Table of Contents
- What Is Inventory Financing?
- Types of Inventory Financing
- Understanding Costs Associated with Inventory Financing
- Pros and Cons of Inventory Financing
- Who May Apply for Inventory Financing?
- How to Apply for Inventory Loans for Small Businesses
- Where to Find Business Inventory Financing
- Alternatives to Inventory Financing
- FAQ
Inventory financing is a small business financing option that allows you to purchase much-needed inventory for your business, with the inventory acting as collateral. Because of this, you may be able to secure a better interest rate and better loan terms, even if your credit profile isn’t as strong as you’d like.
Let’s examine how inventory financing works, its costs, pros and cons, and alternatives to this funding option.
Key Points
• Inventory financing is a loan or line of credit using inventory as collateral.
• Costs include application fees, interest rates, and potential prepayment or late fees.
• Pros are fast funding, better interest rates, and increased sales; cons are high fees and risk of inventory seizure.
• Financing options are typically available as loans with fixed repayment schedules or lines of credit with revolving access.
• Qualification for inventory financing typically requires being in business for at least six months, having a well-organized inventory system, and meeting lender-specific criteria.
What Is Inventory Financing?
Inventory financing is an asset-based loan or inventory line of credit that a business can use to purchase more inventory, maintain consistent cash flow, or support working capital. The inventory your business purchases is collateral, and lenders offer financing based on a percentage of that inventory’s value (typically 20% to 65%). If you default on the inventory loan or line of credit, the lender can seize the inventory you’ve used as collateral.
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Inventory Financing Example
Let’s say you own a wholesale clothing business that serves various retailers. You expect sales to increase dramatically during the holidays and must purchase twice as much inventory as usual to cover demand. But how can you afford to buy that much inventory while still maintaining a healthy cash flow in your business?
Inventory financing may be helpful in a situation like the one described above. Let’s say it will cost you $500,000 to purchase the inventory you need to prepare for the seasonal spike in sales. You find an inventory financing lender who approves you for a loan at 50% of the inventory’s value. The lender advances $250,000 for you to use toward the inventory purchases and other business expenses. You then use the revenue from your holiday sales to pay back the lender.
Because of the flexibility and cash availability inventory financing offers, it’s a popular option for seasonal businesses and/or ones with large amounts of physical assets. Since lenders place a lot of weight on the value of the inventory when evaluating loan applications, you may also find that inventory loans are easier to qualify for compared to other types of small business loans.
However, when choosing whether or not to pursue inventory financing, there are a few essential points to keep in mind:
• Lenders may be less willing to offer financing if your inventory has low turnover.
• Since the lender would need to resell the inventory to recoup any losses, certain types of more risk-averse lenders (e.g., banks) may be less likely to offer inventory financing — if they offer it at all.
• Because inventory financing is often considered riskier to lenders, you may encounter higher interest rates than you might see with business loans or lines of credit.
• Inventory’s value can depreciate over time, creating a more significant loss for lenders (if they need to sell it). Therefore, lenders may calculate inventory loan or line of credit amounts using your inventory’s liquidation value, which is likely lower than its current purchase price.
It’s essential to weigh all your financing options carefully so you can make a solid financial decision for your business.
What Is an Inventory Loan vs Inventory Line of Credit?
In addition to inventory loans, businesses can obtain financing with an inventory line of credit (LOC). As with an inventory loan, enterprises use the value of their inventory as collateral, but instead of a one-time loan, a line of credit is revolving.
With an inventory line of credit, a business can use the funds up to a certain credit limit, pay them back, and use them again.
For example, let’s consider the clothing wholesaler described above. To keep up with the latest fashion trends, she needs to be able to purchase new batches of trendy clothing quarterly. She works with an inventory financing lender to calculate the value of her current and planned inventory purchases, which they decide is $100,000. The lender approves her for an inventory LOC at 50% of her inventory’s value, earning her a credit limit of $50,000.
In Month 1, she spends $30,000 on an order of popular pants she is sure will sell. She still has $20,000 available for additional inventory or other business expenses but makes no other purchases. In the following months, the wholesaler repays her inventory financing lender $30,000 plus interest, using the revenue generated by the pants she could sell. Once the $30,000 is repaid, she can access the full line of credit ($50,000) again.
