What is Inventory Financing and How Does it Work?

There are two main types of inventory financing: loans and lines of credit.

• Inventory loan: An inventory loan is a lump sum amount a borrower can access to secure inventory. The amount issued is based on the total value of the inventory, and the borrower will need to make fixed payments over the life of the loan, which include interest and fees. Inventory loans can be part of a broader working capital loan strategy to ensure your business has the necessary funds to cover other operational costs as well.
• Inventory line of credit: This revolving debt allows you to borrow up to a certain limit. Like a credit card, you can continue to draw from the line of credit if you meet minimum payments and other lender requirements. A working capital loan can complement an inventory line of credit by providing additional liquidity for managing day-to-day expenses.

Inventory financing offers several advantages for growing businesses looking to secure sufficient inventory to meet customer demands.

Pros of inventory loans

• Easier access to funds: While many lenders require a certain personal or business credit score to qualify for a loan, inventory financing may be easier to access since the inventory will back the loan as collateral.
• Faster business growth: Inventory financing is intended to help companies increase inventory to meet growing customer demand. By receiving funds upfront, companies are able to scale more quickly when compared to companies that wait for income generation to support the purchase of additional inventory.

Cons of inventory loans

• Interest and fees: New and growing businesses may struggle to pay back the cost of an inventory loan if the interest rate and fees are too high.
• Approval challenges: Financial institutions will assess the riskiness of your business and products/services when you apply for an inventory loan during a period known as due diligence. This process can take significant time and resources. If the lender believes that you may have difficulty selling the products, they may decide not to approve your loan.
• Partial funding: If your business requires a significant amount of inventory, lenders may be willing to finance only a portion. You'll need to shop around and research various lenders to find one that will provide sufficient capital to meet your needs.

Inventory financing is typically used by established companies like wholesalers, retailers, and seasonal businesses that can prove that their products are selling in the market. Lenders generally won’t lend to a brand-new business that wants the loan to purchase the first round of inventory. Companies in the startup phase may have better luck applying for startup loans instead.

Applying for inventory financing involves several steps, similar to other types of loans.

1. Understand eligibility requirements: Though lender requirements vary, you may need to prove that you’ve been in business for at least a year and furnish the sales records to prove it. The lender is likely to be especially interested in inventory metrics, including inventory turnover, profits, and projections for the upcoming quarters. If you don’t have a system that clearly tracks inventory, you may need to put a process in place that allows you to easily follow merchandise through your product lifecycle and share reports with potential lenders accordingly.
2. Apply for a loan: Once you confirm your business is eligible for a loan, you’ll need to submit an application either online, over the phone, or in person. When you apply, you may need to submit financial statements, including balance sheets and profit and loss (P&L) statements for the prior few years. In addition, you’ll likely need to share a full inventory list and your plans for future inventory that you plan to acquire with the loan.
3. Assist the lender during the due diligence period: Due diligence is the period when a lender vets your business to confirm whether you should receive funding. At this time, lenders may request additional documentation as they comb through your company records and inventory or even ask to visit your offices or the site where you hold your inventory.
4. Review the lender’s preliminary offer: During the due diligence process, you may receive a preliminary offer outlining loan specifics, including the amount, interest rate, repayment terms, fees, and prepayment penalties. While this isn’t an official contract, signing it can demonstrate your seriousness about taking on the loan.
5. Wait for approval and sign the loan contract: If approved, you’ll receive an official loan contract with final details about the amount borrowed, repayment terms, and interest rate. Once you sign, the lender will issue funds in accordance with the contract. Then, you’ll be able to use funds to purchase inventory and begin paying back the loan according to the terms of the contract.

What collateral is required for inventory funding?

Inventory financing primarily requires your inventory as collateral. Lenders will evaluate the inventory's value and quality to determine the loan amount. In some cases, additional collateral or personal guarantees might be needed, depending on the lender's requirements and your business's financial condition.

What are the risks of inventory financing?

Inventory financing comes with risks such as high costs, with potentially higher interest rates and fees. Approval can be challenging if lenders view your inventory or business as risky. Additionally, if your inventory doesn’t sell or becomes obsolete, repaying the loan can strain your cash flow.

How does inventory financing impact a business's financial statements?

On the balance sheet, the inventory loan increases your liabilities as it represents a financial obligation. The inventory used as collateral will appear as an asset, potentially boosting your current assets. On the income statement, interest and fees from the financing will be recorded as expenses, impacting your net profit. Additionally, the increased inventory can lead to higher sales, which may improve revenue, but this depends on how well you manage and sell the stock. Understanding these impacts can help with your financial planning and reporting.