Pros and Cons of Inventory Financing for Growing Businesses

Growing businesses often struggle to meet the increased production and supply requirements to meet growing customer demand. Nonetheless, small business owners have to balance these delicate requirements if they want to grow effectively. Often, small businesses don’t have the cash flow or working capital necessary to meet a sudden surge in demand or a purchase order that is far more than the typical order. That’s where small business inventory loans come in.

Small businesses can leverage business financing for a wide variety of purposes, but when demand exceeds your supply or cash flow, a small business inventory loan can help you meet the demand and create sustainable growth. Growing businesses and startups may struggle to get approval for small business loans from traditional banks or credit unions, but small business inventory loans offer both conventional and alternative lending processes to support your borrowing needs. That said, from a lengthy application process to a high cost of borrowing, business inventory financing isn’t without drawbacks. Here’s what to consider about small business inventory loans.

In this article:

• Learn how inventory funding can support your growing business.
• Understand the pros and cons of small business inventory loans.
• Explore alternative inventory loans for small businesses.

What Is Inventory Financing?

Inventory financing is a short-term loan or line of credit that helps business owners purchase inventory, supplies, or materials to meet growing demand. Inventory financing loans are particularly common for retailers, seasonal businesses, and other product-focused businesses that experience sudden surges in demand or want to leverage upfront working capital to prepare for the busiest time of year. Small business inventory loans can help reduce inventory turnover and smooth out the financial effects of seasonal booms.

How Does Inventory Financing Work?

Inventory financing is a type of loan that leverages the value of assets to determine the value of the loan. This asset-based financing is offered by traditional and online lenders, and can help small businesses with several business needs related to inventory management, including:

• Maintaining steady cash flow through seasonal fluctuations
• Updating product lines
• Increasing inventory supplies
• Adjusting to a sudden surge in customer demand

Retailers, wholesalers, seasonal businesses, and startups may not have the credit history or business assets to serve as collateral for traditional small business financing options. However, inventory funding leverages the value of inventory itself and uses it as collateral to secure a loan. With a small business inventory loan, you can pay the necessary costs to acquire inventory, cover other business expenses to streamline operations, and more.

Types of Inventory Financing

There are several types of inventory financing available. Usually, it’s offered as one of three types of business loans: business lines of credit, term loans, and inventory loans.

• Lines of credit: Inventory lines of credit provide flexible funding to meet ongoing and changing inventory needs. A revolving line of credit gives you a maximum credit limit that you can withdraw from to pay for inventory and other business needs. You only pay fees and interest on what you borrow, and when you repay what you borrowed, you’ll have access to the full loan amount again. It’s a flexible financing solution secured
• Term loans: Business term loans provide an upfront, lump-sum of money that you can use for inventory purchase or other business expenses. Typically, you’ll repay the loan through monthly payments based on an interest rate. Term loans are available from online lenders, traditional lenders, and as SBA loans backed by the U.S. Small Business Administration.
• Inventory loans: A small business inventory loan is one that is expressly tied to acquiring inventory. The inventory itself becomes collateral to secure the loan when it’s time to buy inventory. You’ll usually have a similar repayment schedule to a standard term loan, but rather than provide a personal guarantee (which risks personal assets) or risk business assets, you’ll use the value of the inventory to secure the loan amount. If you fail to satisfy the loan agreement, the lender may seize the inventory.

Pros and Cons of Inventory Financing

While there are advantages to small business inventory loans — whether you’re working with a traditional lender or a financing company — there are also some disadvantages to be aware of. We break them down here.

Pros

• Reduced need for collateral: New business owners or business owners with bad credit may not have to use their personal credit score or risk business assets to get a small business inventory loan.
• Helps meet demand: Whether it’s a lump sum of capital or a line of credit, inventory financing can help companies meet ongoing shifts in customer demand. Whether it’s adapting to a burst in popularity or purchasing inventory in advance to plan for the holiday season, small business inventory loans can help.
• Fast access to capital: Small business inventory loans tend to have fairly involved application processes and require a due diligence period, but they can still be faster than traditional loans. The loan application itself should be quicker, credit score and annual revenue requirements are less scrutinized, and the underwriting process may be quick once the lender has reviewed the inventory you want to buy. It will take more than a few business days, but it’s often faster than traditional financing options.
• Great for new businesses: Many traditional lenders will not offer conventional loan options to startups or new businesses. However, inventory loans for small businesses typically have less strict eligibility requirements, so you can buy inventory when you’re just starting out.