An LOC can be of help to certain qualifying businesses, especially if you:
• Have high turnover on inventory and need to withdraw just the amount you need.
• Need financing to pay repeat expenses or cover seasonal cash-flow shortages.
• Need regular access to cash over a longer period.
Remember that interest rates may be relatively high because an inventory line of credit can pose a greater risk to the lender.
An inventory loan can be a better business loan option for one-time, larger purchases. Lenders may offer certain qualifying businesses longer business loan terms — with set installments, which you can factor into your business budget. Notably, lenders may have different eligibility requirements for inventory loans vs. lines of credit, so be sure to compare lenders that align with your business and its needs.
Business owners may also want to determine if they’re eligible for short-term business loan and long-term business loan options.
Secured vs Unsecured Inventory Financing
The main difference between a secured and an unsecured loan is the way a lender mitigates that risk. While a secured business loan requires a specific piece of collateral, unsecured small business loans are not attached to any collateral.
Types of Inventory Financing
The two major types of inventory financing are inventory loans and inventory lines of credit. Here’s a quick rundown.
| Inventory Loan | Inventory Line of Credit |
|---|---|
| Can provide a business with a one-time lump sum | Can provide a business with ongoing access to cash, up to a preset limit. Paying back the money borrowed replenishes the amount available |
| Uses inventory as collateral | Uses inventory as collateral |
| With a fixed interest rate, repayments can be predictable and uniform | Repayments are based on withdrawal amounts and the terms of the LOC |
| Can be useful if a business has a major one-time expense to cover | Can be useful if a business has recurring or seasonal expenses over a longer period of time |
Understanding Costs Associated with Inventory Financing
As with any small business financing, the rates, terms, fees, and conditions vary depending on the lender and your business’s financial situation. Before you choose an inventory financing lender, check what fees may be included so you can choose the lender that best meets your needs.
The following is a list of common fees that may be included with a business inventory loan or line of credit:
• Application and/or origination fees: Coverage of the cost of reviewing the application and setting up the loan.
• Appraisal/inspection fees: These are the costs of sending someone to inspect and appraise the value of inventory and a business’s inventory management system.
• Prepayment fees: Fees incurred if a borrower repays the loan early (i.e., ahead of the terms set by the lending agreement).
• Late fees: Fees incurred if required payments are made late.
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Interest Rates
Interest rates on inventory financing can range drastically — anywhere from around 9.00% to 97.00% or more. But, generally, banks will offer favorable rates to eligible borrowers, while other lenders may offer much higher interest rates.
How to Calculate the Cost of Inventory Financing
Inventory financing costs will vary depending on whether you have a loan or line of credit. With a loan, you’ll receive your rate and terms after applying. Once you have those terms, using a business loan calculator can help you estimate the total cost of the loan.
With an inventory line of credit, you only pay interest on what you use and don’t pay off by the end of the billing cycle (typically one month). Rates for lines of credit generally are higher than with loans, but if you pay your bill in full each month, you’ll avoid any interest charges.
Both loans and lines of credit may have other fees, too, so you’ll need to factor those into the total cost of borrowing.
Pros and Cons of Inventory Financing
To decide if inventory financing is right for you, it can be a good idea to weigh the pros and cons.
Pros of Inventory Financing
The most significant advantage of inventory financing is that it allows your small business to access the inventory it needs to continue operating or to bring in more sales. And because the inventory acts as collateral for the loan or line of credit, interest rates may be competitive for qualified borrowers.
Another pro of inventory financing is its fast approval and funding times. Startups and businesses with less-than-perfect credit may have an easier time qualifying for inventory financing than for other forms of small business loans.
Cons of Inventory Financing
As with most types of small business financing, the most significant disadvantage to small business inventory financing is that fees and rates may be high, especially for startups or businesses with poor credit.
Another con is that if you’re unable to repay the loan, the lender can seize your inventory, since it was used as collateral for the loan.
