What Are Inventory Loans for Small Businesses?

When customers walk into your store, they don’t want to be greeted with empty shelves. With inventory loans, you can make sure that doesn’t happen. If you own a product-based business or a service business that relies on inventory to keep things running smoothly, inventory loans can put working capital in your hands.

What Is an Inventory Loan?

Generally, an inventory loan is a small business loan that’s designed for purchasing inventory. This kind of business funding is flexible, since you can use it to pay for different kinds of goods and supplies.

Here are a few examples of how different businesses might use inventory financing:

— Restaurant owners could use it to buy linens, flatware or food supplies.

— A salon owner may apply for an inventory loan to purchase towels, manicure supplies or cosmetics.

— A clothing boutique may need to buy apparel, shoes or accessories.

— A bookstore owner could get an inventory loan to stock up on new releases.

“Ideally, a company would always have cash on hand to buy inventory, but sometimes it’s difficult to fund operations with fluctuating cash flow,” says Evan Guido, president and senior wealth advisor, Aksala Wealth Advisors of Lakewood Ranch, Florida. “Some businesses require massive inventory before they collect cash from sales, and retailers might need to stock the shelves before holiday shoppers start ringing the cash register.”

The uses for inventory loans may be varied, but the goal is the same: to help your business get the inventory it needs to operate. Without something to sell, your sales and profits could suffer.

[Read: Best Small Business Loans.]

How Does Inventory Financing Work?

Inventory loans are a kind of debt-based financing. That means you’re getting money from a lender with the agreement that you’ll repay what you borrowed over time, with interest. That’s different from equity financing, where you exchange an ownership share in your business for funding.

When you get an inventory loan, the lender gives you either a lump sum of money or a line of credit that you can use to purchase inventory. Generally, you won’t be able to finance the entire cost of inventory, but expect to be able to finance at least 50% if you’re approved.

The inventory you plan to buy typically acts as collateral for the loan. That means you don’t have to offer any other business or personal assets to get financing. The caveat is that if you default on the loan, the lender could seize the inventory to cover the balance owed. However, some lenders do require a lien on business assets and a personal guarantee, even if you’re using the inventory as collateral.

Inventory loans are usually designed to be a short-term financing solution. The idea is that you borrow money to purchase inventory, then as you sell it, you can use the proceeds to repay the loan. The plan is not for your business to be paying off an inventory loan two years after you sold all the inventory.

Every lender is different when it comes to the loan terms and what’s needed to qualify, but here’s what you generally can expect:

Inventory Financing Guidelines
Loan amounts $5,000 to $500,000
Repayment period Three to 12 months
APR 4% to 99%
Minimum time in business Six months to one year
Minimum annual revenue $100,000
Minimum credit score 600

Pros of Using Inventory Financing for Your Business

The main benefit of using inventory loans to fund your business is that they can help you keep up with customer demand. Inventory financing can keep your shelves stocked and your customers happy. That can also help boost growth.

“The upside to inventory financing is the ability for small- and medium-sized businesses to grow through increased sales,” says Sean De Clercq, CEO of Kickfurther, an inventory lending and management company.

Potentially not having to offer collateral other than the inventory you’re financing is another advantage. If you don’t have a lot of business assets to pledge or you’d rather avoid putting up your assets for a loan, inventory financing can be a preferable alternative to other business loans. But keep in mind that not all inventory financing works this way. Some lenders will expect collateral or guarantees beyond the inventory, so be sure you read the fine print.

Another benefit of inventory loans is being able to take advantage of inventory deals or discounts in the moment. For example, say you run a beachfront surf shop and you’re trying to get prepped for the upcoming season. One of your largest suppliers is offering last season’s surfboards and other gear at a steep markdown. Because the season hasn’t begun yet, you might not have cash at the ready to make a deal. Inventory financing could allow you to stock up on those items at a discount and get ahead of the game.

[Read: Best Bad Credit Loans for Small Businesses.]

Cons of Inventory Financing

Every type of small business financing has a downside or two, and inventory loans are no different. There are two things in particular that can make inventory financing a little less attractive when you need funding for your business.

The first is cost. An inventory loan isn’t a typical business loan, which means you may be looking at higher interest rates when you borrow. This type of financing could prove expensive if you don’t have great credit and aren’t able to qualify for the lowest interest rates. You have to think carefully about the total cost of borrowing and whether that’s justified by the amount of profit you stand to make on the inventory you’re buying.

If the cost of borrowing is more than your profits, then an inventory loan isn’t a good choice. On the other hand, if your profit margin would outstrip what you’d pay for the financing, then it could still be a good source of working capital for your business.

The second consideration is the due diligence that goes into getting approved for an inventory loan. Just like any other loan, lenders will look at your business financials, including your credit score, revenues and time in business. But inventory loans require a few extra steps to approval because lenders also look closely at your inventory records.

Specifically, lenders zero in on how quickly your inventory tends to turn over. Your lender wants reassurance that you’ll be able to sell the inventory within a reasonable time frame to pay back the loan. Beyond that, the lender will also look at the estimated value of the inventory to see what it’s worth compared with how much financing you’re asking for. The reason for this is simple. If you default on the loan and the lender seizes the inventory, the lender will have an idea beforehand of how much it can get for the inventory.

How to Apply for and Get Inventory Financing

If you think inventory financing might be what your business needs, there are a few things to know before you apply.

First, it helps to get organized so you have everything you need readily available. For inventory financing, the kinds of documentation lenders typically ask for include:

— Recent balance sheet

— Recent profit and loss statement

— Up-to-date cash flow statements

— Inventory list and management records

— Sales forecast statement

— Personal and business tax returns for the previous two years

— Business bank account statements

The lender will want to see an estimate of value for the inventory you already have on hand, how quickly you typically sell inventory and an estimate of resale value for the inventory you’re planning to buy.

The next step is choosing a lender. Guido suggests looking for inventory lenders that concentrate lending in your business niche.

“Lenders often specialize in particular industries because that knowledge helps them estimate the value of inventory and the likelihood of default,” he says. “That expertise helps them offer lower rates or better terms.”

Once you’ve submitted your application, the lender will begin its initial review. At this point, you may be asked to pay a fee to fund the research the lender undertakes or commit to taking a loan from that lender, as opposed to applying for a loan anywhere else. Take time to review the proposed loan terms carefully.

De Clercq says, “The exact problems of seasonally affected revenues and delay between production, shipment and payment from vendors that create the need for additional working capital through inventory financing can create cash flow pinches that should be factored into the proposed repayment schedule of the loan.” Essentially, the goal is making sure you can repay an inventory loan according to the lender’s schedule.

You may need to offer additional business or inventory records as part of the lender’s due diligence. Assuming the lender is satisfied with the results, you’ll be approved for a loan and you can move on to the funding phase.

[Read: Best Unsecured Business Loans.]

Are There Other Funding Options?

Inventory loans are just one way to finance inventory purchases. If you need funds to purchase inventory, you could also consider:

— Term loans

— Business lines of credit

Business credit cards

Merchant cash advance

— Accounts receivable financing

Get to know the particulars of these financing options before you borrow. For example, take into account the borrowing limits, interest rates, repayment terms, fees and whether collateral or a personal guarantee is needed. A personal guarantee is a legally binding agreement that makes you personally responsible for a business debt, so it’s important to know if one is required beforehand.

More from U.S. News

How to Find Startup Business Loans

How to Use Peer-to-Peer Loans to Fund Your Small Business

Can You Get a Small Business Loan Without Collateral?

What Are Inventory Loans for Small Businesses? originally appeared on usnews.com

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