What Are The Types Of Inventory Financing?

Businesses the world over are run on the basis that you have to ‘speculate to accumulate.’

That sounds great on a mood board or a refrigerator magnet, but it’s hard to speculate if you have yet to accumulate.

On the other hand, without inventory to sell, no business can accumulate the cash it needs in order to speculate, and the whole thing collapses into business stagnation.

What Are The Types Of Inventory Financing

Inventory financing is the way businesses get around the problem of having no initial capital to buy the inventory they will (hopefully) later sell.

Businesses buy now (using either a line of credit or a short-term loan), sell later, for cash (in whatever form – hard currency or electronic transactions both count as cash in this instance), and then either pay back the loan (or pay it down at an agreed rate, depending on the amount borrowed) or service the line of credit.

That’s how the wheels of retail begin to turn. Eventually, if the venture is successful, the initial inventory financing is paid off, and the company moves into financing inventory from capital or cash flow.

But in the beginning, the two types of inventory financing available to most businesses are the line of credit or the short-term loan, with the purchased inventory acting as collateral against the loan or the default on the credit agreement.

Let’s take a look at these two main forms of inventory credit in more detail.

Inventory Loan

An inventory loan is exactly what it sounds like. It’s a loan, the amount of which, and the repayments on which, are calculated based on the value of your inventory.

Naturally, as the loan is made to allow your business to buy its inventory, the loan is made for an agreed value of inventory, which you then have the capacity to purchase.

An inventory loan is agreed for the set value of your inventory and is then to be paid back in monthly installments, either over an agreed term of repayment or in a lump sum, payable on the sale of the initial inventory.

Once you’ve sold your inventory, you pay back the inventory loan. If you’ve made enough profit to do so and reinvest in more inventory, all to the good.

If you haven’t, you might choose to maintain the loan agreement and service it in monthly increments, while using some of your profits to buy new inventory without adding to the amount borrowed as an inventory loan.

That’s an ideal solution, because if you pay back the loan but then can not afford new inventory, you will need to take out a second inventory loan to finance your new inventory purchase.

So, if you can pay back your inventory loan and have enough money from profits to buy new inventory, then do that as quickly as you can. If that’s too much of a stretch, maintain the loan repayments as agreed, while buying new inventory to keep the business rolling towards the black.

Inventory Line of Credit

What’s the difference between an inventory loan and an inventory line of credit? Simple. An inventory loan is a one-off payment to help you buy the inventory you need to start making money in your business.

An inventory line of credit is an ongoing, as-needed source of funding, that can not only be used to buy your initial inventory, but can remain on standby to deal with any unforeseeable issues that come up as your business navigates the initial phases of its development.

If you’re setting up an inventory line of credit, you’ll probably sign an inventory financing agreement. That allows both you and your lender to establish the terms and conditions that will apply to your credit agreement.

The Pros and Cons

So, you just apply to the people with money, agree either to take a loan or a line of credit with them to fund your initial or ongoing inventory.

They get regular financial payments, you get the relief of not having to buy your inventory out of pocket before you have any sales income coming in. Everybody’s happy. Right?

Well – yes and no. There are pros and cons to any decision in business, and inventory financing is no different.

On the upside, because the loan or the credit is secured on your inventory, rather than an occasionally harsh credit score, it can make the financing easier to obtain in the short term.

You say you want $5,000 of inventory financing to fill your commercial-grade walk-in freezer with premium-aged, corn-fed Delmonico steaks, which you’re going to sell to local restaurants at a mark-up of, say, 20%.

You have all the right permits to sell meat to restaurants and you have a kind face.

The financial organization may want to take a look at your freezer, check that you have viable contacts to whom you can sell the steaks, and run a comb through the tangles of your business plan before it says “Sure, we can invest in steak.”

But if it does - ba-da-bing, ba-da-boom, the money appears in your business account. You call your guy, and before you know it, you now have a whole lot of meat on your hands.

The downside is you now have a whole lot of meat on your hands. That’s your inventory – the inventory for which you just took out a significant loan.

That means the onus is now on you to hold up your end of the deal and sell that meat on, at or about a 20% markup, so you generate the revenue to service the loan or the credit agreement.

If you’re as good a salesman as you think you are, there should be no problem.

There are two problems.

They’re by no means insurmountable, but they’re there.

Number #1 – any loan or credit agreement is subject to interest. That means your 20% mark-up has to take account of the interest on your loan or your line of credit. As is normal the world over, any loan or credit ends up costing you more than the principal amount you borrowed.

Number #2 – you have a freezer full of meat. Every moment it remains in your freezer and is not being exchanged for cash with local restaurants, your inventory is depreciating in value.

So the thing you own, your inventory, is worth less every day, while the amount you owe for having bought it gets more every day.

We used meat as an example because it’s easy to imagine the effect of depreciation on meat – it depreciates too far, you can’t use it in the way you were hoping to. It depreciates even further, you can’t use it at all. The same is true of all inventory, just at different rates of depreciation.

That’s the challenge of starting a small to medium enterprise through inventory financing – what you owe goes up unless you pay it down, including the interest.

What you have goes down in value the longer you don’t sell it. Your skill at selling your inventory is the thing that makes those numbers work out positively for you.

But if you have the skill, don’t let that put you off. Inventory financing through either a short-term loan or through a line of credit has been the backbone of small businesses – and even bigger businesses – for decades.

Manage your business plan well, and there’s no reason it couldn’t work for you too.