inventory financing is an asset-based loan that’s based on the value of some or all of your inventory. The lender provides a loan for a percentage of your inventory’s value and the inventory itself serves as collateral for the loan. In some cases, business owners use inventory financing to purchase new inventory, but it can also be used for many other types of business expenses as well. Inventory financing can help with short-term cash flow gaps for businesses who have a lot of their capital tied up in inventory, or it can help your business stock up on inventory in preparation for a busy season.
Inventory financing is most commonly used by businesses that consistently have very large quantities of inventory, such as retailers, restaurants, and wholesalers. For example, automotive dealers have to purchase large amounts of very expensive inventory and much of their capital is tied up in that inventory. Even a profitable auto dealer can have very little cash available to expand their business or hire more salespeople. Inventory financing can help to provide that additional capital.
Inventory Financing vs Accounts Receivable Financing
Inventory financing and accounts receivable financing may seem like the same thing at first glance, but they have a major difference: depreciation. With accounts receivable financing, like invoice factoring, the amount of money owed by your clients remains constant, no matter how much time passes. The lender could issue you a loan for the full amount of your accounts receivable without worrying about a decrease in value of those outstanding invoices. Inventory, on the other hand, can depreciate in value over time. If a lender gives you a loan equal to the amount of your inventory, and then your inventory doesn’t sell as fast as you planned, there will be a gap between the loan repayment amount and the value of the collateral. This leaves the lender vulnerable to a loss.
However, despite the risk of depreciation, inventory financing can be easier to get than an unsecured loan because the collateral of your inventory lowers the lender’s risk.
Types of Inventory Financing
There are two main types of inventory financing: an inventory loan and an inventory line of credit. While both types of inventory financing are secured by leveraging your inventory as collateral, these two loan types mean different things for the future of your business financing.
An inventory financing loan is simply a loan based on the value of your inventory. Just like a regular small business loan, an inventory loan is for a set amount that is paid back in monthly payments over a fixed repayment term or in a lump sum following the sale of inventory. You will be responsible for paying back the full loan amount and once the loan is paid off, you will have to take out another loan if you need more financing.
Inventory Line of Credit
While the funds from a loan can only be used once, an inventory line of credit can provide you with extra money on an ongoing, as-needed basis. Many business owners like having a business line of credit available to them so they’re able to handle any unforeseeable expenses that may come up. You may sign an inventory financing agreement, which allows you to establish terms and conditions with a lender for a long-term business funding partnership.
Pros and Cons of Inventory Financing
Since these loans are secured by the inventory, lenders are able to put less of an emphasis on your business credit history or credit score and other indicators of creditworthiness. This can make inventory financing easier to obtain for businesses that aren’t able to get funding through a regular business loan, such as a working capital loan. This method of financing can also be faster to apply for and easier to obtain than a business loan.
On the other hand, inventory financing can be more expensive in the long run than making cash inventory purchases because of interest, even if the interest rate is low. Although inventory financing can be secured by the inventory itself, the lender may ask for an additional form of collateral in some situations. A lender may want to come out and see your facility in person to make sure the inventory being financed is being taken care of so it won’t be damaged or depreciate in value before it’s sold. Typically, onsite visits involve an appraisal fee that you will be responsible for paying.
Keep in mind that lenders generally only provide financing for a portion of your inventory’s value, not the full appraised value. Therefore, if you are using inventory financing to purchase inventory, keep in mind that you will need to put in at least a small amount of your own capital.
Applying for Inventory Financing
You can apply for inventory financing through a traditional bank, a credit union or through an online lender. Because inventory financing can be a recurring loan, it is especially important to do your due diligence and find the best financing company for your business.
Inventory financing hinges on the liquidation value of the inventory and its sale in the near future. During the application process, lenders will want to see documentation that proves that you have excellent inventory turnover and are able to actually sell the inventory, such as:
Lenders will also want to see that you have an excellent inventory management system in place so they don’t have to worry that you might be buying more inventory than you really need and are able to sell.
Other Financing Options
If you don’t have a high volume of inventory, inventory financing may not be right for your business. In that case, there are many other types of financing that may provide a more flexible funding option, such as:
Working Capital Loan: These short-term loans can help to cover any cash flow gaps with flexible and unsecured capital. Working capital loans can be used for any business need, from purchasing inventory to hiring more staff. The choice is yours as the owner.
Equipment Loan: If an unsecured loan isn’t the best option, an equipment loan can enable you to purchase new equipment and pay it off over time. As a secured loan option, you may be able to qualify even if you don’t have a stellar credit history.
Find out more about what the best small business loan option is for your business.
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