What is Inventory Financing? A Guide for Small Businesses
Small business owners have several options to finance their dreams, ranging from SBA loans to business credit cards. One option that may be available to you as a small business owner is inventory financing.
Inventory financing is a business loan that gives you capital to specifically purchase inventory or products that you will then sell to pay back the loan. It allows you to buy needed inventory for your company while using those products as collateral for the loan. These loans are helpful if your other financing options aren’t available to use to buy inventory when you need it.
Our guide will help you understand what exactly inventory financing loans are used for, how to obtain one, and if they are the right solution for your business.
What is Inventory Financing?
In its simplest form, inventory financing is a short-term financing option that allows business owners to buy inventory they intend to sell later. As you sell the existing inventory, you pay back the loan to the lender with interest. Small to mid-range sized businesses tend to look at inventory financing to buy products as they typically don’t have large assets or a long financial history, which is needed for other larger funding.
The inventory that is purchased with the loan is then used as collateral for the loan, instead of with other business loans that look at other assets and property if you default. If you can’t repay the inventory financing loan, the lender can take the inventory that hasn’t been sold to help regain some of the loan.
Inventory financing is good for several types of businesses, including those who:
- Need to expand product lines
- Prepare their store for busy seasons like Christmas or back-to-school
- Increase inventory due to customer demand
- Cover any cash-flow problems
Who Can Apply For Inventory Financing?
Due to the nature of the loans, inventory financing is more suitable for established businesses rather than start-ups, who are aware of their inventory flow and needs. A good history of their inventory is important to have when applying for financing. Businesses just starting out can still apply for inventory financing as long as they have been operating for six or more months. Start-ups under six months should look for other small business loans that can help them with cash flow and initial costs.
Some of the types of businesses that rely on inventory financing regularly are ones that need bulk quantities of inventory, often in a predictable timetable, including:
- Car Dealerships
- Retail Stores
- Seasonal Businesses such as Halloween or Christmas Stores
- Wholesalers and Distributors
How Does Inventory Financing Work?
When you apply for inventory financing, the bank or other lender will provide the capital to you in the form of a term loan or a line of credit, depending on what you qualify for. The inventory that is purchased with the loan acts as collateral instead of your personal property or any other assets you may have.
The repayment terms and interest depend on what type of loan you receive. If you receive a term loan, you will be given a lump sum and will need to pay it back along with interest over time, often with a repayment schedule. If you are given a line of credit for inventory financing, it acts similarly to a credit card. You will be given an amount of capital you can use at any time. Once you borrow from that amount, interest will be charged to the amount due instead of the whole amount, as with a term loan.
Keep in mind that the loan might be for less than the market value of the inventory you wish to purchase, as they are typically based on a percentage of the appraised liquidation value of the products.
For example, suppose you are a clothing store expecting a large business increase around the holidays. You might want to consider an inventory financing loan to increase your stock before the rush. If it will cost you $500,000 to purchase the new inventory and you apply for a loan, the bank may grant you $250,000 towards new inventory, or half of what the inventory is worth. The revenue you make from the sale of the new clothes will go towards paying back the lender plus the interest.
Types of Inventory Financing
Inventory financing is not just a single type of loan; there are several options available to businesses, depending on their needs. The most common types of inventory financing are:
Traditional Inventory Financing
You are granted a short-term loan that you can use to buy products for your store. Those products are used as collateral, and if you fail to pay back the loan, the inventory will be seized. These loans usually require a 20% down payment, and many lenders will pay the supplier instead of having the capital directed to you, which can save you some time. Payments are usually due monthly plus interest, or a percentage of your sales is taken.
Lines of Credit
Opening a line of credit for a small business is a good option for those needing extra cash flow to get their company going. You are given a set amount of capital you can use towards inventory or other items and can pay as you go. Interest is charged on what is spent rather than the lump sum of the loan. With a line of credit, you have the option of using your inventory as collateral or applying for an unsecured credit line.
With term loans, you receive one-time financing towards your inventory. This must be paid back with interest, often in monthly installments. Term loans are best for businesses that do not regularly require inventory financing and just need it once or twice. They are similar to lines of credit where your inventory can be put up as collateral, or you can apply for an unsecured loan, which may have higher interest rates.
Pros of Inventory Financing
Inventory financing can be a big help to businesses needing to increase their inventory during certain time periods or due to customer demand, who may or may not have the capital to cover the increasing expenses.
