As a business owner, it is common to experience a shortage of working capital. This could result from late invoice payments, unplanned expenses like equipment breakdown, or several other circumstances beyond your control. If you find yourself in this tight financial spot, it’s only natural to consider getting a loan.
Inventory financing is one of the most popular loan options for small business owners, but there are many entrepreneurs who aren’t familiar with the process. At this point, you might begin to wonder, “What is inventory financing? Can I get a loan on inventory?” Well, the answer is yes, and you can potentially take your business to the next level by leveraging a financing option of this caliber.
Read on to get answers to the questions you may have on inventory financing and, more importantly, whether it’s a suitable avenue for your business.
What is an Inventory Loan?
An inventory loan is an asset-based loan granted to business owners based on the value of their inventory. Inventory financing is used mainly by businesses with consistently large quantities of inventory, such as wholesalers, retailers, and even restaurants.
The lender grants you a loan for a percentage of the inventory’s value, with the inventory acting as collateral. Inventory loans are commonly used for purchasing more stock, but the business owner can choose to spend it on other business expenses. If you have a short-term cash flow gap or you want to stock up for a peak season, an inventory loan can help—It might be what you need to grow and outpace your competition.
Most inventory loan providers do not ask for a personal guarantee. This guarantee pierces the corporate bubble and makes you legally obligated to cover the loan with your personal funds if you can’t repay it with business funds. Pursuing this route gives you access to a short-term loan while keeping your corporate protection intact.
How Inventory Financing Works
Inventory financing is similar to traditional bank loans. You can get an installment loan or line of credit, but inventory becomes the collateral. As a result, you can’t borrow money equal to the entire inventory. For instance, if you have $10,000 in inventory, you may only be able to borrow $5,000 to $8,000, depending on the bank, the inventory, and other factors. You can repay the loan over monthly installments or after you sell your inventory. Inventory financing is a popular short-term loan for small businesses.
You can use inventory financing to get capital from inventory sitting on the shelves or use this funding option to purchase inventory. The latter option is useful for business owners who have seasonal businesses. Buying Christmas ornaments in the summer with inventory financing allows businesses to prepare for the holiday season, a time that ornaments will be in greater demand and sell for higher prices. This funding source is also popular with retailers and wholesalers.
How Do You Borrow Money Against Inventory?
When you apply for inventory financing, the lender provides you the capital as a term loan or a line of credit. The way this type of financing works will depend on how the product is structured.
Similar to real estate or equipment loans, inventory financing lenders do not give loans that are equal to the full value of the inventory you’re going to purchase. In most cases, they will finance about 50% to 80% of the inventory’s appraised liquidation value, which is often lower than the market value of the merchandise. The lender, seeking to protect themselves from a potential default, is assured that even if your business is unable to pay the loan, they’ll still be appropriately compensated. Receiving less than full value only becomes an issue if you cannot repay the loan. Selecting a sufficient amount for your short-term loan can provide enough cash flow while minimizing the risk of losing assets.
Pros and Cons of Inventory Financing
Inventory loan financing has several advantages and disadvantages. It’s good to assess how getting an inventory loan can impact your company. These are some of the pros and cons to keep in mind.
- Get capital for your business: The money you get from a loan can help you expand quicker and maintain operations. Some companies need loans to survive, especially seasonal small businesses.
- Receive funding quicker: If you get an inventory loan from an online lender, you could receive funds within a few days. It can take weeks or months to receive a traditional loan.
- Personal collateral is not required: Most lenders use business assets as collateral for these loans and may not even ask for a personal guarantee. Each lender is different.
- Higher interest rates: Any time a lender bears additional risk, that entity sets a higher interest rate on your loan. Not asking for a personal guarantee or personal assets as collateral translates into higher interest rates for small business owners.
- Losing inventory: If you fall behind on loan payments, the bank, credit union, or online lender can take inventory as collateral. Most lenders will work with you to avoid this outcome, but falling behind on several payments can trigger this.
- Some lenders have challenging approval rates: It can be easier to get another funding source since the lender will have to review your business financials. It can be a worthwhile loan to obtain, but the application process may have high benchmarks. It depends on the financial institution or online lender you use.
Inventory Loans vs. Inventory Lines of Credit
Inventory financing comes in two primary forms: inventory loans and inventory lines of credit. Both types of financing use your current inventory as collateral, but how they are structured could have a different impact on your business finances.
