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:-
#1 – Short Term Loan
A company may avail of a short term loan 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 Credit 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.
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, the list of inventory he is willing to purchase and also the value of it. He may also need to explain the inventory valuation method (LIFO, FIFO or weighted average) used for valuation. (Note: Last In First Out (LIFO) and First In First Out (FIFO) are two inventory valuation methods).
- Business Plan: Business plan provides an overview of the plan that a customer has to pay off the loan. Based on the plan, the bank can decide the amount that can be 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 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
- Every company requires working capital 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 the trading of goods also get significant benefits from inventory financing. The import and export of goods involve significant delays. Depending upon the terms settled between two parties, the payment of the sender 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 option 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 inventory of the company, can make it difficult for the company to pay back the loan.
- It can impact the cash conversion cycle of the company 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 only. While in case of inventory financing, it needs to stay in contact with the lender regularly and at times it is also required to report its inventory levels and its valuation on a monthly basis.
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 –