Other benefits of inventory financing are:
- Move quickly to buy inventory if there is a discount or a large demand; if you are a distributor, you can afford to buy in bulk
- If you have poor personal credit, you may still be eligible for a loan
- Fast loan funding; you won’t have to wait around to receive the money
- Your personal and business assets are protected if you can’t pay back the loan; only the inventory will be on the line
Cons of Inventory Financing
While inventory financing may appear to be the perfect solution to any business needing to add additional products to their store without waiting for extra revenue, there are some disadvantages to these loans and credit lines:
- Interest rates tend to be higher than other business loans and financing options; there are often many fees involved in the process
- You may not be able to borrow the full amount you want or need to fulfill your inventory
- In order to qualify, you must be able to determine the inventory’s liquidation value, which can take time and more effort than other loans.
- Depending on your loan agreement, you may have check-ins by an auditor to check on your sales and inventory levels.
- You cannot use the money to purchase anything but inventory. Other lines of credit may allow you to use the capital for repairs, bills, and other items, but any inventory financing must be used towards inventory only.
How to Apply
If you are interested in inventory financing and think it’s right for your company, there are a few steps to take to prepare for your applications. Many lenders, such as SouthEast Bank, offer inventory financing, including banks, online lenders, and specialty inventory financing companies. You will need to gather several documents and do prep work before applying for inventory financing, just as you would with applying for other small business loans.
Determine How Much You Will Need
Before you begin applying for a loan, you will need to figure out how much capital you need to secure the inventory you want. The amount you need will determine many factors of the loan, including the terms, rate, and even the approval odds. When estimating the amount, you will need to look at your sales volume, what seasons are coming up, market trends, and more.
Find Out if You Are Eligible
After determining what amount you want to request from the lender, look into if you are eligible for inventory financing. Many lenders have specific requirements you must meet. Some of the more common requirements are:
- Be in the business for at least six months to a year
- Be willing to have your inventory audited
- Maintain inventory minimums set by the lender
- Offer products and/or raw goods and materials, not just services
Gather Your Documents
As with all loans, you need to have the paperwork to back up why you are requesting the amount and prove to the lenders you can pay back the money. Some of the documents you will need to gain inventory financing are:
- Recent balance sheets
- Both personal and business tax returns
- Business bank account statements
- Detailed inventory records
- Current inventory lists
- Projected inventory needs
- Profit and loss statement
Finding the Right Lender
If you meet the qualifications, the next step is to find the right lender for you. Comparing lenders is important in determining the best loan for your business, as you will want a reputable and personable lender to work with. If you run into any issues while paying back your inventory financing loan, you will need to work with your lender to make sure you don’t fall behind or default.
While looking for the right lender, consider the following to make sure you are choosing the correct fit for your business:
- How much financing do you need?
- How soon do you need the capital?
- How do the lenders communicate?
- Does the lender specialize in your industry or business size?
Other Options for Business Financing
Inventory financing is just one option to fund the needs of your business. If you need extra cash flow for other parts of your business or don’t believe inventory financing is right for you, there are other financial solutions for long-term and short-term financing.
SBA Loans - SBA loans are loans that are qualified through a lender but backed by the Small Business Association and are a good choice for businesses needing general funding. They require a high credit score and tend to be harder to get but are well worth it. As with inventory financing, there are different types of SBA loans, including the 7(a) loans and even disaster relief loans.
Personal Loans - You can take out personal loans for small businesses if you need more cash flow in a pinch. They tend to be easier to qualify for than other business loans but keep in mind that they will be tied directly to you instead of the business, meaning your personal credit will be affected if you default. If you don’t have much in assets or other collateral, a personal loan might be the way to go, especially if it’s for a smaller amount that you are sure you can pay back in full and on-time.
Equipment Financing - Similar to inventory financing, equipment financing is a loan or lease specifically used to obtain business equipment, which is almost anything considered an asset except real estate. Whether you lease or use a loan, it depends on the type of business you have and what type of equipment you are looking to purchase.
Line of Credit - Although inventory financing can be a line of credit, other lines of credit options are available to small business owners. They are flexible loans that act like credit cards where a business owner is given a total amount they can spend from. Once they start spending, interest is charged on that amount.
Business Credit Cards - Business credit cards are cards designed for business owners that often offer users benefits, such as higher credit limits, better rewards, and banking tools to manage their business. Credit cards are perfect for everyday expenses such as rent and utilities to free up other cash flow for larger purchases.
SouthEast Bank is Here For You
If you are interested in one of these financing options, or inventory financing specifically, SouthEast Bank can help you navigate the confusing waters of business loans. We offer personal services to determine what is best for you and your business every step of the way.
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Information contained in this blog is for educational and informational purposes only. Nothing contained in this blog should be construed as legal or tax advice. An attorney or tax advisor should be consulted for advice on specific issues.