Inventory Financing: Definition, How It Works, Pros, and Cons

What Is Inventory Financing?

The term inventory financing refers to a short-term loan or a revolving line of credit acquired by a company so it can purchase products to sell at a later date. These products serve as the collateral for the loan. Inventory financing is useful for companies that must pay their suppliers for stock that will be warehoused before being sold to customers. It is particularly critical as a way to smooth out the financial effects of seasonal fluctuations in cash flows and can help a company achieve higher sales volumes by allowing it to acquire extra inventory for use on demand.

Key Takeaways

Inventory financing is credit obtained by businesses to pay for products that aren't intended for immediate sale.
Financing is collateralized by the inventory it is used to purchase.
Inventory financing is often used by smaller privately-owned businesses that don't have access to other options.
Businesses rely on it to keep cash flow steady, update product lines, increase inventory supplies, and respond to high demand.
Although businesses don't have to rely on personal or business credit history and assets to qualify, they may be stressed by additional debt if they're new or struggling.

How Inventory Financing Works

Inventory financing is a form of asset-based financing. Businesses turn to lenders so they can purchase the materials they need to manufacture the products they intend to sell at a later date. The reasons why they rely on this kind of financing include:

Keeping cash flow steady through busy and slow seasons
Updating product lines
Increasing supplies of inventory
Responding to (high) customer demand

This kind of financing is common for small to mid-sized retailers and wholesalers, especially those with a large amount of available stock. That's because they typically lack the financial history and available assets to secure the institutional-sized financing options larger corporations are able to access, such as Walmart (WMT) and Target (TGT).

Because they are generally private companies, they cannot raise money by issuing bonds or new rounds of stock. Companies may use all or part of their existing stock or the material they purchase as collateral for a loan that is used for general business expenses.

Some banks are wary of inventory financing because they don't want the burden of collecting the collateral in case of default.

Special Considerations

Banks and their credit teams consider inventory financing on a case-by-case basis. They look at factors like resale value, perishability, theft, and loss provisions as well as business, economic, and industry inventory cycles, as well as logistical and shipping constraints. This may explain why so many businesses weren't able to get inventory financing after the credit crisis of 2008. When an economy is mired in recession and unemployment rises, consumer goods that aren't staples remain unsold.

Depreciation is another factor lenders consider. And not all forms of collateral are equal. Inventory of any kind tends to depreciate in value over time. The business owner who seeks inventory financing may not be able to obtain the full upfront cost of the inventory. As such, any potential hiccup is factored into setting an interest rate on an asset-backed loan.

Inventory financing is not always the solution. Banks may view inventory financing as a type of unsecured loan. That's because if the business can't sell its inventory, the bank may not be able to either. If a retailer or a wholesaler makes a bad bet on a trend, the bank could get stuck with the goods.

Inventory financing is also known as warehouse financing.

Advantages and Disadvantages of Inventory Financing

There are a variety of reasons why businesses may want to turn to inventory financing. But while there are plenty of positives, there are downsides as well. We've listed some of the most common ones below.

Advantages

By turning to lenders for inventory financing, companies don't have to rely on their business or personal credit ratings or their financial history. Smaller business owners don't have to put up their personal or business assets in order to secure financing.

Being able to access credit allows companies to sell more products to their consumers over a longer stretch of time. Without financing, business owners may need to rely on their own sources of income or personal assets in order to make the purchases they need to keep their operations going.

Businesses don't need to be established to be eligible for inventory financing. In fact, most lenders only require companies to be up and running for a minimum of six months to a year in order to qualify. This allows newer business owners to access credit quickly.

Disadvantages

New businesses may already be saddled with debt as they try to establish themselves. Getting inventory financing can add to their liabilities. As a result, these companies may not have the means to repay, which can lead to restrictions on future credit as well as an undue burden on existing finances.

In some cases, lenders may not issue the full amount required to purchase inventory. This can lead to delays and shortfalls. This may be common in the cases of newer businesses or those that have a harder time securing the amount of money they need to keep their operations running smoothly.

The costs to borrow may be high. Fees and interest rates may be high for businesses that are struggling. Having to pay more in additional charges may put more stress on these companies.

Pros

Businesses don't need to rely on business credit ratings/history and assets to qualify
Companies can sell more products to customers over longer periods of time
Newer businesses are eligible and can access credit quickly

Cons

Repayment may be problematic for new and struggling companies
Lenders may not advance the full amount requested
Fees and interest rates are higher for new and struggling businesses

Types of Inventory Financing

Lenders provide businesses with two different kinds of inventory financing. The option that the company chooses is dependent on its business operations. Interest rates and fees depend on the lender and the type of business.

Inventory Loan: Also referred to as term loans, this kind of financing is based on the total value of the company's inventory. Just like a regular loan, the lender issues the company a specific amount of money. The company agrees to make fixed payments every month or to pay the loan off in full once the inventory is sold.
Line of Credit: This form of financing provides businesses with revolving credit. Unlike a loan, it gives them regular access to credit as long as they make regular monthly payments to satisfy the terms and conditions of the contract.

Are There Any Risks Associated With Inventory Financing?

Inventory financing tends to be fairly risky, which is why interest rates tend to be higher compared to other kinds of loans. These loans are short-term and thus, must be paid back sooner. Another key risk is that the borrower may not sell some or all of the goods that serve as the collateral for the loan, which means they may end up in default.

What Are Inventory Financing Costs?

Inventory financing allows companies to borrow to pay for products that they plan to sell at a later date. This inventory is used as collateral for short-term loans or lines of credit. The costs associated with this type of financing include interest rates, origination fees, and prepayment fees if the loan is paid off earlier than expected. Other charges include late payment charges and late payment fees, if any.

Why Do Businesses Use Inventory Financing?

Inventory financing is a form of short-term borrowing. Companies tend to use it as a way to pay their suppliers before selling their products. It is often used by small or mid-sized businesses that may not be established or have a credit history. It also allows these businesses to access financing without having to put up their business or personal assets for collateral.

The Bottom Line

Businesses need cash in order to fund their day-to-day operations, and they have several options in order to secure financing. Inventory financing is just one way. Companies can get cash using the products (or inventory) they intend to sell as collateral. While it can provide a quick injection of cash, borrowers should be weary of the costs and risks associated with inventory financing.