Inventory Financing vs. Purchase Order Financing: What’s the Difference?

Small business owners face many challenges when trying to grow their operations. Being able to serve more customers requires being able to support the broader operations of a larger labor force, more inventory, and more complex logistics. To do that, you need capital. To get capital, you need customers.

Business growth is a complicated game, and when customer demand exceeds supply or cash flow, your business must find the necessary capital to meet that demand. For many businesses, that may mean taking on a loan for inventory purchase. Traditional banks and online lenders alike can help you with borrowing the money necessary to meet demand that is outpacing your ability to meet it. That said, financial institutions are usually reticent to loan to startups and small businesses, with just a 13.5% loan approval rate in the U.S. Here, we break down two alternative solutions to get the business advance funding you need: inventory financing and purchase order financing.

In this article:

• Explore two strong financing options for when you can’t get a traditional small business loan.
• Compare the advantages and disadvantages of different loans for inventory purchase.
• Learn how to meet the demands of busy season to buy inventory, support retail operations, and more.

What is Inventory Financing?

Retailers, seasonal businesses, and other product-focused businesses may experience varying seasonal demand. Rather than get a loan for inventory purchase, they often keep products or materials stored in a warehouse to plan for the busy season. However, stockpiling like this requires a significant amount of upfront working capital.

Inventory financing is a short-term loan that allows business owners to purchase more inventory, supplies, or materials to plan ahead or meet a sudden surge of demand. It’s a type of loan that leverages existing demand to reduce your inventory turnover and support your long-term planning.

Types of Inventory Financing

Depending on your lender, inventory financing may work like other traditional loans for inventory purchase. Inventory financing works as one of three types of business loans: business lines of credit, term loans, and inventory loans.

• Lines of credit: An inventory line of credit is a flexible funding option that lets you address ongoing inventory needs. This revolving loan for inventory purchase allows you access to a maximum credit line, but you only pay interest on the loan amount you actually use. When you repay what you’ve borrowed, you’ll have access to the full amount again.
• Term loans: With a term loan, you’ll receive an upfront, lump-sum loan for inventory purchase that is usually repaid through monthly payments. A loan for inventory purchase typically has short repayment terms, but you can leverage the loan proceeds to address other business needs, too.
• Inventory loans: With an inventory loan, the inventory itself becomes collateral to secure a loan for inventory purchase. Rather than provide a personal guarantee (which risks personal assets) or risk business assets, the lender reserves the right to claim existing inventory if you fail to satisfy the loan agreement. This makes it a slightly less risky loan option, provided you’ve planned well.

Pros and Cons of Inventory Financing

Whether you’re working with a traditional lender or a financing company, there are advantages and drawbacks of getting a loan for inventory purchase you should know about.

Pros

• Helps meet demand: Inventory financing can be particularly useful for helping seasonal businesses meet shifting demand throughout the year by allowing businesses to purchase inventory in advance.
• Fast access to capital: Inventory financing is typically much more accessible than traditional bank loans. The eligibility requirements tend to be less strict, the loan application is usually faster, and you can often receive funding in a matter of weeks. Credit score and annual revenue requirements may be less stringent.
• Flexibility: Some loans for inventory purchase, like a line of credit, you’ll have the flexibility to buy inventory when you need it, and avoid debt when you don’t. Plus, inventory loans allow you to get a necessary amount of money using the inventory as collateral, reducing your own risk.

Cons

• Due diligence: A loan for inventory purchase typically requires thorough due diligence from the lender to assess your operations and verify that you can repay the loan. This can be time-consuming and incur fees.
• Rigid loan terms: Many loans for inventory purchase do not provide everything you need to make the inventory purchases you want. They may also carry higher interest rates or have a minimum loan amount that saddles your business with more debt than you can afford.

What is Purchase Order Financing?

Another type of alternative loan for inventory purchase, purchase order financing directly finances the costs of supporting individual customer purchase orders. A good tool for many types of businesses, purchase order financing addresses the stress put on a business by a major order that it can’t readily fulfill by leveraging the value of that order to buy new materials, inventory, or support innovation.

Purchase order financing covers the immediate cost of supply, helping your business focus on meeting demand. Typically, it works like this:

1. Your business applies for purchase order financing.
2. If approved, the financier pays the supplier to complete your order.
3. The supplier makes and sends the product to the customer.
4. Your business invoices the customer.
5. The customer sends the payment directly to the purchase order financier.
6. The financier deducts their fee from the payment, and sends the remaining balance to your business.

It’s a complex juggling act, but it can allow small businesses to stay agile and complete orders that would otherwise be outside of their capabilities.

