How Do Inventory Loans Work?

Have you ever wondered how new businesses pay for all their initial stock before they’ve even earned a cent? It’s like some sort of commercial magic trick - something from nothing, just like that. Well, the answer involves far less witchcraft and far more borrowing.

While it’s true a fraction of a small business loan could be allocated for stocking bare shelves, it’s more likely that owners have had an inventory loan approved by a lender.

How Do Inventory Loans Work

An inventory loan is a short-term business loan available to retailers specifically, so they can buy stock and start trading. They’re an intelligent, almost self-contained type of loan as the stock itself is used to secure the loan.

If said stock doesn’t sell, it’s used as collateral by the lender, so they can recoup their investment.

These short-term lifeline loans aren’t just for helping businesses that have only just cut the tape, they’re for any retailer that needs a little financial boost to achieve something stock-related.

Perhaps they have reason to believe sales of a certain product are going to skyrocket, such as sandals in summer, and they want to double their next order. Maybe they’ve come across a bulk discount stock deal that they don’t have quite enough in the bank to take advantage of. 

What about those times when business isn’t booming? An inventory loan can help pay off stock invoices for products that simply haven’t sold. No matter what the specifics of the situation are, if it’s stock-related, you can apply for an inventory loan to help you get by.

Inventory loans are always more popular come the holiday season as businesses need to buy in bulk to meet consumer demand.

As it’s possible they don’t have the extra cash lying around to bump up their order numbers, an inventory loan is the perfect supplement. As long as all the stock ordered with the inventory loan is sold, everything should work out just fine. 

So, to summarize, an inventory loan is for a small retail business to…

  • Expand Product Lines
  • Prepare for Busy Seasons
  • Cover Short-Term Shortages
  • Unlock Capital Tied up in Inventory
  • Keep up with Sudden Consumer Demand

What Happens if You Can’t Make the Repayments on an Inventory Loan?

Remember when I said the stock you purchase with the inventory loan is the collateral? Well, if repayments aren’t made, the lender will seize your stock to recoup losses. As you can never be sure what is going to sell, inventory loans can be considered more of a gamble than some others.

What Are the Terms of an Inventory Loan?

The terms of an inventory loan can be vastly different from lender to lender, but there are certain accepted parameters that help to give you a general idea of their nature.

  • Maximum Borrowing Amount - In some cases, a lender will be able to provide 100% of the inventory’s liquidation value; however, typically, 50 - 80% is what’s agreed upon.
  • Repayment - You can normally choose to make repayments over a 36-month period, but in many cases, that’s the maximum. To save money on interest, retailers tend to sign up for repayment schemes between 3 and 12 months.
  • APR - The interest rate is the widest fluctuating variable between lenders. It can be as low as 4% or as high as 100% depending on the adjoining terms and your credit score.
  • Additional Fees - Some lenders might charge the borrower an appraisal fee in order to assess the value of the purchased stock.
  • Origination fees - a sum paid to the processors of the loan - are another possibility. There may also be prepayment penalties should you try to pay off your debt prematurely.

How Inventory Loans Work

If you’re looking to take out an inventory loan, you have two options, the most common of which is a term loan from a lender. A term loan is the standard borrowing format. The full amount is paid out to you in one lump sum.

You then make what are normally equal monthly repayments over an agreed-upon length of time to pay back the borrowed sum plus interest.

Your second option is to take out a line of credit, which by and large, works the same way a credit card does. You’re afforded an amount of cash that you can dip into as and when it’s necessary. Unlike term loans, you only pay interest on the amount you borrow from the credit.

Within the line of credit route, there are a further two options. The credit can be static or revolving. A static line of credit is a finite pool you can draw funds from. Say you have a $5000 line of credit.

If you take out $1000 to pay for restocking your shelves, even when you’ve paid that back plus interest, you can only borrow a further $4000.

A revolving line of credit is the opposite. If you take $1000 out of your $5000 credit pool, once you’ve paid it back plus the agreed-upon interest, the credit pool replenishes, allowing you to borrow a further $5000.

Let’s look at a specific example to clarify how an inventory line of credit works:

  • It’s the holiday season. Customers are practically throwing their money at you for gifts, food, and drink, so you need to bulk order to meet their demands. 
  • You figure out this bulk order is going to cost you $120,000, which you currently don’t have.
  • A lender assesses the liquidation value of the stock you wish to buy at, say, $100,000. They may then offer you 80% of the liquidation value of the stock, which comes to $80,000. This is now your credit pool.
  • Your lender stipulates that it has a 5% flat interest rate and must be paid back over a 12-month period.
  • Should you take out the whole $80,000 to help pay for the $120,000 worth of stock, you’ll then have to repay $6666.66 a month plus $4000 interest spread out evenly throughout the term.
  • If your line of credit is revolving, once these repayments are made in full, that credit pool fills right back up to $80,000 again. If it’s a non-revolving line of credit, that’s that. You borrowed, spent, then repaid - all is accounted for.

Regardless of the loan type you choose, the stock you intend to purchase is always held as collateral against the loan. This means you cannot dip into your inventory loan funds to pay for other things, even if they’re business-related. 

The whole structure of the inventory loan system is based on the value and sale of the appraised stock, so you can secure one without providing business or personal details and assets. In some cases, even a poor credit score won’t prevent a lender from offering you a deal.

Inventory loans are also a fantastic option for budding businesses as many lenders only require a 1-year business history, while typical term and line of credit business loans normally require you to have been in business for at least two years.

How much can you borrow against inventory?

Different lenders will offer you different deals, but, as I touched upon earlier, you can sometimes borrow up to 100% against the inventory you need to replenish your stocks, but that doesn’t necessarily mean the inventory loan covers all costs.

A lender will provide you with 100% of the liquidated value of the stock you purchase rather than the free-market value. 

What is liquidation value? It’s the estimated price given to an asset that’s been removed from the open market before it’s had adequate exposure to potential buyers. 

For an asset to have fair market value, it has to exist on the open market, but the liquidation value of the same asset is how much it’s worth when forced into sale in a short time period.

Simply put, it’s how much a lender believes they can definitely make from selling on the asset, and it’s always less than open market value.

So, the price of the stock you need to buy may be $500,000. You’re chosen lender will then offer a 100% liquidation value loan.

The real-world figure that 100% amounts to is dependent on their appraisal of the stock. They might estimate that the liquidation value is $350,000, so that’s the money they’ll lend you.

It’s important not to rely on a lender offering you 100% of the liquidation value, as many will offer much lower rates. That said, there’s no shortage of lenders at the minute, so feel free to shop around until you find the best deal for you.