How do you feel when you have to tell a customer that you’re out of a product they want? Not good.
You’re in business to please customers, not disappoint them. Unhappy customers are less likely to return and more likely to post a negative review.
You may have suppliers that won’t extend your needed credit terms. You may have worked with traditional banks that don’t understand your business. To get the credit that you need, an inventory credit line might be the way to go.
What Is an Inventory Credit Line?
You’re probably using some form of credit right now. The credit was given to you as either a lump sum (term loan) or as revolving credit (line of credit).
Term loans are typically used for long-term investments in your business, like equipment. A credit line is used for short-term financing, like inventory.
Inventory credit lines are simply lines of credit secured by your business’s inventory. A lender uses your inventory on hand and/or inventory being purchased as collateral.
Different industries – from manufacturers to the corner grocer – use inventory financing to fund purchases. What all these businesses have in common is that they sell physical products – not services.
Imagine the product you’re selling is swimwear. It’s the middle of winter and you’ve purposely kept your inventory low.
Fast forward a few months and you need to have the best selection of swimsuits on the block for spring break shoppers. You also have to hire an extra employee to deal with the rush of customers. Your cash flow is tight.
Before we find a solution to get cash flowing in your business, let’s review a few important terms to know when considering inventory finance.
Asset-based Lending
Inventory financing is a type of asset-based lending. This means a loan or line of credit secured by business assets like inventory.
Liquidation Value
Lenders will assign a liquidation value to your inventory. This is the value of the inventory when the seller is extremely motivated to sell. Don’t be surprised if the liquidation value is less than the book value you put on your balance sheet.
Advance Rate
Lenders will assign an advance rate to the liquidation value of your inventory. The advance rate is the percentage of the liquidation value that determines your spending limit.
How Does an Inventory Credit Line Work?
Here’s a quick and easy example of how an inventory credit line works.
Scenario 1
Revisiting your bathing suit retail shop stocking up for peak selling season – you want to buy inventory at a cost of $100,000. Your supplier’s payment terms are 30 days and you want to hire a seasonal worker.
If you don’t buy your bathing suits, you don’t have anything to sell. If you tie up all your cash in inventory, you can’t hire help and you won’t move the inventory as quickly. The proverbial small business retailer’s paradox!
You decide to check out inventory finance options. Your lender determines the liquidation value of the bathing suits is $80,000. The advance rate is set at 80%, giving you an inventory credit line with a $64,000 spending limit.
You max out the line to buy the inventory to have stocked shelves when the customers rush in. Most lenders allow you to pay interest only for a period of time. These are often weekly payments.
As peak season winds down, you’ve accumulated enough to pay off the principal balance on the line. You can now use the line for additional purchases or working capital needs.
Scenario 2
Another scenario might be that you have the cash to buy the inventory but didn’t plan to hire a seasonal worker.
But a couple of weeks into peak selling season, you realize that to move the inventory as quickly as customers are demanding, you need to hire. You can go to a lender and use the already purchased inventory as collateral.
If you’re unable to pay back the inventory credit line because the inventory didn’t sell, the lender will take possession of the inventory.
What Types of Businesses Benefit from an Inventory Credit Line?
Large and small business across various industries benefit from an inventory line of credit. Wholesalers and dealerships have been using inventory financing for decades.
Until recently, it was difficult for smaller retailers and online retailers to get inventory credit lines. These businesses used to rely heavily on credit terms with suppliers.
With the advent of online lenders, inventory financing is more accessible for small retailers. Small brick-and-mortar shops, e-commerce retailers, as well as eBay and Amazon sellers can get inventory credit lines.
Most business owners have dealt with a supplier that can’t or won’t extend credit terms. This puts you in a tough spot. Even if credit terms are available, they might need payment faster than you can convert your inventory into cash.
Businesses that have uneven cash flow can leverage their inventory to help with working capital. 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.
Seasonal businesses that rely on one or two seasons to make money have uneven cash flow. The money that you make during peak season needs to last you until the next season. An inventory credit line means you’re prepared to make inventory purchases when cash flow is slowest.
If you’ve been rejected by traditional lenders, you may qualify for inventory financing with an online lender. Traditional lenders don’t embrace businesses without long-term assets, like equipment. Traditional lenders also struggle to provide funds to newer businesses.
Who Qualifies for Inventory Financing?
Before applying for an inventory credit line, consider some fundamentals that lenders want to know about your business.
Inventory Management Systems
Current and clean reports on the status of your inventory are important for lenders. This is how they will get paid back. They want to know what’s going on. Some questions to ask yourself:
- 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?
Monthly Revenue Minimums
This will vary by lender but most have a minimum amount of revenue they want to see. Traditional lenders will want to see a much higher revenue level than online lenders. An online lender’s required monthly minimum revenue could be as low as $12,500.
High 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.
Cost of goods: $60,000
Average inventory: $20,000
$60,000 / $20,000 = 3.0 inventory turnover rate
Decent (But Doesn’t Need to Be Perfect) Credit
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.
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.
1. Gather these business documents:
- Tax returns
- Balance sheet
- Income statement
- Bank statements
- Inventory list
- Inventory management records
- Sales forecast
- Complete lender’s application
- Get approved
2. Due diligence
The first 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.
3. 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.
What Are the Advantages of an Inventory Credit Line?
Without a doubt, there are advantages to having an inventory credit line. Are any of these important to operating your business?
- Allows you to leverage inventory
- Easier to get than conventional financing
- A line can increase as your company grows
- Prepare for peak season by accumulating inventory
- Take advantage of bulk discounts from supplier
Like all business decisions, there are trade-offs which we review below.
What Are the Disadvantages of Inventory Credit Line?
When a lender takes inventory as collateral for a line of credit, they want to verify the value of the inventory and protect the value of the inventory.
The need to verify and protect the collateral can translate into the following disadvantages.
- Requires more due diligence than some other types of financing.
- Requires more monitoring than some other types of financing
- Higher interest rates than traditional financing
For some business owners, the disadvantages aren’t worth it. In that case, you may consider credit card financing or supplier credit.
To Apply or Not to Apply?
Your customer demands are not always predictable. The economy is not always predictable. For these reasons, you want to have options to keep your inventory current.
If you’re a product-driven business, an inventory credit line might be the right solution. Check out your options with online lenders.