April 18, 2022
Explainer

A guide to inventory financing: How it works, and choosing the right financing options for your business

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Cash is the lifeblood of every growing business. There are many business financing options available to you, such as venture capital and business lines of credit. However, securing financing through your inventory is potentially the best choice.

In this guide to inventory financing, you'll learn how your inventory can act as a great source of urgent cash along with the following:

What is inventory financing?

Inventory financing is a loan or line of credit collateralized by the borrower's inventory. For instance, a retailer can borrow money from a bank and place its existing or future inventory as collateral. If the retailer defaults, the bank will seize and sell the retailer's inventory to recover the loan principal.

Businesses seek inventory financing from specialized lenders since banks offer this option to established or well-capitalized companies with strong balance sheets. (If you need to learn how to create a balance sheet see our guide).

 

Which businesses benefit the most from inventory financing?

Companies that rely on large inventory stores to drive business will benefit from inventory financing. It allows them to monetize non-liquid assets on their balance sheets. Here are a few example businesses that benefit from inventory financing:

  • Retailers: General and specialty retailers rely on inventory to drive sales. They can use future inventory purchases as collateral and raise cash.
  • Wholesalers: Wholesalers warehouse large amounts of inventory. As with retailers, they can use these stores to raise cash.
  • Vehicle dealerships: Vehicle dealerships face huge inventory costs that cash flow cannot cover. Inventory financing is a great option for these companies, too.
  • Companies in seasonal sectors: If a company faces cash shortfalls at certain times of the year, inventory financing can smooth cash flow.

How does inventory financing work?

Companies that need cash can borrow money from lenders based on their existing or near-term inventory values. For instance, a clothing wholesaler might need to purchase $500,000 worth of inventory to account for increased demand.

Instead of paying cash and pushing its working capital levels dangerously low, it can use inventory financing. The company can apply for financing and receive 80% of the inventory value from a lender ($400,000), It can use this cash to fund purchases and later pay the lender back from sales.

While the process sounds simple, keep these factors in mind:

Financing costs

Keep the following costs in mind when applying for inventory financing:

  • Loan application fees: Lenders will charge you for reviewing your application.
  • Appraisal fees: Lenders will appraise your inventory value and charge you for their time.
  • Early repayment fees: Lenders will charge you a penalty for paying them back ahead of schedule.
  • Late fees: Pay lenders too late, and you'll be charged a fee.

Interest rates

Pay special attention to interest rates since they determine whether inventory financing is a good option for you.

Banks will offer the lowest rates, ranging between 3-6%. Inventory financing specialists will usually charge between 8-20%. Online lenders offer different options, and their rates can range from 5% to an astronomical 99%.

Qualification criteria

Qualifying for inventory financing can be tough for some businesses. Here are some criteria your business must fulfill:

  • Actively trade for at least one year before the loan application.
  • Sell physical products, not services.
  • Have a profitable track record in your industry.
  • Demonstrate ability to sell inventory (marketing plan, sales outlets, payment capture systems, etc.)
  • Accurate inventory projections.
  • Up-to-date tax returns without liens.

Some lenders might impose additional criteria depending on the application. Before applying, consider whether your business stands a reasonable chance of receiving approval.

Field audits

Before approving your application, lenders visit your facilities and inspect your inventory. Called field audits, these visits are critical to the approval process. After approval, lenders might pay surprise visits to your facilities to check whether your inventory is stored correctly.

In addition to inventory, inspectors will evaluate your storage systems, software, and related processes. It's best to invest in inventory management systems and train your employees in best practices before applying for inventory financing.

Inventory loan versus inventory line of credit

There are two forms of inventory financing. Your company might receive either a business loan or a line of credit (aka LOC). Here are the differences between these options.

Inventory loan
Inventory LOC
One-time cash injection
Revolving credit limit that decreases as you draw from it
Suitable for large, one-time purchases
Suitable for long-term cash requirements
Relatively low interest rates
Higher interest rates compared to inventory loans
Regular qualification criteria
More stringent qualification criteria
Added to liabilities on balance sheet
Amount added to your liability account depends on credit limit drawn

Pros and cons of inventory financing

Inventory financing has its advantages and disadvantages:

✅ Pro : Meet consumer demand quickly

If you can predict seasonal customer demand, inventory financing can help you plug cash flow holes while addressing that demand. For instance, a retail company can plug cash flow holes caused by increased procurement expenses during the holiday season.

Lenders specializing in the retail sector will evaluate your finances quickly and offer you tailored terms, helping you quickly address working capital needs.

✅ Pro: Simple collateral terms

Inventory financing demands inventory as collateral and nothing else. In contrast, banks can demand a combination of inventory, real estate, and other fixed assets to help them cover the risk of a business loan.

✅ Pro: Credit score is less important

Almost every financing option demands a healthy credit score. However, inventory financing is great for businesses with smaller credit histories since inventory quality is all that matters to lenders.

❌ Con: Tough approvals

While the inventory financing process is simple, qualifying for financing can be tough. If you're running a new business, opting for personal or private financing is the best option. Inventory financing criteria emphasize experience and profitable track records in your sector. Without these, qualifying is tough.

❌ Con: High interest rates

While banks offer low inventory financing rates, these rates can be higher than those on traditional business loans. Thus, if your credit score is impeccable, opt for a traditional loan.

How can you apply for inventory financing?

Applying for inventory financing is straightforward. However, you must prepare beforehand to ensure you experience a smooth process.

Step #1: Check eligibility and determine the sum you need

Before applying, take the time to check financing eligibility criteria with various lenders. While most lenders apply ad-hoc criteria upon receiving your application, all of them impose some common conditions. These conditions might make other financing options a better choice.

