Inventory financing 101: Types, pros, cons & alternatives

Inventory should fuel production and sales, not drain profits. But for many businesses, those goods sitting in storage hold the key to unlocking new growth through inventory financing. 

According to a 2023 Kearney study, excess inventory is a $250+ billion problem in the U.S. On a global scale, U.S. census data shows it amounts to trillions wasted, as someone inevitably pays for all that overstocked product.

While this overstocking problem demands better inventory management, it's undeniable that it can hinder expansion. That said, inventory financing flips this burden into an opportunity, allowing companies to leverage their very stock as collateral to secure much-needed financing.

In this guide, you’ll learn the ins and outs of inventory financing, and explore its types, pros and cons, and alternative financing options.

What is inventory financing?

Inventory financing, also known as stock financing, is a loan that empowers businesses to leverage their goods as collateral to secure capital. It's a form of asset-based financing where the value of their stock – from raw materials to finished products – determines the amount of funding they can access.

Think of it as unlocking the value trapped within a company’s warehouse. Instead of letting their stock sit idle, inventory financing allows them to tap into its worth to fuel their growth.

Stock financing is particularly beneficial for businesses with substantial inventory that need immediate liquidity to capitalize on market opportunities or manage operational costs.

In summary, these are the key features of inventory financing:

• Asset-based lending: The funding amount is based on the value of the inventory.
• Flexible use of funds: Businesses can use the liquidity to purchase additional inventory, manage cashflow, or invest in other areas.
• Collateral: The stock serves as collateral, reducing the lender’s risk and potentially offering better financing terms for the borrower.

Types of inventory financing

Lenders offer two primary types of inventory financing, each tailored to different business needs.

1. Inventory loan (term loan)

Also known as term loans, this type of inventory financing provides a lump sum payment based on the total value of your products. Much like a traditional loan, you agree to repay the borrowed amount through fixed monthly installments or a single payment upon selling the inventory.

2. Line of credit

A line of credit offers revolving access to funds. Unlike a term loan, you can repeatedly draw upon the credit line as needed, as long as you adhere to the repayment terms. It gives more flexibility for businesses with fluctuating inventory needs.

How does inventory financing work?

1. Assess cashflow needs

The initial step involves pinpointing the business's cashflow requirements. Inventory financing can bridge gaps caused by temporary disruptions or support expansion initiatives that require immediate funding.

2. Inventory valuation

Once the need for financing is clear, a third-party appraisal determines the market value of the inventory. An accurate valuation establishes the maximum funding amount that can be borrowed against the stock.

3. Negotiate terms

With the inventory valuation in hand, the business and the lender can negotiate the financing terms. These should include the capital amount, repayment schedule, and any associated fees or interest rates. The financing can be structured as a one-time-only or an ongoing arrangement, depending on the organization’s needs.

4. Continuous monitoring and financing (optional)

For ongoing financing, lenders may require periodic re-evaluations of the inventory – weekly or monthly. This process allows them to adjust the funding amount based on the current inventory value. Continuous access to funds ensures the business can meet its obligations to scale plans.

Inventory financing example

For you to better understand the process, consider the following inventory financing example.

GreenTech Solutions, a company exporting high-efficiency solar panels from the USA, faces cashflow challenges due to long production cycles and delayed international payments. To manage these gaps and expand their market reach, they seek stock financing.

Partnering with Finance Solutions, GreenTech Solutions gets a third-party appraisal of their unsold inventory, valuing it at $200,000. Based on this valuation, they secured a loan of $200,000 with a 12-month repayment term and favorable interest rates.

The financing empowers GreenTech to pay off its debts, cover production costs, and manage shipping expenses, thereby maintaining smooth operations and meeting international demand efficiently. 

To ensure continuous access to capital, GreenTech can opt for monthly inventory re-evaluations. By adjusting the financing amount based on current stock values, they can always secure the necessary monetary resources. Continuous monitoring keeps their cashflow steady, supporting their growth in the export market.

Pros and cons of inventory financing

Like any financial strategy, inventory financing comes with its own set of advantages and challenges. Here’s a closer look at the pros and cons to help you determine if it’s the right fit for your business.

