How to Find Inventory Financing for Your Small Business
All businesses, small and large, product- or service-focused, are somewhat at the mercy of supply and demand. If you don’t have the supply to meet the demand, you’re likely to endanger existing or potential customer relationships.
On the flip side, if supply exceeds demand — especially if you’re distributing tangible goods — you could wind up in a precarious financial situation, especially if your business is relatively new. Keeping enough goods in stock without depleting your operational cash is a delicate balance. Enter inventory financing.
What are inventory loans?
Inventory loans are exactly what they sound like — short-term loans or lines of credit provided to business owners to buy more inventory, which itself serves as the collateral. The most common type of businesses that turn to this financing option are retailers and wholesalers, especially those with seasonal business cycles or who are looking to grow their business or launch a new product. It might also come in handy if a business owner gets an offer of inventory at big discount, but doesn’t have the cash on hand to make the purchase.
Businesses largely reliant on international vendors are also often in need of inventory financing, as there can be a lag between paying for supplies and receiving the goods.
While many business owners use inventory financing to purchase additional stock, others leverage the value of their existing inventory to secure funding for other needs or to stabilize cash flow during cyclical lows.
How does inventory financing work?
Inventory financing most often takes the form of a traditional loan or a line of credit. The line of credit is the more common option, with the lender providing access to a set limit of funds. The borrower can then draw only what’s needed, and pay interest only on the cash that’s used.
Loan products are typically shorter-term with frequent payment terms (weekly or even daily) and may also have higher interest rates. While each inventory loan is a one-time transaction for a predetermined amount, lines of credit are revolving and can be borrowed against as needed, during seasonal slowdowns or ahead of anticipated growth spurts.
Borrowers can’t expect inventory financing to cover all of their needs, as lenders typically only finance a percentage of the inventory’s appraised value (usually no more than 80 percent). This appraised value is based off the Net Orderly Liquidation Value (OLD) or Forced Sale Liquidation Value (FLV), or the amount the inventory could reasonably fetch if sold at auction. Both figures can be significantly below perceived market value.
For example, let’s say you run a gourmet food store and would like to purchase $100,000 in non-perishable inventory. An independent appraiser determines the liquidation value is $70,000, so your lender agrees to fund $56,000 (80 percent of $70,000) of the $100,000 you need.
How likely are you to qualify for inventory financing?
Like most small business loans, good credit and a proven sales history (usually at least a year’s worth) help with getting approved and securing a favorable interest rate. Another vital factor for inventory loans, however, is a track record of efficient inventory management. A lender wants to see that a potential borrower’s inventory has successfully moved off the shelves in the past. Just as important is a detailed sales plan for the future. If a business plans to increase its inventory, are the sales projections there to support it?
Are there additional inventory financing options?
There are non-traditional alternatives that may not have as stringent an approval process as a term loan or business line of credit. In exchange, the repayment terms may be more aggressive or the interest rates higher.
Businesses can sometimes negotiate a vendor line of credit to get inventory delivered upfront and pay for it in 30 to 60 days, either in full or through installment payments. This is a good option for startups that have limited financing options, but the vendor will likely check your credit and may assess fees or late payments, if necessary.
Online lenders offer inventory financing as well, but while the funding may be quicker than traditional lenders, the interest rates are likely to be significantly higher.
What are the pros and cons?
- Since inventory financing is secured with the collateral of the inventory itself, borrowers with less-than-perfect credit may qualify, though some lenders may also require additional collateral
- Access to extra capital can have other business benefits, such as the ability to negotiate bulk discounts from vendors
- A line of credit can increase as the business grows
- Loan minimums can be high ($500,000 in some cases), and interest rates can be higher than other financing options
- Failure to repay the loan or line of credit will likely result in the inventory being repossessed
- A more intimate relationship with your lender. Surprise inspections or appraisals of the inventory (AKA the lender’s collateral) might be part of the deal.
- Lenders will only finance a portion of the needed inventory, so you’ll still need to make up the difference elsewhere
How do I apply?
With the exception of vendor lines of credit and online lending options, inventory financing is not a get-funding-quick option, so prepare to be patient. The approval process requires layers of due diligence from the lender, who needs to survey the inventory carefully and audit the business.
Expect to walk through several steps during the review process.
- Like any request for financing, you’ll want all of your paperwork handy. Assemble your profit and loss statements, balance sheets, sales records, bank statements and tax returns (both personal and for your business).
- Since inventory is at stake, you also want to provide documentation on your inventory: what you already have, what it’s worth, where it lives, any history of damage or loss, and a look back at how quickly it has sold in the past. You also want a detailed plan of the inventory you plan to acquire with the funding, as well as sales projections.
- Once you determine what financing option is best for your business (line of credit or term loan), complete an application. Most lenders will have an online version for your convenience.
- If your credentials are positive, the next step is for the lender to examine the inventory itself, a task that may result in additional costs to the business owner. The lender might want the following:
- A field visit to the business operations and a review of the inventory management system
- A review of the business’s accounting
- An appraisal of the inventory, including any applicable raw materials
- Following this deep dive into the particulars of your business, it’s time to wait for the final decision. If it’s a positive one, there will be a little bit of paperwork before the funds are yours.
The bottom line
Inventory financing is a good choice for a particular niche of business. This includes ones that distribute products (instead of services), have expected fluctuations throughout the year, and occasionally struggle with maintaining steady cash flow, but are also large enough to warrant the minimum loan size that many lenders require.
At the same time, the best candidates for inventory financing can demonstrate a sales record of products that can retain their value for months or years (making them a worthwhile investment for the lender). Smaller businesses that are just starting out or whose owners are unsure of their sales cycles may fare better negotiating lines of credit with their vendors, or exploring other financing options.