How to Finance Inventory
January 9, 2023 | Last Updated on: May 24, 2023
January 9, 2023 | Last Updated on: May 24, 2023
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Financing inventory is the process of purchasing supplies, wholesale goods, or other inventory with borrowed funds. There are many circumstances where an entrepreneur may consider financing inventory. Let’s look at a few instances where business needs justify this type of loan:
Starting a new business is an exciting time for any business owner, but startup costs can add up quickly. Before being able to open your doors for business, you’ll need a significant amount of money to cover legal costs, licenses, and permits, advertising costs, real estate expenses, and more. If your new business idea includes selling products or finished goods, you’ll also need startup funds for inventory in order to meet customer demand. Financing inventory gives new business owners the opportunity to make initial inventory purchases upfront and pay for it with future revenues.
Some business plans include an expectation for seasonal fluctuations in revenues, like entertainment venues, holiday merchants, swimming pool manufacturers, and more. For these types of businesses, it can be difficult to plan for busy seasons when inventory turnover is rapid, but it is a financial risk to run out of inventory. Seasonal business owners often rely on invoice financing to make large purchases at the beginning of their season and make payments on the purchase after collecting more sales.
Often suppliers and manufacturers offer a discount on large purchases. If the inventory your business needs can be purchased in bulk at a lower price per unit, inventory financing can give you the capital you need to make the purchase. Reducing the overall cost of your inventory can help you increase annual revenues and generate a profit faster.
Just like any other business decision, there are pros and cons of financing inventory. It is important to consider how borrowing funds to purchase will impact your business in both a short-term and long-term capacity.
The most obvious pro to financing inventory is that it allows you to be able to cover the costs of your inventory needs at any time. Traditional bank loans typically have long approval processes where funding is not accessible for months. Inventory financing cuts the waiting period down to a few business days and lets entrepreneurs get on with their business fast.
Another benefit of using inventory financing is the flexible eligibility requirements. Since lenders that specialize in inventory financing don’t rely on credit alone to approve borrowers, the approval odds are higher for new business owners or those with less-than-perfect credit scores. Plus borrowers are able to take advantage of the lower interest rates offered with secured loans without pledging business assets as collateral.
While there are many benefits to financing your business’s inventory, there are also some disadvantages to this type of small business loan. Loans, lines of credit, and vendor repayment plans can be expensive, so entrepreneurs must decide if the benefits to the business of having the inventory outweigh the con of covering the financing costs during repayment.
Business owners looking for the capital necessary to finance inventory generally turn to a lender to evaluate their options for loans, lines of credit, or other financing agreements. For most inventory financing methods, the lender will need to evaluate the creditworthiness of the borrower to approve funding. Creditworthiness reveals the borrower’s ability to repay the funds by measuring the business credit score, the company’s reputation, time in business, and payment history. However, credit is not the only factor in determining if an entrepreneur will be able to borrow funds to purchase inventory. Some financing agreements rely on a type of collateral to secure the loan, which may be future sales or the inventory itself.
Short-term loans are a traditional type of financing arrangement where the borrower receives a lump sum of money upfront and repays the funds over time according to a predetermined repayment plan. Inventory loans for the purpose of financing inventory are typically short-term, which means that the borrower is expected to repay the financial institution in two years or less with monthly payments of principal and interest.
Since short-term loans for inventory financing are secured by the purchased inventory, so the lender can offer lower interest rates than other unsecured financing arrangements. However, that also means that if the borrower defaults on the loan or does not make their monthly payments according to the loan agreement, the lender can seize the new inventory. Some lenders may also require a down payment of up to 20% of the inventory costs, which is paid directly to the wholesaler or supplier.
A business line of credit is another great option small business owners use to finance inventory. Lines of credit are a type of revolving credit that works similarly to a business credit card. The line of credit lets the business access the funds needed for inventory at any time by extending borrowers with an approved maximum credit limit. As payments are made on the balance, the funds become available for use again. A line of credit may be secured, where the inventory serves as collateral, or unsecured where the repayment plan and loan terms are not connected to the value of the inventory.