Inventory financing advantages

New trading opportunities 

Inventory financing can open up new trading opportunities, especially for businesses working with delayed payment terms or those looking to expand into new markets. This allows them to grow without waiting for existing receivables to clear.

Liquid capital

It provides an instant cash boost, which can be crucial for avoiding bad debt or funding expansion initiatives. Liquidity helps businesses to remain agile and responsive to market demands.

Manage seasonal demand

Businesses can navigate slow periods and manage seasonal demand more effectively. By boosting cashflow during off-peak times, they have the necessary funds to maintain operations year-round.

Borrowing against owned assets

A company can borrow capital against its inventory without needing additional collateral, leveraging what it already possesses and can sell.

Stock management

Engaging in ongoing stock finance agreements often prompts businesses to re-evaluate their stock and purchasing practices. For example, they might streamline its supply chain or adopt just-in-time inventory management, leading to increased efficiency and profitability.

Facilitating international trade

Expanding into international markets becomes more feasible with inventory financing. It supports the funding of overseas inventory, allowing businesses to meet global demand without immediate financial pressure.

Inventory financing disadvantages 

Costs and fees

Inventory financing comes with various costs and fees, including charges for financial services and potential hidden expenses like third-party stock valuation. These additional costs can erode the financial benefits, making the financing less cost-effective than initially anticipated.

Eligibility issues

Not all businesses qualify for this type of financing. Lenders may reject applications if they deem the inventory insufficiently valuable or unsellable. Specialized or perishable goods, for example, might not meet the criteria, posing a significant hurdle for some companies.

Stock used as collateral

Using inventory as collateral carries the risk of repossession if the loan cannot be repaid. The seizure of inventory might halt production or sales, resulting in substantial financial losses and impacting the business's ability to generate revenue.

Alternatives to inventory financing

While inventory financing is a viable option for many businesses, it's not the only one. Depending on specific needs and circumstances, other financing methods might be more suitable.

1. Revenue-based financing

Revenue-based financing (RBF) provides you with immediate access to future revenues. Through RBF, you receive an advance based on your projected sales, giving you the capital to grow your business.

Pros:

• Repayments are directly proportional to your revenue, meaning payments adjust to what you can afford
• More affordable repayment amounts compared to alternative business funding services
• No need to pledge collateral or assets, reducing risk to your operations
• Quicker to process than traditional financing options, allowing you to access capital within 48 hours of signing the documents

Cons:

• Companies may be hesitant to invest large sums due to the performance-based repayment structure
• Offers are often based on the business's financial history, which might disqualify some or limit the amount of funding available
• No fixed repayment periods, making it difficult to predict when the funding will be fully repaid

Read further: What is Revenue-Based Financing?

2. Invoice financing

Invoice financing, also known as invoice factoring or accounts receivable financing, offers a powerful alternative for businesses seeking to accelerate their cashflow by leveraging their unpaid invoices. 

According to research conducted by PayIt, NatWest’s open banking solutions provider, over half (55%) of small businesses in the UK still had outstanding unpaid invoices from the 2022/23 tax year alone. Fortunately, this alternative financing empowers suppliers to access immediate capital without waiting for customers to settle their dues.

Pros:

• Quick access to funds, often within 48 hours
• No collateral is needed, as the invoice itself serves this purpose
• Greater chance of approval based on the buyer’s creditworthiness, not the business’s
• No need to chase the buyer, as the financier handles collections and takes the loss if unpaid
• Opens growth opportunities by providing upfront cash to invest and grow

Cons:

• Invoice financing companies usually charge a percentage of the factored amount
• Applicable only for invoices sent to other businesses (B2B), not consumers
• Non-recourse factoring reveals to the buyer that the supplier is using a finance provider, as the financier collects payments directly from the buyer
• In recourse factoring, the supplier must repay the advance if the buyer fails to pay the invoice, making the supplier liable for the debt

Learn more: Everything You Need to Know About Invoice Financing/ Factoring.

