Carrying enough inventory can be a make-or-break situation for many small businesses… which is why many businesses eventually consider securing inventory financing.
Inventory financing is a form of debt-based funding for businesses. The basic idea is that business owners receive money from a lender in order to purchase new inventory to sell. Companies built around selling products, whether retail or wholesale, know that cash flow issues are one of the most common reasons why small businesses fail. Sometimes bills are due before you have all the cash in hand from selling your last batch of inventory. That’s where inventory financing comes in handy.
The decision to take on debt in order to fund business operations is never an easy one. It should only be undertaken if the business finds that they simply can’t meet the demand of suppliers otherwise. Taking on that debt, and repaying it with interest, may help small businesses avoid the kind of cash flow mismanagement that doom many ventures.
While some businesses in this situation choose to pursue more traditional forms of financing, like a small business loan, inventory financing can be a more direct way of obtaining the funds you need to keep your business running.
Let’s review the six things you need to know before you decide that inventory financing is right for you:
What is inventory financing?
Inventory financing is a relatively simple form of funding. Lenders that offer inventory financing will provide funds to borrowers specifically for them to use to buy necessary inventory.
During the approval process for your inventory financing loan, the lender will set a payment schedule for you to follow. Make your payments on time and in full, and you can freely sell and utilize your inventory however you’d like.
Fail to make your payments, however, and your lender can repossess the inventory you’ve purchased as repayment. They may also seize other inventory of similar value if they believe that inventory will better help them recoup the loan.
Small and medium-sized retailers and wholesalers are the most common types of businesses to use inventory financing. That’s because, unlike big retailers like Amazon or Target, they often lack the wiggle room and leverage with suppliers to avoid prompt payment—even if that payment is due before they offload all of their inventory.
Rather than take out expensive short-term loans to cover the cash flow gap, or sacrifice other areas of the business—laying off workers, for example—these businesses instead take up the offer of inventory financing, if they qualify.
Is inventory financing a secured or unsecured loan?
Most loans fall into one of two categories: secured loans or unsecured loans. To “secure” a loan is to offer (or rather, be required to offer) collateral to the lender, such as real estate or equipment, that can be recouped to repay the debt in case of default.
Technically, inventory financing is a “self-secured” loan: The inventory purchased with the loan acts as its own collateral. Lenders, however, may consider it an unsecured loan if no additional collateral is put up—because if the business can’t sell their inventory, the lender may not be able to either.
The specifics of the loan or line of credit you receive from a lender offering inventory financing will depend on your financial situation, industry, and credit history.
Does my business qualify for inventory financing?
To qualify for inventory financing, your business needs more than just possible collateral and the need for funding. Every lender is different, but here are the baseline qualifications:
- Be a product-based business: By nature of the type of financing, your business cannot be a service-based business.
- At least one year in business: Having a business history is fairly common for most types of business loans. The longer you’ve been in business—at least one fiscal year is the minimum, but ideally more—the better the terms will be for your financing.
- Meet the lender’s minimum requirements: Some lenders will only consider lending to businesses that need hundreds of thousands of dollars worth of inventory, in order to make their time spent underwriting the loan worth the investment. You will also need a solid credit history, including a good business credit score, to even be considered.
- Detailed financial history: Part of the loan application process will likely be submitting detailed financial records to the lender, including tax returns, balance sheets, profit and loss statements, inventory turnover ratios, and any other records that demonstrate how your business has done in the past.
- Adequate time for due diligence: If you need financing for inventory right away, inventory financing may not be for you. Depending on your lender, your credit history, and your needs, the underwriting process may take weeks or even months if you use a traditional lender like a bank. Financing from an online lender will be faster, but more expensive.
What are the costs of financing my inventory?
The exact costs of your inventory financing will depend on the kind of product your lender offers. You may receive a standard loan from a traditional lender, a short-term loan from an online lender, a line of credit, or financing directly from the vendor selling you the inventory.
Other factors will also determine your interest rate, APR, and service and origination fees. Your time in business, business credit report, and potential collateral all affect your overall costs.
When comparing the costs of different inventory financing options, be sure to use APR—annual percentage rate—to ensure an apples-to-apples comparison.
What are the pros of inventory financing?
There are some clear and obvious advantages to inventory financing if you decide that’s the right move for your small business, including:
- Higher potential sales volume: If you’re finding that demand is far outpacing the supply you can afford, an infusion of funds will help you obtain greater inventory volume that you can quickly flip for a profit.
- Ability to expand product lines: You don’t need to use this financing to purchase the same inventory you’ve always had. You can also use it to expand into new product lines and create a more diversified revenue stream.
- Unlikely need for personal assets as collateral: If your lender allows you to use the inventory itself to secure your loan, you won’t need to put your assets on the line, reducing risk.
- Easier to start back up from the low season: If you run a seasonal business and find that moving from low to high season is difficult without financial momentum, this financing can get you back on track.
- Reduced cash flow issues: Inventory financing can help you avoid defaulting on your other financial commitments when inventory doesn’t move the way you planned.
What are the cons of inventory financing?
No form of financing is perfect, of course. Here are the drawbacks associated with inventory financing:
- Limited use of funds: Unlike loans and lines of credit, you can’t use inventory financing to fund any and all of your working capital needs—it’s just for purchasing product.
- Potentially difficult to qualify for: Inventory financing is seen as slightly riskier than other forms of financing due to its self-secured nature, so finding financing that is affordable and available to you—especially as a younger business—may be difficult.
- Higher interest rates than more elite forms of financing: If you can qualify for loans with lower interest rates—such as SBA loans, which are considered the lending gold standard—and have time available for a lengthy application process, inventory financing is simply a less affordable option.
Now that you are armed with extensive knowledge of what inventory financing is and how it can work for you, it’s time to gather up your important and relevant financial documents, find potential lenders, and start the application process.
Inventory financing is just one of many kinds of business funding available to established small businesses. Using debt-based financing to grow your business is a common tactic that can deliver a good return on investment, so don’t be afraid to explore this possibility. Just be sure to take the time and research all of your options—plus, talk to your accountant or other financial advisors—before you move ahead and apply.
This guest post was written by Eric Goldchein in partnership with Fundera.
Eric Goldschein is a staff writer at Fundera, a marketplace for small business financial solutions such as business loans. He covers entrepreneurship, small business trends, finance, and marketing.