Why do product-based small businesses have an advantage over service-based small businesses when it comes to borrowing options?
Inventory. The products that you stock on your shelves or in your warehouse have value that banks are willing to lend against.
Are your suppliers’ terms limiting the growth of your business? If so, it makes sense to explore an inventory line of credit. Are you using credit cards with high interest rates for last minute inventory buys? Think about an inventory line of credit.
Finding the best loan for your small business can be stressful. Finding the best inventory loan for your business can add weeks to the application process.
What Is Inventory Financing?
Inventory loans allow you to leverage products you have purchased or plan to purchase. The inventory acts as both collateral and as a source of repayment of the loan.
Most inventory loans are revolving lines of credit. Like a credit card, you’re given a spending maximum by the bank. Often you pay interest-only on the balance for a few months, allowing you some breathing room before you’re expected to sell the inventory and repay the principal.
Inventory credit lines are short-term loans – meaning they are meant to fix short-term problems and be repaid within 12 months.
Different industries – from manufacturers to the corner grocer to wholesalers – use inventory financing to fund purchases. Banks often focus on specific industries and specific sizes of business when it comes to lending against inventory.
There is a good reason for this. Inventory loans are a lot of work and a lot of risk for the bank. Until recently, inventory lines were often a minimum of $500,000. With the advent of online lenders, small retailer borrowers are finding inventory loans for smaller amounts.
Before you dive into the loan application process, read below for tips on making your inventory loan approval process go smoothly.
Tips to Make Your Inventory Loan Process Go Smoothly
Knowing what lenders want from borrowers is always the first step to being a strong loan applicant. Inventory loans require more documentation than a simple term loan and will take several weeks of due diligence before you receive the funds.
Be aware, that often lenders will promote their turnaround time as a few days. An initial approval doesn’t mean immediate funding. The funds won’t be disbursed until the lender has done its due diligence on your inventory and feels satisfied that it’s solid collateral and a reliable source of repayment.
Tip 1: Understand How an Inventory Line of Credit Works
Let’s imagine that you have a shoe store. While you have a website for information purposes, all of your sales take place in the retail storefront on Main Street.
It’s only July, but the coming winter season predicted to bring unprecedented amounts of snow and ice to your area. You want to be prepared for your customers with a wide selection of styles and sizes of boots. Let’s walk through an example of how an inventory loan might help your small business.
Your Shoe Shop Needs an Inventory Loan!
You want to buy inventory at a cost of $100,000. Your regular boot supplier changed payment terms to 30 days instead of 60 days. The newest and trendiest boot designer is demanding cash on delivery, but you want the buzz that comes with the new designer. You realize you need more flexibility than these suppliers are offering.
You decide to check out inventory finance options. You apply for a $100,000 inventory line of credit. The lender will use the boot inventory for collateral and as a source of repayment. The boots will cost you $100,000.
However, the lender determines the liquidation value of the boots is only $80,000. The line of credit is approved for $80,000. This means that the lender believes they can only get $80,000 if they had to sell the boots. The advance rate is set at 75%, giving you an inventory credit line with a $60,000 spending limit.
By the New Year, the Line Is Maxed Out
Fortunately, you had a great holiday selling season and are able to pay off the line down to zero and have made a nice profit. Your working capital position is strong heading into the next buying season.
Being in a strong cash position, you don’t need the line of credit to purchase spring and summer inventory. Instead, you want to use the line of credit for a marketing campaign. Inventory lines can be used for more than just purchasing inventory. In this case, existing inventory would be used as collateral.
Some lenders may restrict the use of an inventory line of credit to inventory purchases. Other lenders allow you to use the funds as you wish.
Tip 2: Know Thyself! Understand What Your Business Needs
Lenders want to know that you understand your business. Put yourself in your lender’s shoes. What would you want to know? Be prepared to clearly articulate answers to these questions:
- How much money do you want?
- How much money do you need?
- Do you have uneven cash flow due to seasonal fluctuations?
- If you purchase more inventory, will you need more labor or space to sell it?
- Are you a young business but performing well? Do you recognize what your business needs are to keep growing?
- Are you an established business, but struggling? Do you know why you are struggling?
- Are you an established business that is thriving? Are you keeping track of performance? Not overbuying?
If you’re a small brick-and-mortar shop, an e-commerce retailer, an eBay or Amazon seller, you may have been rejected by traditional banks. Historically, these businesses have had to rely heavily on credit terms with suppliers. Fortunately, many online lenders are eager to lend to small retailers – whether they’re online or on Main Street.