An inventory loan is quite similar to a traditional small business loan, but it’s based on your inventory’s value. The loan is paid back to the lender in monthly installments over a fixed period or in a lump sum after the sale of the inventory. These are usually fixed monthly payments, but if you take out a loan with a variable rate, those monthly payments can fluctuate if the Fed raises or lowers the interest rate. Variable-rate loans usually start with lower interest rates since the borrower incurs more risk. Once you’ve paid the loan in full, you can apply for another inventory loan if you need additional capital for your business.
On the other hand, an inventory line of credit gives you access to a set amount of money that you can use whenever you need it. This means you will only pay back what you have borrowed, plus interest. Credit lines are typically revolving in nature, which means that after you pay what you owe, you’re given access to the maximum approved amount again, and you won’t have to keep reapplying for funding. Most credit lines have variable interest rates, but some have fixed interest rates. Inventory lines of credit are more flexible than term loans because of their revolving nature, making them a great option for an entrepreneur who wants to stay one step ahead of the latest challenge.
Other Inventory Financing Options
Installment loans and business credit lines are the two most popular choices, but they’re not the only ways to get inventory financing. Here are some other ideas to consider:
- Merchant cash advance: This funding option provides small business owners with upfront capital, but they have to repay the lender a percentage of every debit and credit card transaction. Merchant cash advances can get more expensive than other financing options, especially if you’re working with a non-transparent lender.
- Accounts receivable financing: You can sell unpaid invoices to factoring companies and receive a percentage of the invoice’s value upfront. This is one of the best financing options for small business owners with bad credit, unpaid invoices, and a desperate need for cash. You don’t incur any debt from invoice factoring, and the invoice factoring company does the work to receive invoices from customers.
- Business credit cards: Each business credit card features a revolving line of credit and rewards program. You can get cash back on the investments you make into your business and only invest when necessary. You’re not stuck with a traditional installment loan that racks up interest every month, even if you don’t use the capital right away. If you can’t get an unsecured business credit card, you can start with a secured one. This isn’t the best way to raise money, but a secured credit card has a lower barrier to entry and can put you in a position to qualify for better financing in the future.
How to Get Better Terms for Your Inventory Loan
Businesses need capital to maintain operations and reach new customers. Some businesses generate enough cash flow on their own, but loans can help companies prepare for rising demand and increase revenue. However, if you get stuck with a high-interest rate, the loan can become more trouble than it’s worth. Using these strategies can help you get better terms for your inventory financing loan.
Improve Your Credit Score
Lenders will look at your credit score before giving you a loan. Since you’re applying for a small business loan, most banks, credit unions, and online lenders will want to see your business credit score as well. There are many ways to improve your credit score, but most of those strategies boil down to paying debt on time. Taking out a business credit card and using it for your purchases can demonstrate good payment history and help with your credit utilization ratio.
Many lenders have credit score requirements that you must meet to qualify for a small business inventory loan. Check their requirements before applying so you don’t hurt your credit score or waste your time with an unnecessary application process in the event you don’t qualify. Having a credit score higher than the minimum can help you get lower interest rates.
Work on Your DSCR Ratio
Your debt service coverage ratio (DSCR) helps lenders tell if you can pay off the new loan. If you pay $10,000 per month in loans on $132,000 in annual revenue ($11,000/mo), lenders won’t want to give you loans. They want a greater margin of safety for their investments in small businesses. Some lenders post their requirements, and being lower than the requirement will help you secure lower interest rates. The only two ways to improve your DSCR are by minimizing your monthly debt payments (i.e., paying them off or refinancing) or by increasing your company’s earnings. Business owners may not have time to address their DSCR ratios if they urgently need financing, but keeping this in mind can help you get a better bank loan in the future.
Provide a Personal Guarantee
Not all lenders require a personal guarantee, but providing one can improve your odds of getting a loan and securing a lower rate. A personal guarantee increases the borrower’s risk by making them personally liable to cover loan payments with their personal assets and cash if the business cannot sufficiently cover the loan payments.
Add More Years to Your Loan
A lengthier loan spreads the monthly payments and makes them all smaller. This helps your DSCR and makes payments more affordable. While you pay more money when you increase a loan’s duration, you may get a lower interest rate. Some small business owners believe getting a higher present cash flow from this strategy is worth the cost of paying more interest over the loan’s duration. Business owners with this mentality may opt for a refinance with more years and lower monthly payments to capitalize on more cash flow at the moment.
Shop Around for Lenders
Not every business owner sticks with their first lender, and if you don’t have a lender yet, it’s best to look for the best rates and terms. It’s tempting to start the application process with the first small business lender you find, but not assessing the other choices can result in you paying more money than you should. While shopping around for lenders, you can also use that time to increase your credit score by a few points with on-time payments on other financial obligations.