Is Inventory Financing Right for Your Startup?
Inventory is one of the most difficult things to manage for a startup or small business. It requires a delicate balance between your cash flow and your products. Mistakes are usually expensive.
Too much inventory ties up valuable cash flow in unsold stock or raw materials that just sit in your warehouse until sold. On the other hand, too little inventory can also cause serious problems. You could run out of products and lose orders – and clients.
However, having the right levels of inventory can be difficult to accomplish, especially if your company is not well financed. You may not be able afford to keep products and materials stocked in your warehouse to fulfill orders.
Inventory problems get more complex as you grow
This problem gets more complex as your company grows. There are a number of possible scenarios, but here’s an example. It’s common for startups and small businesses to celebrate when they get a large order from a big box retailer or similar company. This reaction makes sense, as these orders can be great opportunities for a company.
Reality soon sets in once they realize that most large contracts – especially with retailers – have various inventory clauses specifying that the small business must maintain certain levels of inventory at all times. They must be able to fulfill and turnaround potential (but not guaranteed) orders quickly. Failure to meet this provision can result in penalties and the loss of the contract.
As you can imagine, this failure is expensive – very expensive.
The fact is that few companies can afford to grow without a source financing. One tool that can help fund your company and improve your cash flow is inventory financing.
How does inventory financing work?
Inventory financing is a type of asset based lending that allows you to leverage your inventory. It can also be used to finance finished products or raw materials (used in manufacturing). Financing inventory frees up some of your funds. It provides your company with working capital that can be used to pay for company expenses or purchase additional inventory.
The financing line allows you to get an advance based on the appraised value of your inventory. The advance can range from 50% to 70% of this value. Transactions usually settle once the client pays for the inventory.
The appraised value of your inventory, which determines the size of the financing line, is a critical variable in this type of funding. It determines how much funding you can get. Most finance companies determine the value of your inventory using either the Net Orderly Liquidation Value or the Forced Liquidation Value.
Keep in mind that these appraised values can be lower than what you paid your supplier for the inventory. Learn more about inventory finance.
Can inventory financing help your startup?
The short answer is: it depends. Although inventory financing can help startups, it cannot help brand new companies. Your company must have some traction.
Generally, this solution is easier to get than a conventional loan. However, qualifying for inventory financing is not easy. Your company must have:
- Two years of positive trading history
- Marketable inventory
- A perpetual inventory system
- Good financial and inventory controls
- Accurate accounting
To qualify for inventory financing, you must have a reasonably large market for your inventory. Unfortunately, you won’t meet this requirement if you are building custom-made products with a limited market.
Also, your company must have a perpetual inventory system in place. This type of system allows you to know the exact level of inventory at any given time. It allows you and the finance company to determine which inventory items can be financed and which have been sold.
Advantages and disadvantages
The obvious advantage of financing inventory is that it can improve your working capital. It can provide you with a tool to finance your assets and grow your business.
However, inventory financing does have some disadvantages. The main disadvantage is cost. It is more expensive than other asset based solutions, such as invoice factoring.
Inventory finance lines have high setup costs because the inventory must be appraised and the business must be evaluated. The appraisal is done on-site by the specialized appraiser. The lines also have high operational costs, as appraisals need to be done regularly.
Additionally, the appraised value of the inventory can often be substantially lower that what you paid your supplier. This lower appraised value affects the amount of financing you can get.
Things to do before considering inventory finance
Before considering a financing solution, make sure that your inventory is at an optimal level. This level of inventory reduces your need for financing and helps protect your profit margins.
Also, review your invoicing and collections procedures. Make sure that you are collecting unpaid invoices efficiently. This step improves your working capital immediately. In some cases, it could eliminate your need for external financing.
Lastly, use inventory financing only after you have exhausted cheaper asset based financing options.