Inventory Loans vs. Inventory Line of Credit: What’s the Difference?
Ezra Cabrera | August 19, 2022
Inventory financing allows you to leverage your company’s unsold inventory in exchange for immediate and revolving cash flow. Through financing, your business could secure the funds necessary to grow your business.
There are two types of inventory financing available for entrepreneurs. These are, namely, the inventory loans and inventory lines of credit.
How Inventory Loans Work
Inventory financing is asset-based financing. This means that you provide the lender with the inventory you're looking to acquire as a guarantee. If you fail to settle your obligations, the provider will seize your supplies and auction them to recover their losses.
Because of the risk involved, lenders will typically extend only you a percentage of the assessed value of the inventory. Creditors are known to finance between 20% and up to 90% of the inventory's value. However, the amount depends on certain factors.
Here are some of the considerations lenders can have when deciding the actual financing amount:
Type of inventory
The type of inventory you want to acquire is of prime concern to lenders because this is where you get the funds that you then use to settle your debt with them. Thus, products that move quickly or do not depreciate rapidly could fetch a higher financing amount. These include raw materials, as these objects can be made into various products that borrowers can sell. On the other hand, perishable items like food are less likely to get approved for financing.
History of strong sales
Lenders will always favor those businesses with a strong selling history involving the products they're trying to secure financing for. Aside from demonstrating that you can pay, sales history also gives lenders a glimpse at how difficult it would be for them to dispose of the inventory when they seize it from you. If you cannot sell the commodity fast, they cannot auction them off that quickly.
Although inventory financing is secured by your new inventory, some creditors may want to look at your credit record as an additional layer of security. Generally, borrowers with a track record of timely payments have higher odds of getting approved for inventory financing. However, that is not always the case, as the two factors above would still bear more weight.
Inventory loans are theoretically a good source of financing for businesses looking to buy additional supplies for their shelves. However, like any form of financing, it has its own pros and cons.
Advantages and Disadvantages of Inventory Financing
Here are some of the advantages of securing inventory loans for your business:
Quick approval process
Lenders providing inventory loans do not require much paperwork for their application process. You may only need to provide proof of sales history and a sales invoice from your supplier to apply. Creditors also take only one to two weeks to approve applications.
Secures customer demand
Part of your business' reputation relies on how you meet your customers' demands. You could lose customers from chronic supply problems alone. With inventory financing, you ensure both consistent sales and customer retention. These two, in turn, raise the possibility of business success.
No personal collateral needed
The lender only requires that you pledge your future inventory as collateral. You don't have to risk losing personal properties and existing business assets if you eventually default on your obligations. You enjoy peace of mind from the first payment until the last amortization of your debt.
An inventory loan is not without its cons. Here are a couple of disadvantages you might want to consider:
This financing is not for all types of inventory
Lenders are meticulous when it comes to the merchandise they accept as collateral. Only those items with a high potential for quick sales have good chances of getting approved for financing. Even if you seek to finance purchases of high-selling products, you still have to prove your sales history to the lending company.
High interest rates
Lenders face significant risk when extending inventory financing. It's risky for them because your ability to repay hinges on how fast you can dispose of the pledged inventory. They also face the same hurdle when they auction your stocks in the event of default. To minimize losses, lenders will impose high interest rates.
However, with a good sales and marketing strategy, you can also minimize the disadvantages and risks you face when seeking inventory financing.
How to Apply for Inventory Loans
The application process for inventory loans is very straightforward. Here are the steps that make up the procedure:
Prepare your financial statements
Lenders need to know your business' financial health, particularly your recent sales history of the inventory you're looking for finance. Ideally, you must demonstrate a stable income in your most recent reports. All this information is encoded in your financial statements, like your balance sheet, profit and loss accounts, and inventory management records. You might also want to throw in your sales forecast reports too.
Pick a lender and submit your application
There are various lenders offering inventory financing online. Take time to see which one offers the most favorable terms for you, and submit your application. Thanks to the Internet, application processes take no more than 10 minutes. You can create an account on the lender's website and upload digital versions of your documents there.
Cooperate with the assessment process
Every lender has its own assessment procedure to follow. Some keep the process remote, while others may want to visit your store if you maintain a physical location. In any case, assessment is a routine part of your application. Assist the lender's representative as best as you can.
Go through the draft offer
The lender's customer service representative will present you with a draft financing offer with all the details you need, including interest rates and repayment schedules. Make sure to go through the fine print. You should have a solid understanding of what you're borrowing before committing to a contract. Take your time, and don't hesitate to ask the creditor any questions.