Some vendors, wholesalers, and suppliers extend credit to approved applicants which allows them to order the inventory they need and pay for it in installments. Before approving a credit limit for customers, the vendor will request a completed credit application in pursuit of some due diligence. The application process may include a credit check, which includes running a copy of the business credit history and the business owner’s personal credit report, and reference checks, where other suppliers or vendors used by the business are contacted. Repayment plans directly with the vendor typically include financing costs which are set at the vendor’s discretion.
Invoice factoring is a type of accounts receivable financing where a business can sell its unpaid invoices to a factoring company. Invoice factoring typically works when the factoring company advances funds to the business for up to 90% of the value of the invoices, the company then collects for the invoices, on the business’s behalf, and disperses any amount, less their fees and financing costs, back to the business. The fees collected by the company are called factor fees and are calculated according to a factor rate, disclosed in the original factoring agreement. Invoice factoring companies do not issue funds based on credit decisions, so they are a good option for entrepreneurs that need to buy inventory but have bad credit or are a startup business with no established payment history.
A merchant cash advance (MCA) is another common method used to finance inventory. An MCA is not a loan, but a unique financing agreement like a cash advance arrangement. The borrower receives a lump sum payment upfront to make the inventory purchase and the debt is repaid with future credit card or debit card sales. MCAs are popular with retailers and business owners in hospitality industries. The payments are made weekly or monthly and calculated as a percentage of sales, so if the business is slow, payments will be low.
Finding the right inventory financing is just like connecting with any other small business financing tool. There are several resources available on the internet, including expert reviews like this one from FinImpact.com that lists Biz2Credit as a top choice for inventory financing. Other methods of finding the right lender might include asking business associates and friends or family for references.
If you are hoping to secure inventory financed directly from the vendor, you’ll want to reach out to your suppliers directly. Vendors that offer supply credit will give new customers a credit application. The application process may also include a request for the contact information of other suppliers. The vendor may also request a copy of the business’s financial records before making a credit decision.
Traditional lenders include banks and credit unions. Not every financial institution provides inventory financing options, but if you are interested in working with a traditional lender start with the bank where you already have a business bank account. If the bank has financing options for inventory, they may ask you to provide some documentation along with a credit application including:
Alternative lenders include online lenders and marketplaces, like Biz2Credit. They are often preferred by small business owners because they offer several types of inventory financing in one easy-to-complete application process. Inventory financing agreements with alternative lenders may be in the form of a small business loan, merchant cash advance, or a line of credit. Alternative lenders typically offer an online application process and may ask for some of the documents listed above to be uploaded with the application. The funding time is much faster than with traditional bank loans. Some borrowers, like this beauty product distributor, receive funding for their inventory purchase in as little as 1 to 3 business days.
Financing inventory is a great option for many entrepreneurs, but it is not the only way to secure capital for your small business. Some alternative financing options may include using funds from a personal savings account to purchase inventory or making smaller purchases while the business is still in the building phase. Some small business owners prefer to seek out peer-to-peer (P2P) loans, apply for personal loans, or turn to one of the following financing options.
Crowdfunding is the process of collecting small investments or donations from multiple sources. The donations may be reward-based where the donor expects something in return, equity-based where the contribution is given in exchange for ownership in the company, or simple donations. Crowdfunding has grown in popularity throughout the last couple of years thanks to an abundance of online crowdfunding platforms like Kickstarter and GoFundMe.
SBA loans are small business loans backed by the U.S. Small Business Administration. The funds are issued by an SBA-approved lender, but the government guarantee makes these loans lower risk for the lender so down payments and interest rates are lower than other business lending arrangements. There are multiple loan programs through the SBA including the SBA 7(a), 504 loans, Microloans, and Express loans. Some SBA loan programs determine the permitted use of the funds, so not all programs are right for inventory financing. Microloans and some 7(a) loans do not restrict the use of funds, so they may be a great option for business owners that need to purchase inventory.
There are multiple ways to finance your inventory, just make sure the terms work for your balance sheet. Whether you finance the full amount needed for your inventory or just a percentage, you don’t need to be afraid to take out a loan. Just look at how Vital Foods grew their business from 3 employees to over 1,200 with smart financing.