Inventory financing is a type of business loan that provides you with capital to purchase inventory, in other words, products that your business will sell. Inventory financing can be structured as a traditional commercial term loan or a line of credit, depending on the lender, and the products purchased serve as collateral for the financing.
That said, in addition to helping you keep your shelves stocked, inventory financing also allows you to take advantage of vendor opportunities. Plus, since the inventory itself serves as collateral, you don’t need to put up additional collateral on the loan.
In this guide, we’ll break down everything you need to know about inventory financing, including how it works, the best options for small businesses, and how to qualify.
How inventory financing works
Given our overview of the top inventory financing loan options, you may be interested in learning more about how inventory financing works.
In short, when you apply for inventory financing, the lender will provide you with capital in the form of a term loan or line of credit to purchase inventory. As mentioned earlier, the inventory you purchase will serve as collateral for the loan, which makes inventory financing a type of asset-based financing.
That said, the way inventory financing works may be a little different depending on whether the product is structured as a commercial line of credit or a commercial term loan. With a term loan, you will receive a lump sum of capital to purchase your inventory and repay that amount, with interest, over time.
With a line of credit, on the other hand, you will receive a line of credit from which you can draw to purchase your inventory. Unlike a term loan, which requires you to repay the full amount you have borrowed with interest, you only pay interest on the amount you draw from your line of credit. So, if you have a $100,000 line of credit, but only need $20,000 to purchase your inventory, you can draw that $20,000 and only pay interest on that amount.
With this distinction in mind, in general, as long as you make your scheduled payments on time and in full, the inventory that serves as collateral for the loan is yours to keep or sell as you see fit. However, on the other hand, if you default on the loan, your lender is entitled to repossess your inventory as payment on the loan.
In addition, it is also worth mentioning that you will not always get a loan equal to the full value of the inventory you wish to purchase. Similar to the way real estate or equipment loans work, an inventory finance company may only finance about 50% to 80% of the appraised liquidation value of the inventory. Often, the liquidation value will be lower than the market value of the inventory and, in this way, lenders ensure that they will receive adequate compensation if your company is unable to repay the loan.
In general, inventory financing is commonly used by retailers, wholesalers, and seasonal businesses, as well as automobile dealerships and other types of businesses with significant capital tied up in inventory. Inventory financing can be used to cover short-term cash flow gaps, prepare for a peak season, capitalizing on supplier discounts, or launch a new product.
Example of inventory financing
To get a better idea of how inventory financing works, let’s take a look at an example:
Suppose you own a car dealership and want to buy $1 million worth of new cars. You approach a lender for an inventory financing loan and hire an independent appraiser to value the inventory (note that online lenders generally will not hire appraisers). The appraiser finds that the liquidation value of the cars is $750,000. If the lender’s policy is to lend 70% of the appraised liquidation value of the inventory, you will receive a loan or business line of credit for $525,500.
As explained above, if the financing is structured as a term loan, you will get the full amount of money all at once. You can use the money to purchase the cars and you will repay the loan, with interest, according to the lender’s repayment schedule. On the other hand, if the financing is structured as a line of credit, you can withdraw money from your line of credit to pay for your car purchases as needed, and then you will repay the withdrawals with interest over a specified period of time.
Pros and cons of inventory financing
Ultimately, it’s up to you to determine whether or not inventory financing is right for your business, and if you decide it is, where you should apply for inventory financing.
That said, if you are still unsure whether inventory financing is right for your business or not, you can review the following pros and cons to help you make a decision.
Advantages of inventory financing
- Increase sales volume: Inventory financing is most effective for small and medium-sized businesses that use it strategically, typically to replenish depleted inventory after demand has outstripped supply. In general, these companies know that they could sell more inventory if they had the volume available, but do not have the cash on hand to buy or manufacture the inventory for sale. In these cases, inventory financing is a fantastic opportunity to increase the amount of inventory your company can purchase or manufacture, and then quickly pay off your loan with the proceeds from your increased sales volume.
- No personal property as collateral: Because the inventory itself acts as collateral for the loan, inventory financing can save you from the risk of offering your own home or property as collateral for the loan, or signing a personal guarantee.
- Preparing for busy months: For seasonal businesses, acquiring the inventory needed to prepare for the busy season after a long period of low sales can be cost-prohibitive. Having gone several months without much revenue, these companies may not have the cash available to make a large inventory purchase. Inventory financing can fill the gap for seasonal businesses by allowing them to purchase additional inventory to sell during their busiest seasons.
Cons of inventory financing
- Can be difficult to qualify for: while inventory financing is often more affordable than a traditional bank loan, it is not always the easiest way to obtain debt financing. The goal of inventory financing is for the inventory itself to be used as collateral; however, the reality is that if you can’t sell your inventory, a lender won’t be able to sell it either, which means some lenders are more reluctant to approve loans or lines of credit that use inventory as collateral.
- Potentially higher interest rates: You’ll want to keep in mind that the advantages of avoiding other collateral or a personal guarantee may come at a cost. Because inventory financing is generally considered less secure than a more traditional loan product, lenders often compensate for that additional risk in the form of higher interest rates.
- Potentially lengthy and costly due diligence process: Perhaps the biggest challenge to inventory financing as a commercial financing solution is the potential length and cost of the approval process. If your lender requires due diligence, the process of meeting with an auditor and gathering records can be time-consuming and costly.