And finally, you may not be able to get the full amount that your inventory is worth financed. Most lenders will lend only up to 80% of the value of the inventory to qualified borrowers. This is because inventory tends to depreciate as the months and years go on, so lending only a percentage of the total value helps protect the lender from some potential losses.
Who May Apply for Inventory Financing?
Well-established businesses with a proven revenue history and high inventory turnover could be good candidates for inventory financing. Startup small businesses likely have different inventory needs and a shorter business history, which may make them better suited for alternative types of small business financing, like personal small business loans or angel funding.
The following industries commonly rely on inventory loans or lines of credit to keep up with demand while also maintaining regular cash flow.
• Car dealerships: Often have high turnover and need to replenish inventory on a regular basis
• Retail stores: Sell products daily and often have seasonal needs that require them to stock up on extra inventory
• Wholesalers/distributors: Small- to medium-sized wholesalers that want to keep inventory fresh for their customers and stay on top of seasonal demands
• Seasonal businesses: Those that earn a majority of revenue during specific times of year with a high level of predictability, making it easier for them to rely on inventory financing
How to Apply for Inventory Loans for Small Businesses
So you’re thinking about small business inventory financing, but where do you go to get it? Several kinds of lenders offer inventory loans and lines of credit, including traditional banks, online lenders, and inventory finance companies. The following steps can help you prepare and apply for inventory financing.
1. Determining Amount and Type of Inventory Needed
Inventory loans for small businesses are typically dependent on the amount of inventory needed. The more inventory a business needs, the more it may want to borrow. In addition, the underlying inventory value of different businesses can affect the terms, rates, or approval odds of an inventory loan.
To determine your inventory needs, closely examine sales volume and seasonality patterns and consider economic factors that may affect customer activity. Overestimating your needs can leave you with hefty payments and unsold inventory, while underestimating those needs can leave businesses scrambling for sellable inventory or additional financing.
Lenders may be more willing to finance inventory that you have a solid track record of selling successfully. If you choose inventory that’s difficult to sell or that you don’t have experience with, some lenders may decide not to lend to you or may add additional interest or fees to cover potential risk.
2. Determining Eligibility
Once you’ve evaluated your inventory and deemed it a potential candidate for financing, you can take a closer look at your business to assess further the likelihood of its eligibility to obtain an inventory loan or line of credit.
As with other types of funding, traditional banks are typically the most difficult lenders to borrow inventory loans from. However, they may offer more competitive interest rates and terms for well-qualified borrowers. Regardless of where you choose to apply for inventory financing, you’ll likely need to meet the following familiar qualifications to be considered eligible:
• Be in business for at least six months to one year
• Sell products or raw materials, not just offer services
• Meet inventory minimums set by lenders
• Maintain a well-organized inventory management system
• Be willing to have inventory audited if the lender requires it (this may involve surprise site visits)
Additionally, lenders may evaluate your industry and customer base to determine how likely they are to receive repayment on an inventory loan. For example, lenders may be less likely to extend funding if your industry is in flux or your customer base is spending less due to current events.
3. Choosing an Inventory Finance Lender
If you meet the initial loan qualifications stated in the previous step, you may want to compare lenders that align with your business needs. Here are some questions to think over when evaluating different lenders:
1) How soon do you need the funds?
Bank loans typically take longer to process than online business loans or other forms of alternative financing. So, it can be helpful to research how quickly different lenders take to evaluate applications and disburse approved funds.
2) How much financing do you need?
Some lenders offer more financing than others, so apply for those that can meet your specific inventory needs.
3) Does the lender specialize in your industry?
Partnering with a lender who knows your industry may offer a more fair and accurate evaluation of your current inventory.
4) Do you want revolving credit?
If you know that you’d like ongoing access to cash, choosing a lender that offers options like an inventory line of credit may be of interest.
It’s important to choose a lender carefully and apply only for the financing you truly need. When a lender runs your credit for the final approval of financing, it’s considered a hard credit pull. If you have numerous hard pulls in a short amount of time, it could appear suspicious to lenders.
4. Gathering Documents to Apply for Inventory Financing
Now that you’ve chosen a qualified lender, it’s time to fill out the loan application. In addition to the application, lenders may ask for a number of documents to prove your business’s eligibility. It may help streamline the application process if you gather the following documents in advance.