Cons

• Additional debt: New businesses often take on debt when they’re just starting out, and small business inventory loans will add to your liabilities. That could make it difficult to repay the loan or meet other financial obligations.
• Short funding: Lenders often do not issue the full amount required to purchase inventory in order to protect themselves against depreciation and the risk of damaged, lost, or stolen inventory. That can lead to delays or shortages. More established businesses are more likely to get the full loan amount needed.
• Due diligence: Small business inventory loans typically have a due diligence period in which a loan representative assesses your operations to determine whether or not you’ll be able to repay the loan. This is time-consuming, but it’s also expensive. You’re on the hook for the bill.
• High costs: Fees and interest rates are often higher for small business inventory loans than they are for other types of loans.

What to Consider About Small Business Inventory Loans

Now that you understand the pros and cons of small business inventory loans, there are a few important considerations that will help you better understand this type of financing.

Inventory financing is not as straightforward as other types of loans. Small business inventory loans are often viewed with skepticism by banks and credit unions due to several factors, including:

• Depreciation of inventory over time
• Perishability of inventory
• Risk of losing inventory
• Risk of theft

All of these factors typically make lenders build provisions into small business inventory loans that can raise their overall borrowing cost. Banks rarely provide the full amount necessary to acquire all of the inventory you need, and will factor the above risks into the interest rate of an asset-backed loan.

Alternatives to Small Business Inventory Loans

If you’re unsure about the drawbacks of inventory financing or you’re having trouble finding or qualifying for small business inventory loans, there are some other worthwhile alternatives to consider:

• Invoice factoring or financing: Invoice-based businesses often experience payment delays. With invoice factoring or financing, you sell your unpaid invoices or other receivables to a third party in exchange for upfront cash. With financing, your unpaid invoices serve as collateral until you collect from the customer and pay off the loan. With factoring, the factoring company buys the invoices from you at a discount and assumes responsibility for collecting from customers.
• Business credit card: Using a business credit card can be a good way to make small purchases, just try to avoid racking up too much high-interest credit card debt.
• Purchase order (PO) financing: Purchase order financing is similar to inventory financing is that it provides a lump sum of money to cover cash flow gaps. However, you can only use PO financing for the needs of a specific purchase order rather than for general business purposes.
• Equipment financing: In some cases, you may just need the infrastructure to increase your inventory production. Equipment financing allows you to buy business equipment and pay for it over time.

Final Thoughts

Small business inventory loans are a useful way to gear up for busy seasons, meet growing customer demand, and support your business’s innovation and growth. However, while business inventory financing may be more accessible for new businesses or business owners with bad credit, these loans often have high costs and rigid loan terms. Always discuss financing options with a financial advisor before deciding to move forward.

FAQS About Small Business Inventory Loans

What are the risks of small business inventory loans?

Any time you take on debt, there are risks involved. Small business inventory loans may be particularly risky due to the short repayment schedules, high costs of borrowing, and the potential of losing inventory if you default on the loan.

What are common inventory financing costs?

Some of the costs associated with inventory financing include interest rates, origination fees, prepayment fees, and late payment fees. Depreciation costs may also be built into the loan by providing a smaller amount than the full value of the inventory.

Why do businesses get small business inventory loans?

Inventory financing can be a useful way for businesses to load up on inventory to prepare for the busiest time of year or if they don’t have a strong enough credit history to qualify for traditional loans.

What types of businesses use inventory financing?

Small business inventory loans are particularly useful for retailers, wholesalers, and seasonal businesses.

What are some alternatives to small business inventory loans?

If you can’t qualify for traditional financing options, some good alternatives may include invoice financing or factoring, purchase order financing, business credit cards, or business lines of credit.

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