What is Inventory Financing?

Inventory Financing is the short-term loan or a line of credit that keeps revolving after a pre-decided period used to finance the inventory of the company and the purchased inventory acting as collateral for the availed loan. If the company fails to repay the debt, the lender has full authority to seize and sell that inventory to recover the lent capital.

Inventory forms a significant part of the company’s current assets as it constitutes the goods held for a short-term duration to meet the expected demands. But if the number of days of receivables is high, the company’s capital may get locked, and it’ll not have sufficient funds to purchase more inventory.

TThe companies involved in consumer products such as automobiles and FMCGFMCGFast-moving consumer goods (FMCG) are non-durable consumer goods that sell like hotcakes as they usually come with a low price and high usability. Their examples include toothpaste, ready-to-make food, soap, cookie, notebook, chocolate, etc.read more products most often avail inventory financing since they often have their capital tied up due to a longer cash conversion cycle, which, if available, can be used to expand sales.

Types of Inventory Financing

Now we shall discuss the different types of inventory financing, which are as follows:-

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#1 – Short Term Loan

A company may avail of a short-term loanShort-Term LoanShort-term loans are defined as borrowings undertaken for a short period to meet immediate monetary requirements.read more from a bank to purchase the inventory, but it is a tedious process as the company will have to go through the whole process of loan sanctioning every time it needs that.

#2 – Line Of Credit

A Line Of CreditLine Of CreditA line of credit is an agreement between a customer and a bank, allowing the customer a ceiling limit of borrowing. The borrower can access any amount within the credit limit and pays interest; this provides flexibility to run a business.read more is an agreement between the company and the financial institution. Both entities agree upon a maximum amount to which the borrower can access funds as long as it does not exceed the maximum limit.

Example of Inventory Financing

Suppose a car dealer is expecting increased demand for cars in the upcoming season. To cater to this demand, he decides to ramp upRamp UpRamp Up in economics refers to the boosting of a company’s production.read more his inventory. But unfortunately, he needs to purchase more cars from the supplier, which will require huge capital.

To meet the capital needs, he gets a loan sanctioned from a national bank based on the value of the cars he will purchase. Inventory financing is a key part of the business cycle, as whenever he is selling a new car, he can use that money to pay off a portion of his loan.

How does Inventory Financing Work?

There are some general requirements:

  • Good Credit Record: If the customer has defaulted on his payables in the past, the possibility of getting inventory financed is low.Inventory Value: The customer also needs to provide the bank with the list of inventoryList Of InventoryInventories list is the systematic record of the raw material, work-in-progress and finished goods available with the company. All the stock items are entered along with their SKU number or inventory Id, name, description, unit price, quantity, value, reorder level, reorder time, quantity in record and discontinuation status.read more he is willing to purchase and its value. He may also need to explain the inventory valuation method (LIFO, FIFO, or weighted average). (Note: Last In First Out AccountingLast In First Out AccountingLIFO (Last In First Out) is one accounting method for inventory valuation on the balance sheet. LIFO accounting means inventory acquired at last would be used up or sold first.read more and First In First Out Inventory First In First Out Inventory Under the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost.read more are two inventory valuation methodsInventory Valuation Methods Inventory Valuation Methods refers to the methodology (LIFO, FIFO, or a weighted average) used to value the company’s inventories, which has an impact on the cost of goods sold as well as ending inventory, and thus has a financial impact on the company’s bottom-line numbers and cash flow situation.read more).Business Plan: The business plan provides an overview of a customer’s plan to pay off the loan. Based on the plan, the bank can decide the amount sanctioned as a loan.

How does Agreement Work?

Inventory financing is an arrangement between the financial institution and the company. Following are the major parts of the agreement:

  • Extension of Credit: It may specify under what conditions the lender may extend the customer’s credit limit.Financing Terms: They indicate the interest rate and its payment schedule.Security Interest: This indicates the collateral that the customer uses to avail the loan. It can be the inventory that the customer already holds or the inventory he will purchase.

Things to Consider Before Availing Loan for Inventory

  • Nature of Inventory: Inventory financing may not be a good option for companies with a low inventory turnover ratio (which means the inventory takes time to convert into revenue) because it will be difficult to repay at times. That’s why it is mostly the FMCG companies that use this facility.Credit Score: If the companies do not have a good credit score, they will find it difficult to get capital. Even if they manage to get that, the interest rate will be relatively high because there are chances of default.Confidence Level in Inventory: The lender has the right to inspect the inventory to ensure it has maintained its value, and it can also track the inventory level.

Advantages of Inventory Financing

  • Every company requires working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It’s a measure of a company’s liquidity, efficiency, and financial health, and it’s calculated using a simple formula: “current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)“read more to meet its day-to-day expenses, including purchasing the inventory. Inventory financing can help in managing the working capital efficiently.This is especially beneficial for seasonal businesses because these businesses’ demand is not stable. To meet unforeseen demand, inventory financing is a good option.The companies involved in trading goods also get significant benefits from inventory financing. The import and export of goods involve significant delays. Depending upon the terms settled between the two parties, the sender’s payment of the goods may get delayed as the receiver will pay the amount only after receiving his order. In this case, the sender will not be able to serve its other customer, and hence he can utilize inventory financing options to serve others.

Disadvantages of Inventory Financing

  • Any unexpected event such as an economic slowdown that may reduce the demand or a natural calamity that may impact the company’s inventory can make it difficult for the company to pay back the loan.It can impact the company’s cash conversion cycleCompany’s Cash Conversion CycleThe Cash Conversion Cycle (CCC) is a ratio analysis measure to evaluate the number of days or time a company converts its inventory and other inputs into cash. It considers the days inventory outstanding, days sales outstanding and days payable outstanding for computation.read more as the company will keep relying on loans to meet short-term requirements.Usually, when a company avails a loan, it is obligated to pay regular interest payments. While in the case of inventory financing, it needs to regularly stay in contact with the lender. At times, it is also required to report its inventory levels and its valuation every month.

Thus, inventory financing can be a useful option for businesses involving longer cash conversion cycles or seasonal demand or trading of goods. But they must choose their lender carefully after considering all the repayment terms. And companies should try to shorten their cash conversion cycle to avoid too much reliance on short-term loans.

This has been a guide to what is inventory financing & its definition. Here we discuss how inventory financing works along with types, examples, advantages, and disadvantages. You can learn more about accounting from the following articles –

  • Shrinkage FormulaInventory ShrinkagePerpetual Inventory SystemIs Inventory a Current Asset?