Tip 3: Understand What Lenders Want
Different lenders look for different kinds of borrowers. Research traditional banks and online lenders to find the best fit for you and your business.
- Does the lender have a minimum or maximum loan amount? Don’t waste your time or their time by applying for a $50,000 dollar loan with a lender whose minimum loan size of $500,000.
- Does the lender require a minimum amount of revenues?
- Does the lender have a minimum time in business?
- Does the lender have a minimum credit score?
Some lenders may not need a strong credit score, while others do. Some may require strict auditing of inventory, while others don’t. Do the research. Be prepared. You will impress your lenders.
Who Qualifies for Inventory Financing?
Businesses that sell products, not services, are candidates for inventory financing. Some of the things that lenders want to know about your inventory management are:
- Can employees find what they need?
- Where and how is inventory stored?
- Is it too hot, too cold, too wet or too dry for the inventory to maintain value?
- Do you have too much inventory or too little?
- How do you forecast sales?
- How much of your inventory gets lost or damaged?
- What are your monthly revenues? Are they at least $12,500?
What are your inventory turnover rates? A lender wants to see strong sales performance which can be measured by your inventory turnover rates. This measures how many times inventory is sold in a given time period. You can calculate your rate by dividing the cost of goods sold by the average inventory.
Example of Inventory Turnover Rate Calculation
Cost of goods: $60,000
Average inventory: $20,000
$60,000 / $20,000 = 3.0 inventory turnover rate
Each lender has its own criteria for borrowers. If you are a small business and your business doesn’t have a credit track record yet, lenders will look at your personal score. For traditional lenders, this would need to be over 700. For online lenders, the score minimum is usually about 600.
Tip 4: Apply to Three Lenders
If you have done your preparation you know your strengths and weaknesses. You know which lenders are the best fit for your borrowing needs. Is there a lender that is more focused on sales performance than your credit history? Is there a lender that can get you an approval fast?
What Is the Application Process?
The steps below outline the general application process. Each lender will have their own requirements but this list should give a good idea of what to expect.
First, gather these business documents:
- Tax returns
- Balance sheet
- Income statement
- Bank statements
- Inventory list
- Inventory management records
- Sales forecast
- Business plan
Second, complete lender’s application.
Third, get approved.
Fourth, due diligence. The first two or three steps move along quickly. An online lender may get back to you in a few days. A traditional lender will likely take a week or two to approve your application. This step, due diligence, is often what takes the most time to complete. This involves an examination of your inventory, its value and its storage.
Fifth, sign. When reviewing your loan agreement, be sure you understand what value the lender gave your inventory, the advance rate, interest rate, and repayment terms.
Most lenders provide lines of credit for periods of less than one year. Ask about the possibility of renewing your line.
Tip 5: Weigh the Pros and Cons of Each Offer
Making a decision about what loan is right for your business is a lot easier if you already have a business plan in place. I can see your eyes rolling. Who has time to write a business plan? You!
A complete discussion about business plans is beyond the scope of this post. But it’s important to remember that operating a business without a business plan is like taking a road trip without a map or GPS.
At a minimum, your business plan should clearly articulate the market need your product addresses, marketing plans, and sales projections. If you’re looking for help in creating a business plan, there are a lot of resources available to you. Having a business plan can also help you feel more in control.
Reviewing Your Offers
You know by now that the application process for an inventory loan is more intense than for other types of loans. Having an inventory loan can also be more intense than having other types of loans.
- You may get an offer that has a competitive rate but requires a lot of monitoring.
- You may get an offer that has a higher rate but doesn’t require auditing of your inventory.
- You may get an offer that restricts the use of the line to purchase of inventory only, while another may allow you to use the funds however you wish.
- You may get an offer where you have to pay interest only for several months, while others may require principal and interest payments.
- You may get an offer that requires you to sync with an online inventory system that would require you to make upgrades to your computer systems.
As a small business owner, you’re constantly making trade-offs between time and money. Only you know which one to prioritize at this moment.
While having inventory to borrow against is an advantage, inventory loans are riskier for a bank and therefore tougher for applicants to get an approval. Being thoroughly prepared to respond to lenders is critical.
When making a decision about an inventory loan, think long term. In addition to selecting a lender that offers the right rate and terms, you should like working with your lender.
If your lender likes working with you because you demonstrate you’re a good borrower, then the next time you need an inventory loan, the lending process will go even more smoothly.
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