3. Merchant cash advance

A merchant cash advance (MCA) offers a lump sum of capital to a business in exchange for a percentage of future sales. It’s an appealing option for companies that need quick access to cash and have fluctuating revenues, as the repayment is directly tied to their daily sales.

Pros:

• Quick approval and disbursement, often within a few days
• Repayments are tied to sales, resulting in smaller payments during slower periods
• No collateral is required

Cons:

• Higher fees and interest rates compared to traditional loans
• The daily percentage taken from sales can strain cashflow
• Generally short-term, making them unsuitable for long-term needs

4. Purchase order financing

For businesses that operate primarily on a purchase order basis, purchase order financing can provide the necessary funds to fulfill large or unexpected orders. Under this arrangement, the funding company advances the cash required to buy the necessary inventory or materials to complete the order.

Pros:

• Fulfill large orders without depleting cash reserves
• Take on larger orders that might otherwise have to be declined
• Avoid increasing the debt load, as purchase order financing isn’t a loan

Cons:

• More expensive than traditional loans due to fees and interest rates
• Access financing only if you have confirmed purchase orders
• Undergo a detailed approval process that may require significant documentation

5. Microloans

Microloans from the U.S. Small Business Administration (SBA) offer another viable alternative to inventory financing. Nonprofit community-based organizations with experience in lending and technical assistance administer these loans, providing not just financial support but also business counseling and training.

Pros:

• Designed for smaller businesses and startups that may not qualify for larger loans
• Usable for a variety of business needs, such purchasing inventory or supplies, working capital, and machinery or equipment
• Often comes with additional support and guidance from microloan intermediaries

Cons:

• The maximum loan amount is $50,000
• Interest rates can be higher than those on larger SBA loans
• Repayment periods are typically shorter, usually up to six years

6. Vendor financing

Vendor financing involves collaborating directly with a supplies vendor to secure funding for purchases. In some cases, it can also include transferring stock shares from the borrower to the vendor. These funding alternatives may come with higher interest rates than traditional bank loans.

Pros:

• Streamlined financing process directly through the vendor, simplifying the acquisition of necessary goods or equipment
• Strengthened ties with suppliers by using their financing options, fostering mutually beneficial partnerships
• Negotiated favorable terms and payment schedules with the vendor

Cons: 

• Higher interest rates than other options, increasing the overall cost of purchases
• Increased dependency on vendor financing, limiting financial flexibility and growth
• Potential strain on relationships if repayment issues arise, affecting future deals

Frequently Asked Questions (FAQ)

What are the risks of inventory financing?

The main risk of inventory financing lies in the possibility that the inventory doesn’t sell as expected. This issue can lead to difficulties in repaying the loan, potentially resulting in financial strain and the loss of the stock used as collateral.

What is the difference between inventory financing and invoice financing?

Inventory financing allows businesses to borrow against the value of their stock, while invoice financing involves borrowing against outstanding invoices. It’s ideal for companies with significant physical stock, whereas invoice financing suits those with substantial receivables and less inventory.

Why do businesses use inventory financing?

Businesses use inventory financing to maintain a steady cashflow, update product lines, increase inventory supplies, and respond to high demand. It’s particularly useful for smaller, privately-owned companies that might not have access to other financing options.

Can I get an inventory financing loan with bad credit?

Low-credit borrowers might find it easier to qualify for inventory financing compared to traditional loans because the stock serves as collateral. While a credit check is still required, some lenders extend credit to those with scores as low as 500.

Inventory financing: Is it the best alternative?

Sure, inventory financing lets you turn your stock into working capital, giving your business a temporary cash injection. It sounds great – fuel growth, grab opportunities, keep the cash flowing. But before you jump in, let's talk about the elephant in the room (or should we say, the warehouse?). 

Inventory financing relies on one pretty big assumption: that you're cool with your stock being held hostage. Your precious inventory becomes collateral. If things go south, you could be left with empty shelves and a whole lot of explaining to do.

We offer a different path. Instead of putting your stock on the line, you can unlock fast funding with what you're owed (invoice financing) or the revenue you're making (revenue-based financing). No inventory fire sales required.

Ready to keep your stock and still fuel your growth? Let's talk.