• Recent balance sheet
• Profit and loss statement
• Organized and up-to-date cash flow statements
• Current inventory list and projected inventory needs
• Detailed inventory records, which could include:
â—¦ Inventory turnover
â—¦ Inventory gross profits
â—¦ Loss or damage to past inventory
• Sales forecast statement
• Personal and business tax returns
• Business bank account statements
5. Preparing for Inspection
After you’ve chosen a lender, gathered required documentation, and applied for a business inventory loan or line of credit, it can be useful to prepare for the possibility of an inventory inspection — also called a “field audit.”
Typically, lenders will have examiners inspect the inventory and storage facilities to assess its value, ensuring the lender is taking on a manageable risk. Even after a business receives an inventory loan, lenders may make periodic (sometimes surprise) visits to inspect the inventory.
Be prepared by keeping workspaces clean and well-organized, inventory stocked and visible, and employees trained and aware of potential inspections. Even if inspectors never show, your business will benefit from preparedness moving forward. Lenders will also frequently require regular audited financial statements from the business they loan to.
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Where to Find Business Inventory Financing
There are several types of lenders that may offer inventory financing to qualifying businesses. These can include the following:
• Traditional banks
• Credit unions
• Online banks
• Specialized inventory financing lenders
Alternatives to Inventory Financing
Inventory financing is an option to help fast-paced business stay on top of inventory and customer needs while maintaining cash flow, but it can come with significant downsides. If you’re curious about other short- and long-term financing solutions, check out the following alternatives.
• Equipment Financing: Used for the purchase of machinery, vehicles, or other business-related equipment.
• SBA loans: Backed by the U.S. Small Business Administration (SBA) and offered by banks and approved SBA lenders. SBA loans typically take longer to process, but their interest rates may be more competitive.
• Personal loans: Unsecured personal loans are based on your personal credit history (not business credit) and can usually be used for business expenses.
• Commercial real estate loans: For the purchase of a building for business use, such as office space, a retail shop, or any other commercial function.
• Business lines of credit: Gives access to a maximum amount of funding with interest only charged on unpaid balances.
• Business credit cards: Similar to a business line of credit, these are designed for short-term business needs on a revolving line of credit with interest charged on unpaid balances from previous billing cycles.
• Online business loans: Online lenders offer loan options similar to those of traditional banks, but they typically have a faster approval process and may provide more options for people with lower credit scores.
• Merchant cash advances: Allows small businesses (“merchants”) to get a cash advance for business expenses in return for a portion of their future sales or receivables.
• Invoice factoring: You may be able to sell your invoices to a factoring company that is then responsible for collecting payment from your customers.
The Takeaway
As the owner of an established small business, you have options to choose from when it comes to financing. Inventory financing is a short-term loan or revolving line of credit made to a company to purchase products to sell. This type of small business loan is typically secured by existing inventory and does not require pledging personal collateral.
Ready to grow your business? SoFi Small Business Loans can give you fast access to the capital you need. Check your eligibility in minutes.
FAQ
How does an inventory loan work?
An inventory loan is a type of small business funding in which the inventory acts as collateral for the loan. Because of this, you may be able to secure a lower interest rate than you could with traditional small business loans.
How do you calculate inventory financing costs?
To calculate inventory financing costs, you’ll first need to add up all fees associated with the loan, which may include application fees, inventory inspection fees, processing fees, and more. From there, you’ll need to consider what interest rate you think you’d qualify for and the amount you need and then use an online calculator to estimate your total interest costs.
What are the disadvantages of inventory financing?
Disadvantages of inventory financing may include not receiving the entire amount you need for inventory, potentially paying high rates and fees (especially if you have poor credit), and the lender seizing your inventory if you cannot repay the loan.
What is the interest rate for inventory financing?
Rates for inventory financing can vary from about 9.00% to 97.00% depending on the lender and the financial credentials of your business.
Can startups qualify for inventory financing?
Most lenders prefer established businesses for inventory financing. However, some lenders specialize in working with new companies, making it key to explore options.
Photo credit: iStock/alvarez
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