Let’s imagine a common scenario:
You opened your first pet supplies business two years ago. Business has been pretty good, and you’ve been sticking to your budget and making your startup loan payments.
Then you decide to launch a new marketing campaign for an extra sales boost, and it’s effective—so effective that, suddenly, customer demand increases 80%.
Nice job! But… Uh oh.
You’re running out of inventory to sell, but don’t have enough money on hand to buy enough inventory to match customer demand. You’re worried that you’ll lose frustrated customers who aren’t able to find the products they want when they want them.
On one hand, this scenario sounds like a wonderful thing: sales are booming! Customers love your store!
But on the other hand, it presents a major practical and financial dilemma: how can you purchase enough inventory if you don’t have the cash on hand yet? And what if you lose the business of new customers who are disappointed in your lack of inventory?
In this situation, you can turn to inventory financing: a type of loan specifically intended for business owners who need to borrow money for inventory.
How is Inventory Financing Different from a Regular Loan?
A traditional term loan will often require either collateral or a personal guarantee from you to ease the risk for the lender.
With inventory financing, the inventory itself serves as the collateral.
Collateral is essentially anything that can be turned into cash by the lender in the event of a loan default. By posting something as collateral, you’re handing over the rights to seize it if necessary to the lender, so that if you can’t pay back your loan, they’ll be able to recoup the money they’ve lent you.
There are a few different types of collateral:
1. “Real” collateral
Any type of physical asset—your house, your car, your motorcycle.
This is one of the most popular types of collateral, and also one of the most tangible. If your business fails, you don’t want to lose your house too, so many business owners are understandably reluctant to post physical collateral.
2. Savings as collateral
If you’re using a savings account as collateral, you’d apply for a loan from the same bank that holds the account.
If you default on the loan, the bank can empty your savings account. This is called a “savings secured loan,” a “cash secured loan,” or a “passbook loan,” depending on the bank.
Liens are legal claims attached to loans that give the lender the right to sell your business’s assets if necessary to pay themselves back for the loan.
The most common type here is a blanket lien, which gives the lender essentially unrestricted access to any asset or type of collateral owned by the business.
4. Invoice financing
If you have unpaid invoices, you can turn them into cash immediately using invoice financing, which uses the invoices themselves as collateral.
The lender will front you the cash until the invoices are paid, and then you can use that money to repay the loan.
5. Inventory financing
You’ve got this one now: the unsold inventory acts as collateral, much like with invoice financing.
A personal guarantee is another way of lowering the lender’s risk.
It’s a legal agreement that will give the lender the right to chase after your personal assets and collateral if they need to—so it’s similar to a blanket lien, only this time your house, car, savings account, and child’s college fund are at risk. There are several types of personal guarantees, however, and some of them set dollar limits on the amount of money the lender is allowed to seek from you.
It is possible to get a loan without collateral—it’s called an unsecured loan—but these loans carry high interest rates and short repayment periods, so they shouldn’t be your first choice.
By taking care of your inventory needs, this type of financing can free up cash for other business expenses, like payroll and marketing.
Different Kinds of Inventory Financing
Inventory financing can take the form of a line of credit, a term loan, or a short-term loan.
With a line of credit, the lender will extend funding to you up to a certain threshold (your credit limit) to be used only for inventory purchases.
Term loans will give you a set amount of financing that you’ll pay back in predetermined amounts at regular intervals.
Short-term loans are best for those with lower credit, but often come with higher interest rates attached.
Not all inventory financing looks and functions the same way, but all types are intended to finance the purchase of new inventory, and uses the inventory itself to secure the loan.
Are you Eligible for Inventory Financing?
The most important factor in your inventory financing eligibility is your sales history.
If you have a history of low inventory turnover, lenders will be reluctant to offer you financing. If you have very little history at all—meaning that you’re a new business that’s been open for less than a year—you’ll need to look for a different type of financing to bump up your sales.
Inventory financing lenders are looking for borrowers with a history of strong, consistent sales and high inventory turnover, because it shows them that you’re more likely to sell off the increased inventory financed by the loan or line of credit.
In our opening scenario, the pet store owner—provided that he or she has been in business for several years—would be very likely to receive inventory financing, because of that sudden surge in demand. The lender would see the rapidly increasing sales and understand the benefits of providing financing for an increase in inventory.
