Inventory Financing

What is Inventory Financing?

Inventory Financing is the short term loan or a line of credit that keeps revolving after a pre-decided time period, that is used to finance the inventory of the company and the purchased inventory acting as collateral for the availed loan. In case 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 that are held for 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.

The companies involved in the business of consumer products such as automobiles, FMCG products most often avail inventory financing since they often have their capital tied up due to 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:-

Types of Inventory Financing

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#1 – Short Term Loan

A company may avail of a short term loanShort Term LoanShort term loans are the loans with a repayment period of 12 months or less, generally offered by firms, individuals or entrepreneurs for immediate liquidity requirements. These are usually provided at a higher interest rate, these short term loans often have a weekly repayment schedule.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

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 as per which, both entities agree upon a maximum amount up to which the borrower can access funds as long as it does not exceed the maximum limit.

Example of Inventory Financing

Suppose there’s a car dealer who is expecting increased demand for cars in the upcoming season. To cater to this demand, he decides to ramp up his inventory. To do that, 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 cars he is going to purchase. Inventory financing is a key part of the business cycle as whenever he will be selling a new car; he can use that money to pay off a portion of his loan.

Inventory_Financing

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How does Inventory Financing Work?

There are some general requirements:

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 that on what conditions, the lender may extend the credit limit of the customer.
  • Financing Terms: They indicate the interest rate and its payment schedule.
  • Security Interest: This indicates the collateral that is used by the customer to avail of the loan. It can be the inventory that the customer already holds or also the inventory he is going to purchase.

Things to Consider Before Availing Loan for Inventory

  • Nature of Inventory: Inventory financing may not be a good option for companies with low inventory turnover ratio (means the inventory takes time to convert into revenue) because it will be difficult for them to repay at times. That’s the reason 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 the 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 track the level of inventory as well.

Advantages of Inventory Financing

Disadvantages of Inventory Financing

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

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

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