Finalize the loan with the lender
When you're happy with the terms, it's time to finalize the deal with the lender. Affix your signature on the final contract and wait for the creditor to forward the funds to your account. After this, your sole obligation is to keep up with your repayment schedule and maintain good standing with the company.
What Is an Inventory Line of Credit?
The inventory line of credit or LOC is a flexible form of inventory financing. It is the opposite of an inventory loan, which features fixed repayment terms. Inventory loans typically close the borrower's account once they have settled their obligations in full. The LOC, on the other hand, remains usable until the borrower decides to close the account or they default.
Advantages and Disadvantages of an Inventory LOC
The main advantage of having an inventory LOC is control over your finances. The LOC extends your business a fixed amount of credit for you to use. However, you need not withdraw the entire amount at any time. Instead, you can draw down only the amount your business requires to keep your inventory n top shape.
In other words, you pay only the amount you owe and the interest that comes with it. The rest of the credit line remains available to withdraw from when needed. It's common to have multiple loans and due dates when using an inventory LOC; its flexibility lets you make several withdrawals even if you still have pending payments.
Another advantage of the inventory LOC is its revolving nature. Repaying an earlier loan in full returns the amount borrowed to your total credit. As long as you manage your finances correctly, your business will always have a ready source of working capital with this line of credit.
Last but not least, the inventory LOC helps your business build a positive credit score. Consistent, timely payments increase credit score and create a good relationship with the lender. Just make sure that you monitor your business credit score and ensure that every transaction is reported.
On the other hand, the biggest drawback of having an inventory line of credit is its susceptibility to mismanagement. Some business owners find themselves unable to keep up with the periodic payments. You can mitigate this risk by instituting a monitoring discipline to ensure your obligations are within your company's capacity to pay.
How to Apply for an Inventory LOC?
Applying for an inventory LOC is similar to securing an inventory loan. LOC lenders will ask for the same documents to assess your business's sales history and capacity to pay. Some lenders may also want to evaluate your inventory management systems. For instance, they will want to know if you and your team accurately keep track of inventory movement.
Another concern that lenders may want to look at is your storage and inventory loss ratios. Unlike a fixed-term inventory loan, the LOC is a long-term commitment. Your creditors will want to know if your inventory management systems keep your business from incurring inventory loss or damage. Loss and damage could translate to lost revenues and affect your capacity to repay your withdrawals from the LOC.
What Businesses Can Benefit From Inventory Financing and Inventory Line of Credit?
Any business that sells tangible products to customers and clients can be eligible to apply for inventory financing. These companies are grouped into three categories, namely:
These businesses purchase supplies in bulk but resell them on a per-item basis. These include brick-and-mortar stores, supermarkets, department stores, and boutiques. Shops specializing in specific products are also considered retailers and could apply for inventory financing.
Like retailers, wholesalers purchase products in bulk, but they sell their wares off at lower prices than retailers. They also provide discounts for those who decide to buy in higher quantities. These businesses move suppliers faster than retailers and always need to replenish their supplies at equally fast paces.
These entrepreneurs depend on quick supply movements at certain times of the year. They can either be retailers or wholesalers who can leverage inventory financing to prepare for their products' incoming rise in demand.
If your business falls into any of these categories, you might want to consider getting inventory financing. Financing will help your enterprise prepare for seasonal sale spikes and ensure that your shelves have the necessary stocks to address the demand.
The Bottom Line
Both inventory loans and inventory lines of credit have many benefits for businesses selling products in the market. Inventory lines of credit are generally more advantageous because of their revolving nature. Business owners also don't have to apply again if they want to take out more credit from their accounts.
However, a revolving line of credit may have lower limits than what a business needs to procure additional inventory. This deficiency could theoretically lead to the enterprise incurring more debt than it could keep up with as it seeks other sources of financing.
On the other hand, inventory loans allow for pre-agreed repayment amounts over several months as stipulated in the contract. They're easier to monitor than inventory LOCs because of their fixed nature. However, they could tie down a significant portion of the business' cash flow until the entrepreneur fully pays off the loan. Entrepreneurs would also have to go through the application process again to secure additional financing.
Deciding which of the two inventory financing options is more beneficial for you hinges on your business' specific circumstances. The lower credit limits of inventory LOCs can fit the capabilities of small businesses that have a solid financial management system in place. On the other hand, an inventory loan is ideal for sellers with stable sales histories and are capable of significant inventory movements.