Introduction
Retail ecommerce businesses are always hungry for capital. This is because a majority of the resources are spent on maintaining inventory levels for a smoother delivery operation. With inventory financing, you now have the ability to turn your biggest liability into an asset.
Short-term loans against inventory allow you to increase the cash flow into your business and acquire more operational capital. Before you go about sketching dreams of a big empire funded by the inventory financing option, read the below-detailed blog. We have covered every aspect of the concept so that you can understand every pro and con of the method before using it.
What is Inventory Financing?
Inventory financing is a method to raise working capital by using the inventory to be bought or existing inventory as collateral. Usually taken in the form of a credit line or a direct loan, this method of financing is typically used by newer and smaller companies that do not fulfill the criteria for a normal loan at financial institutions.
The capital acquired through this method is used to inject fresh cash into the operational supply chain. This allows businesses to meet the demand in the market without having to handicap themselves due to the lack of capital. Some businesses also use this method to free up the capital that is tied up in existing inventory levels to finance immediate operational and purchasing requirements.
While the interest rates are comparatively high, this method is quite effective for seasonal businesses. As these businesses do not enjoy the same demand and cash flow throughout the year, they can use their inventory as an asset to introduce additional cash flow into their businesses. Along with this, it also helps businesses raise quick cash in case of supply-demand fluctuations.
2 Primary Types of Inventory Financing
Before we dive into the concept of inventory financing, let’s understand the classification of inventory financing. This classification will enable you to understand your options in the market and make the right choice for your business.
1. Inventory Loan
Through this type of inventory financing, you will be able to avail of a loan for the market value of your inventory. The other terms, including the terms of repayment, will be similar to that of a standard loan. However, institutions may charge a higher interest rate given that the collateral inventory may fluctuate in value as well as can be a hassle to sell in case you default on your loan. The repayment can either be in monthly installments or a lump sum payment post the sale of the mortgaged inventory.
2. Inventory Line of Credit
In this type of inventory financing, the institution issues you a line of credit for the value of your current/future inventory. The main difference between a line of credit and a loan is that the line of credit enables companies to have access to rolling capital for the sanctioned amount. This means businesses can continue to have access to the capital for the sanctioned amount as long as the terms of payment declared in the contract are fulfilled. that need regular access to capital to finance their purchase orders or have longer payment terms.
How Does Inventory Financing Work?
Inventory Financing is a method used to introduce fresh or additional cash flow into a business. The capital raised can be used to purchase inventory / raw materials to generate stock for sale in the foreseeable future.
Instead of borrowing money against their assets or shares, private companies prefer to use the existing or future inventory levels as collateral for the capital. This is beneficial for companies that are relatively small or do not have enough cash flow to qualify for a loan for the required amount.
When raising capital through this method, the companies have to submit the intended or existing inventory levels to the lender. The lender then calculates the value of the inventory after factoring in various risks and potential market fluctuations. The sum of money for that value is then offered to the business in the form of a loan or line of credit, along with payment terms and interest rates.
Once the inventory has been sold, businesses will repay the bank/lender as per the terms stipulated in the contract. In case of default, the inventory will be used to reimburse the lender for the loan amount.
5 Factors Dictating the Interest Rates in Inventory Financing
Now that you have understood the ins and outs of the financing method, let’s take a look at some influential factors that you should consider before applying. These factors will essentially dictate the probability of approval, the interest rate as well as the flexibility in loan terms.
1. Resale Value of the Inventory
The retail value of the item and the resale value of the item will always be different. As the inventory is the collateral for the loan amount, the resale value of the product becomes crucial in determining the sanctioned amount and the terms of the loan.
2. Perishability
What good is the spoiled product to a lender? Therefore, the perishability of the products, especially in the FMCG and the Pharma sector, is a crucial factor that is considered. Along with this, the institutions will check the viability of the products over a period of time in the market. For example, a product that has surged in demand due to a trend can be considered perishable.
