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How Does Inventory Financing Work?

inventory financing
Lantern
LanternUpdated January 3, 2024
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Editor’s note: Lantern by SoFi seeks to provide content that is objective, independent and accurate. Writers are separate from our business operation and do not receive direct compensation from advertisers or partners. Read more about our Editorial Guidelines and How We Make Money.
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 take a look at how inventory financing works, costs associated with inventory financing, pros and cons of inventory financing, and alternatives to this funding option.

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 serves as 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 that you’ve used as collateral. 

Inventory Financing Example

Let’s say you own a wholesale clothing business that serves a wide variety of retailers. You expect sales to increase dramatically during the holidays and need to purchase twice as much inventory as usual to cover demand. But, how can you afford to purchase that much inventory while still maintaining healthy cash flow in your business?In a situation like the one described above, inventory financing may be helpful. 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 towards the inventory purchases and other business expenses. You then use the revenue generated from your holiday sales to pay back the lender.Because of the flexibility and cash availability inventory financing can offer, it’s a popular option for businesses that are seasonal and/or have 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 important things to keep in mind: 
  • If your inventory has low turnover, lenders may not be as willing to offer financing.
  • 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 seen as riskier to lenders, you may encounter higher interest rates than you might see with business loans or lines of credit, for example.
  • Inventory’s value can depreciate over time, creating a greater 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.
At the end of the day, it’s important to weigh all your financing options carefully so you can make a solid financial decision for your business. Recommended: How to Get Fast Business Loans

What Is an Inventory Loan vs. Inventory Line of Credit?

In addition to inventory loans, businesses can also obtain financing with an inventory line of credit (LOC). Like an inventory loan, businesses 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 on a quarterly basis. 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 that she is sure will sell. She still has $20,000 available to use on 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 was able to sell. Once the $30,000 is repaid, she has access to 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 of time. 
Keep in mind that because an inventory line of credit can pose a greater risk to the lender, interest rates may be relatively high. An inventory loan, on the other hand, may be a better business loan option to be used 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. It’s notable that 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.

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’ 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: Costs to send someone out to inspect and appraise the value of inventory and a business’ inventory management system.
  • Prepayment fees: Fees incurred if a borrower repays the loan early (i.e. ahead of the terms set by your lending agreement).
  • Late fees: Fees incurred if required payments get made late. 
Recommended: 19 Types of Business Loan Fees

Interest Rates

Interest rates on inventory financing can range drastically. But, generally, banks will offer favorable rates to eligible borrowers, while other lenders may offer much higher interest rates. Typically, borrowers can expect the following interest ranges for specific types lenders:
  • Banks: 8% and up
  • Online lenders: 8% to 99%
  • Inventory financing company: 8% to 20%

How to Calculate the Cost of Inventory Financing

The costs of inventory financing will vary depending on if you have a loan or line of credit. With a loan, you’ll receive your rate and terms after applying. If your rate is 10%, for example, you would multiply your loan amount by 10% to give you the cost of the loan, including interest.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 are typically 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, so you’ll need to factor those into the total cost of borrowing, as well.

Pros and Cons of Inventory Financing

To decide if inventory financing is right for you, it’s best to weigh the pros and cons.

Pros of Inventory Financing

The biggest advantage of inventory financing is 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 fast approval and funding times. Startups and businesses with less than perfect credit may have an easier time qualifying for inventory financing as opposed to other forms of small business loans.

Cons of Inventory Financing

Like most types of small business financing, the biggest disadvantage to inventory financing is fees and rates may be high, especially for startups or businesses with poor credit.Another con is if you are 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 of inventory financed. Most lenders will lend 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 only lending a percentage of the total value helps protect the lender from additional losses.

Who May Apply for Inventory Financing?

Businesses that are well-established, have proven revenue history, and have high turnover on inventory 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 alternate 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.

Applying for Inventory Financing in 5 Steps

So, you’re thinking about inventory financing, but where do you go to get it? There are a number of lenders that offer inventory loans and lines of credit, including traditional banks, online lenders, and inventory finance companies. The following steps could 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, take a close look at patterns in sales volume and seasonality, and consider economic factors that may affect customer activity, as well. Overestimating your needs can leave business owners with hefty payments and unsold inventory, while underestimating these needs can leave businesses scrambling for sellable inventory or needing 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 is difficult to sell or you don’t have experience with, some lenders may choose not to lend, 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 further assess the likelihood of eligibility for obtaining an inventory loan or line of credit. As with other types of funding, traditional banks are typically the most difficult to borrow from, but they may also 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 common 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. If your industry is in-flux or your customer base is spending less due to a current event, for example, lenders may be less likely to extend funding. 

3. Choosing an Inventory Finance Lender

If you meet the initial loan qualifications stated in the previous step, then you may want to begin comparing lenders that align with your specific 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 make sure to apply for those which meet your specific inventory needs.Recommended: Large Business Loans

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 who offers options like an inventory line of credit may be of interest.It’s important to carefully choose a lender and only apply 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’ 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:
    • Inventory turnover
    • Inventory gross profits
    • 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 its storage facilities to assess its value, making sure the lender is taking on a manageable risk. Even after a business receives an inventory loan, lenders may still 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. Frequently, lenders will also require regular audited financial statements from the business they loan to.

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 and offered by banks and approved SBA lenders. SBA loans typically take longer to process, but 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 line 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 similar loan options as a traditional bank, but typically have a faster approval process and may offer more options for people with lower credit scores.
  • Merchant cash advance: 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: Sell your invoices to a factoring company who is then responsible for collecting payment from your customers.

The Takeaway

As an established small business, you have options to choose from when it comes to financing. But, how do you know which one is right for your situation? Whether you need quick cash or a long-term solution, Lantern Credit is ready to help you find the right solution.By filling out one simple application, you’ll be able to compare online small business lenders that suit your unique needs. Whether you need an inventory loan or an installment loan, Lantern has the tools to help your business secure the capital it needs to succeed.

Frequently Asked Questions

How does an inventory loan work?
How do you calculate inventory financing costs?
What are the disadvantages of inventory financing?
What is the interest rate for inventory financing?
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About the Author

Lantern

Lantern

Lantern is a product comparison site that makes it easy for individuals to shop for products and compare offers with top lenders. Lantern is owned and operated by SoFi Lending Corp., the digital personal finance company that has helped over one million people get their money right.
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