Pros and Cons of Purchase Order Financing

Like any other loan for inventory purchase, there are pros and cons to purchase order financing.

Pros

• Fast access to capital: Purchase order financing supports lean, fast operations as funding can be completed in just a few business days.
• Accessibility: New businesses often have limited credit history and may not be able to secure traditional forms of financing. PO financiers can structure solutions to your business’s unique needs.
• Support growth: Refusing orders that are too big is not a good habit to get your business into. With purchase order financing, you can take on every order, even if the demand outstrips your present supply.

Cons

• Transaction-specific financing: Purchase order financing doesn’t work for every type of business. You can only use it for specific orders or transactions, making it a less flexible form of capital for your business.
• Cost: Purchase order financing typically has much higher fees and interest rates than traditional loans, making it a costly borrowing tool.

Differences Between Inventory Financing and Purchase Order Financing

While both can be valuable loans for inventory purchase, especially for small businesses that are at the beginning of growth stages, there are several key differences to understand between inventory financing and purchase order financing. Both provide a solution to cash flow problems, but each may be better for different issues. Some key differences include:

• Due diligence: While purchase order financing typically just requires a review of your current financial statements and potentially tax returns, inventory financing typically requires extensive due diligence. That includes a field person investigating your present operations.
• Funding advance: Purchase order financing may provide up to 75% of what your end customer pays you, and must be used specifically to pay the supplier expenses associated with the customer’s order. Inventory financing lines usually provide up to 70% of either the forced liquidation value (FLV) or net orderly liquidation value (NOLV) of your inventory. Sometimes, that may result in a valuation that’s much lower than the current market price, creating potential issues for borrowers.
• Cost: Both inventory financing and purchase order financing are expensive borrowing options. A traditional loan for inventory purchase would likely be more cost-effective, but inventory financing tends to have higher costs than both due to the fees associated with due diligence.
• Flexibility of use: Purchase order financing can only be used to finance a specific transaction. Inventory financing is typically used for inventory purchase, but some financing lines may be more flexible, allowing you to address other business needs.
• Qualification requirements: Qualifying for purchase order financing is usually much easier and less expensive than qualifying for inventory financing. As a loan for inventory purchase, PO financing is better suited for new businesses, while inventory financing may be suitable for established businesses.

Inventory Financing or Purchase Order Financing?

As a loan for inventory purchase, both inventory financing and purchase order financing have advantages and drawbacks. One isn’t necessarily always better than the other, it just depends on your specific needs. If your company has a major order that you will have difficulty fulfilling, purchase order financing may be a better option to support that specific order. If you’re trying to get ahead of the busy season and get a loan for inventory purchase, inventory financing loans may work better.

Final Thoughts

Meeting customer demand can present cash flow or operational challenges, especially when your business is going through a growth period. Getting a traditional small business loan may not be possible due to your personal credit score, a lack of collateral, or other reasons. But if you’re looking for a loan for inventory purchase, both inventory financing and purchase order financing may present more accessible alternatives. With this guide, you’ll be prepared to navigate the application process and meet the business expenses needed to grow your company.

FAQs About Loan for Inventory Purchase

What's the key difference between inventory financing and purchase order financing?

The core difference lies in the asset being leveraged. Purchase order (PO) financing provides capital based on confirmed customer orders (purchase orders), funding the cost of goods before production or acquisition. Inventory financing provides capital secured by a business's existing inventory, allowing them to access funds against goods they already possess.

What types of businesses use loans for inventory purchase?

Businesses with strong, creditworthy customers that need to fulfill specific orders — like retail, wholesalers, and manufacturing businesses — might leverage purchase order financing.

Businesses that rely on substantial, readily available inventory like retailers and distributors may rely on inventory financing.

When should you use a loan for inventory purchase?

If your business is in a position where it will be unable to meet customer demand, such as when a client makes a major order or you expect a holiday boom in sales, it’s a good idea to leverage a loan for inventory purchase.

Can businesses use both inventory financing and purchase order financing?

A business might use PO Financing to fund the production of specific orders, and then use inventory financing to manage their overall inventory levels, perhaps for products that are consistently in demand or to cover a longer sales cycle. They are not mutually exclusive and can complement each other to optimize working capital.

How do I choose the right option for my business?

The best choice depends on your specific needs and situation. If you have confirmed orders but lack funds to fulfill them, purchase order financing is likely the better fit. Inventory financing is more appropriate if you have valuable existing inventory and need working capital for general business operations or growth. It's often advisable to consult with a financial advisor or lender specializing in these financing types to determine the most suitable solution for your unique business circumstances.

Frequent searches leading to this page