Also—this is sort of obvious, but worth pointing out nonetheless—inventory financing is only available for businesses that work with inventory, not businesses that provide services. Businesses in the retail, wholesale, manufacturing, and distribution sectors are eligible for inventory financing.
What Constitutes “Inventory”?
Inventory includes raw materials and works-in-progress in addition to finished goods.
So if your business sells handmade jewelry and you need to buy wire, beads, and crimps, those count as inventory and are eligible for inventory financing.
Or if you’re a construction company and you need wood, you can use inventory financing to fund that purchase, too.
This type of loan or line of credit isn’t limited to the purchase of finished goods to sell directly to customers, although that is one of its popular uses.
Other Reasons You Might Want to Apply for Inventory Financing:
We’ve focused on recent and sudden growth so far as an excellent reason to seek an inventory loan or line of credit, but there are a number of other scenarios in which your business might be in the market for this type of financing.
1. You’re a seasonal business
If you sell garden supplies and the bulk of your sales occur during the spring and summer, you might find yourself having a hard time stocking up on inventory during the slower months due to less money coming in.
Inventory financing is ideal for these situations, especially when you have years’ worth of sales records showing that your business consistently turns over more inventory in the warmer months.
2. You’ve heard complaints from customers about not having what they need in stock
One of the fastest way to lose a customer—and not just for this sale, but for future sales—is to be out of stock of the item they want. In order to attract and keep customers, you need to consistently have a fully stocked storefront (or online store).
3. You’ve had trouble getting loans in the past
If your credit isn’t stellar or you don’t want to sign a personal guarantee, using your inventory as collateral might be a better loan option for you.
(Remember that you do still need to be able to demonstrate a strong sales record and have been in business for over a year.)
4. You’re running a wholesale business
Wholesalers need to keep larger amounts of inventory on hand than traditional retailers, which can provide a tricky cash flow problem if they aren’t able to buy all the inventory upfront.
Securing Inventory Financing
Other than a strong sales history, what are lenders looking for when evaluating businesses for inventory financing eligibility?
Organized and well documented inventory
You should have systems in place both for organizing and displaying for inventory and for keeping track of what you have in stock and what you’ve sold.
You’ll need to present these records to any prospective lender, and it’s important that you’re giving them a clear and accurate picture of your current stock. There are a number of software programs designed to help you keep track of inventory.
For example, QuickBooks, a program many bookkeepers already use for recording and logging day-to-day expenses, has add-on programs for inventory management.
From there, it’s easy to print out all the documentation you need.
Don’t waste the inventory you do have
Don’t over-order—you want to minimize the amount of your unsold stock, because too much will tell lenders that you’re not capable of turning over inventory.
You should also make sure that your storage conditions are right for your product, so that you’re not losing anything due to spoilage or damage. Lenders will look at loss and damage to your past inventory, and any significant amount of either will reflect badly on your application.
You’re on the same page about the loan principal amount
Lenders often turn away prospective borrowers who are looking for smaller amounts of money.
Because much of the cost of underwriting a loan is fixed, higher-principal loans are going to be more profitable for the lender than lower-principal loans.
This is especially true for inventory financing, which can involve extra time and paperwork. Many lenders have minimum borrowing amounts, which can be as high as $500,000. If this is too high for your business—you don’t need this much inventory—inventory financing might not be right for you.
How Fast Can You Get Inventory Financing?
Inventory financing can be slow to apply for and to receive.
Remember how we just said that inventory financing requires more time and paperwork?
That’s because there’s often a highly detailed inspection process of your business and its inventory, depending on the lender your credit score, the size of the loan, and your financial history. They might even send a person out to inspect your warehouses, talk to your employees and look at the presentation of stock in your store.
Inventory financing isn’t a good option for someone who needs cash in days: it can take weeks, or sometimes months, for you to receive the cash.
If your business’s sales all of a sudden pick up, big-time, don’t panic—this is a major opportunity for business growth.
Sometimes you need to spend some money in order to make more money, and inventory financing is a great option for eligible businesses who need help with restocking.
The post Inventory Financing: How to Finance Your Business’s Growing Demand appeared first on Fundera Ledger.
from Fundera Ledger https://www.fundera.com/blog/2016/07/12/inventory-financing-2/