3. Logistical Restrictions
Not all products are transit friendly. If the inventory is bulky or heavy in nature, the resale value of the inventory as well as the resale probability is impacted. If the institutions see that the inventory can be difficult to sell in case of default, then they may consider it as a liability and increase the interest rate.
4. Depreciation/ Appreciation
The rate of depreciation or appreciation for your product is a crucial factor in determining the capital sum approved against your inventory. The depreciation factor may also impact the interest rate, and the payment terms as the banks will not want to hold on to something that is continuously losing its value.
5. Sales Record/ Performance History
While the value of the inventory and other factors are important, your sales record is probably the most important factor of all. Despite the value and the nature of the inventory, if the lender believes in your ability to sell the inventory, they are more likely to have flexibility regarding the rate of interest and payment terms.
5 Advantages of Inventory Financing
1. Acquire Operational Capital for Shorter Time Frames
For most consumer-focused businesses, a majority of their starting capital is tied up in inventory levels. However, there is a horde of other expenses while starting a venture. Inventory financing allows you to acquire operational capital against your inventory levels for shorter time frames so that you do not have to handicap your operations due to a lack of capital.
2. Enable better supply-demand management
Seasonal businesses always have to face a cash crunch in their off-season. By procuring finance against their future inventory levels, seasonal businesses can gear up for their season with ease. This also enables businesses to acquire inventory according to their demand in the market rather than their capital.
3. Beneficial for the MSME Sector
Even though the MSME sector is the backbone of any economy, banks and financial institutions do not lend capital due to a lack of assets. Therefore, inventory financing is instrumental in their growth as they can borrow capital per their needs.
4. Efficacious Use of Funds
A business cannot extract the complete value from the borrowed capital if the lender restricts its use. In the case of inventory financing, you can use the funds acquired to purchase inventory or raw materials, pay wages or pay for rent or utilities.
5. Easier Access
Getting a loan or finding an investor can be tedious and laborious. On the other hand, through this arrangement, short-term loans become accessible to smaller businesses. This will allow you to acquire and sell inventory at a much faster rate so that you can grow according to your business plan.
4 Disadvantages of Inventory Financing
1. Unavailable for Service Industry
The Service sector virtually has no collateral inventory against which finance can be acquired. Hence this method of financing becomes unavailable for all types of service businesses. This also includes modern-day businesses like SaaS, Law Firms, etc.
2. Impractical for Expansion Plans
Inventory financing is a loan or line of credit extended to a business till the inventory mortgaged is sold out. Essentially, it becomes a short-term loan arrangement. Therefore, while it is an effective way to raise working capital, this capital cannot be used to fuel expansion plans.
3. Higher Interest Rates
The collateral against the capital borrowed is volatile in nature. Considering the risks involved, financial institutions and lenders are more likely to charge higher interest rates. For example, a business loan from a bank will have an interest rate of anywhere between 6-10%. On the contrary, interest rates on the inventory loan can range anywhere between 11-30% depending on the nature of the inventory and the volatility of the business.
4. Hinders Growth for Newer Companies
With reduced profitability, the businesses won’t have as much capital left to invest in the sales cycle. Businesses won’t have sufficient cash to expand their operations or increase their productivity and profitability. This handicaps the newer businesses as they are thrown into a constant cycle of cash crunch.
Conclusion
We hope that you have given enough details for you to able to consider the full potential of Inventory Financing. The method can be used to get the starter capital and working capital for newer businesses. In return, while they do lower their profit margins due to higher interests, they get to keep their equity. This equity will come in handy when you want to raise funds in the future for expansion plans.
FAQs
1) What are the other alternatives to inventory financing?
The two main alternatives to inventory financing are Vendor Credit and Business Loan. Procuring the inventory on credit from the vendor requires you to have a long-standing relationship. Alternatively, securing a business loan requires a strong credit history and assets as collateral.
2) Are there standard methods to evaluate the inventory?
Yes, the lender will ideally use one of the three standard methods to evaluate your inventory - FIFO ( First In, First Out), LIFO (Last In, First Out), and WAC (Weight Average Cost).