Is Inventory Financing Right For You?

One of the most difficult aspects of running any business is inventory—maintaining sufficient inventory, buying new inventory, or obtaining financing for purchases in the first place. Nearly 42% of business owners report cash flow problems, so you might just have to take out a loan to be able to afford new inventory.

What is Inventory Financing?

All loans essentially fall into two categories: secured and unsecured. Secured loans are backed by collateral, which serve as a guarantee that borrowers will not default on their obligations. Collateral for a business loan is diverse, and can consist of anything from equipment (such as a bakery’s industrial-strength ovens), to a business automobile (such as a delivery van).

Anytime an entrepreneur takes out a secured loan, they are borrowing against their own assets—and banks are betting that they’ll pay off the loan on time, rather than risk giving up valuable business equipment or property.

What types of businesses should consider inventory financing?

As the name suggests, inventory financing is one type of secured loan where entrepreneurs use their inventory as collateral for capital, often in the form of a revolving line of credit.

Take the example of a high-end bicycle shop, which sells a wide range of expensive mountain, road, and hybrid bikes that can easily run into the thousands of dollars. If the shop is getting a lot of business, the owner will likely want to purchase more bikes, components (from which to assemble bikes), and other accessories—all of which require capital.

As a result, the entrepreneur takes out a loan against his bikes. The lender will then give the entrepreneur an advance that is a certain percentage (for instance, at 50-70%) of the appraised value of the bikes. As each bike is sold, a portion of the revenue goes towards paying off the advance; the loan is slowly settled one bike at a time.

What are the benefits and drawbacks of inventory financing?

As with other loans, inventory financing has considerable weaknesses and advantages that require a closer look:

Benefits

Since inventory financing is a type of secured loan, many lenders consider it a low-risk type of financing. As a result, the barriers to entry are relatively low. Inventory financing doesn’t rely so heavily on your credit score. Additionally, due to a lower perceived risk, lenders may offer a faster turnaround with less paperwork.

When it comes to borrowers, inventory financing is also a less risky proposition. Entrepreneurs won’t face penalties like high-interest rates, closing fees, or prepayment penalties.

Drawbacks

Unfortunately, inventory financing does still have a number of problems. Some lenders may actually consider inventory financing a poor investment and refuse to grant such loans altogether. After all, physical inventory is vulnerable to damage, theft, and natural disasters.

Additionally, inventory financing does require both preparation and maintenance. Because the loan is assessed as a portion of the value of the inventory, it must be accurately and fairly appraised by expensive specialists—not just during the planning process, but also periodically afterwards due to depreciation.

Keep in mind that it’s in the interest of both the specialist evaluator, as well as the bank, to declare that the appraised value of your inventory is lower than the the actual market price. After all, should you default on the loan, the bank has to seize these assets—and then sell them off to recoup their loss. In order to turn a profit, lenders may well undervalue your assets, which will, of course, lead to a smaller loan.

Is the tradeoff worth it?

Ultimately, inventory financing can be a suitable stopgap that helps your business replenish its valuable assets during highly profitable seasons and dry spells. But as with all other types of secured and unsecured loans, inventory financing comes with its own set of surprising risks. Be sure to read up as much as possible on the ups and downs and consider the fine print before moving ahead with any business loan.