If your business is eligible, determine the cash you need. Rely on the right financial forecasting tools to estimate capital needs and project the amount you should borrow.

Step #2: Evaluate potential lenders

You have many options in the inventory lending field. You can choose a bank, an online lender, or a specialized firm. Each option has its pros and cons. A bank will offer low interest rates but have the strictest eligibility criteria.

Online lenders have the most lenient criteria but will demand high interest rates the fewer criteria you fulfill. Specialized firms will offer you customized terms, but they might not be willing to lend you the entire amount you need.

Step #3: Gather documents

Lenders will demand detailed documents connected to your business. Here are the documents you will need, at a minimum:

  • Accounting statements including balance sheets, income statements, and cash flow statements
  • Inventory lists that show turnover, loss, and damage rates
  • Projected inventory needs
  • Gross margin breakdowns
  • Business tax returns
  • Business bank account statements
  • Sales forecasts
  • Financial projections

Step #4: Apply and review offers

Before offering you terms, lenders will conduct field audits of your facilities. Make sure you understand the loan or line of credit's terms fully. Choose the best option for your business and sign the relevant documents.

What are the alternatives to inventory financing?

Inventory financing might not offer your business the best options. Here are other financing avenues you can choose.

Government loans

Governments worldwide offer businesses loans and schemes to leverage. For instance, the United States Small Business Administration (SBA) loans are a great option for businesses of qualifying size. Check to see which options are available to you and apply accordingly.

Personal loans

Personal loans are a good choice if your funding needs are small and you're certain of your ability to repay the loan on time. You can apply for personal loans with your bank or online. Typically, interest rates on personal loans are lower than on business loans, making them an excellent funding choice.

Venture capital

If your funding needs are significant, consider approaching a private investor or venture capital (VC) firm. VC firms usually invest in technology-driven companies and are a great option if you're selling a SaaS product.

Even if your company isn't tech-oriented, private investors can fund your business and help it overcome funding issues. Alternatively you could look at corporate credit cards as a source of startup finance.

Merchant cash advances

If you need cash right now and are certain you'll pay it back within a month, a merchant cash advance is a good choice. The approval process is quick, and you'll have instant access to cash. The issue is you'll be borrowing against future earnings at astronomically high interest rates. Hence, it's best to rely on them for a very short while.

Invoice factoring

Also called accounts receivable financing, invoice factoring companies lend you money against the value of uncollected invoices. For instance, if you have $500,000 in uncollected customer invoices, you can "sell" them to a factoring company at a 20% discount ($400,000).

The factoring company assumes the risk of your uncollected invoices, and you receive cash. If your company faces lengthy customer credit cycles, invoice factoring is a great choice. Note that approval times can be lengthy, with qualification criteria similar to inventory financing.

Combining different forms of financing

You can combine different forms of financing to lower your cost of debt. For instance, you can use an inventory line of credit to address long-term capital needs and draw a merchant cash advance for a quick cash injection. 

Much depends on the quality of your financial processes and projections. For instance, if you're making common spend management mistakes, minimizing debt financing is your best choice. If you face seasonal and predictable cash deficits, inventory financing or invoice factoring is a good choice.

How Ramp can help you fund your inventory with commerce-sales based underwriting

Many companies face unique challenges when accessing financing options. Cash-based underwriting does not take your needs into account. Ramp's commerce sales-based underwriting offers a solution that is tailor-made for your business.

Access up to 30X higher credit limits than traditional offerings

Thanks to Ramp's commerce sales-based underwriting and connections to popular commerce platforms such as Stripe, Shopify and Amazon Business, you can access higher credit limits and deploy more capital toward inventory.

Streamline expense management

Expense and spend management are key to securing funding regularly. Control these functions in your company using finance automation tools, and you'll boost your margins and create robust working capital positions.

 

E-commerce expense management relies on a range of SaaS apps to execute workflows. With Ramp's centralized vendor management feature, you can control SaaS spending from a single platform and eliminate duplicate spending.

Ramp helps you collect employee receipts within 30 minutes, not days, thanks to AI-powered matching.

Build approval workflows to account for rapid growth and pre-approve expense categories to streamline expense management.

Build business credit and save money

Boosting your business' credit score can help you land lower interest rates, drastically reducing the cost of debt financing. Ramp's corporate credit card doesn't just help you build credit: It also saves you money.

Ramp's real-time reporting will give you insight into spending trends and potential savings.

By gaining control of your expenses, Ramp helps you build a strong financial position that will satisfy lenders and lower your cost of financing. In turn, you can use inventory and other assets to draw cash and push your business to new heights. 

Learn more about how Ramp can help you save time and money

Learn how Ramp strengthens your finances

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FAQs
Is inventory financing the best option for my business?

If your business depends heavily on selling inventory to finance future purchases and faces seasonal demand, inventory financing might be your best choice. If you're unsure of collection times and have a strong credit history, traditional business loans or private investment might be better options.

What is the difference between an inventory loan and an inventory line of credit?
Inventory loan
Inventory LOC
One-time cash injection
Revolving credit limit that decreases as you draw from it
Suitable for large, one-time purchases
Suitable for long-term cash requirements
Relatively low interest rates
Higher interest rates compared to inventory loans
Regular qualification criteria
More stringent qualification criteria
Added to liabilities on balance sheet
Amount added liability account depends on credit limit drawn

What are the costs associated with inventory financing?

Here are the costs you will incur when opting for inventory financing:

  • Loan application/origination fees 
  • Appraisal fees
  • Early repayment fees
  • Late fees 

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