Inventory Financing for Small Businesses

What is inventory financing?

Inventory financing is a short-term loan or a line of credit that helps your business purchase inventory. You can receive financing using your inventory as collateral (which, in most cases, needs to be assessed by an auditor). If you don’t have enough cash or working capital on hand, inventory financing can be a viable option to hold enough inventory for increased sales while paying your suppliers and payrolls to keep your business in shape.

When is inventory financing a viable option?

Most businesses own inventory, but that doesn’t mean that all of them should take out a loan or a line of credit with their inventory as collateral. Sometimes there are seasonal fluctuations in demand for products that your company sells and you have to acquire excess inventory. 

For example, if you happen to be a seller of snowboarding gear, your seasonal demand will be concentrated in the winter months as opposed to the summer months. This makes your cash flow unpredictable or insufficient to support your business operations as you make most of the sales during the winter but might not have enough capital to support your winter demand.

Predicting Demand

To prepare for the upcoming sales season, you first need to predict how much you need to order based on past seasonal demand patterns. If you have sales software, try creating a chart of prior year sales and expect a similar pattern this year. Keep in mind the variables and levers that affect your sales, like the weather or the number of local tourists. This type of demand forecasting is considered a statistical method, which includes time series analysis, regression analysis, ARIMA (AutoRegressive Integrated Moving Average), and exponential smoothing.

You can also adopt more advanced methods like the causal demand forecasting model, which combines years of qualitative and quantitative data into consideration. It mathematically expresses the relationships between each variable like market study and past sales data and processes them in a flow system pipeline. For most small businesses, a causal model can be difficult to implement and too costly, so unless you’re ordering a very large amount of inventory in terms of order value, the return on investment might not be worth it.

Benefits of Inventory Financing

The obvious benefit of financing your inventory is the ability to meet demand even when you do not have enough cash on hand. Because inventory costs money but also creates gross profit (unless you’re selling at a loss), if the cost of capital is lower than the expected gross margin you will generate through sales, it logically makes business sense to finance inventory to handle demand higher than what your working capital is capable of.

If that’s the case, you can increase working capital by receiving inventory financing to meet other basic business needs like payroll, subscription costs, and other various expenses.

Types of Small Business Financing for Inventory

7(a) Loans

The 7(a) Loan Program is the primary business lending program from the SBA (Small Business Administration). It can be used for short and long-term working capital, which includes purchasing inventory. To be eligible for the 7(a) loan, you have to be a small business and operate for profit, along with other requirements. You can borrow up to $5 million, but the amount may vary depending on your business situation.

Inventory Financing

As the name suggests, inventory financing uses your inventory as collateral to lend you money. The terms are likely worse than other types of financing (such as higher interest rates), as your only collateral is inventory. 

However, since other factors like credit score are less important when it comes to financing, it can be a viable option for new businesses without established credit scores and assets.

Vendor Financing

Another type of financing you should consider is vendor financing, where the manufacturer of the product provides it upfront and gets paid later. Because there is no upfront cost to securing inventory, vendor financing is a perfect alternative to loans from financial institutions. 

However, vendor financing terms could vary greatly depending on the vendor, your relationship with the vendor, or their financial situation.

Revenue-based Financing

Payment processors like Stripe or financial firms may provide revenue-based financing to small businesses. Typically, the loan amount depends on the revenue your business generated in the past and you pay back the loan with the interest by deducting them off of your revenue payouts.

Revenue-based financing may depend less on the creditworthiness of the business and allow easier access to capital.