Inventory Finance: What Is It, Types, Pros and Cons

You have just received a big order, larger than any previous order received by your business. Or peak season is six weeks away and your supplier is offering a bulk discount that disappears at the end of the month. You are faced with an opportunity and you also face a challenge since most of your funding is already committed to your current inventory levels.

This is one of the most common financial pressure points for product-based SMEs in Australia. Cash flow is not the issue, but the timing gap between purchasing stock and receiving payment from customers becomes a problem that can cause owners to forgo expansion opportunities.

Inventory finance is a funding solution designed specifically for this problem. This article explains what inventory finance is, how it works, the main types available, who it suits, and the honest pros and cons.

What Is Inventory Finance and How Does It Work?

Inventory financing is a type of asset-based financing in which a business borrows funds to purchase stock, using that stock as collateral for the loan. This type of financing is different from a traditional business loan since it may require you to pledge property, equipment, or other business assets. The only thing that is needed is the inventory itself. If a borrower defaults, the lender can seize and sell the collateralised goods to recover the outstanding balance.

It is important to note that inventory finance is purpose-specific. The funds provided through inventory finance must be used to purchase stock. It is not possible to allocate the money for marketing expenses, payroll or other business expenses, which is a distinction from more flexible financing products such as a line of credit.

How the Financing Cycle Works

The process is quite simple and includes the following steps:

1. Application: Submit an application with your inventory records, financial statements, and business details.
2. Evaluation: The financing provider evaluates your inventory and conducts due diligence on your business.
3. Funds advanced: Once approved, you will receive a lump sum or access to a credit facility based on a percentage of your inventory's appraised value.
4. Purchased stock: You use the funds to buy inventory from your supplier.
5. Sell stock: You sell the goods to your customers and collect revenue.
6. Repayment: Revenue from sales, together with interest and fees, is used to repay the facility.
7. Repeat of cycle: For revolving structures, repaid amounts become available to draw again.

What Providers Look at Before Approving

Before advancing funds, providers usually conduct some or all of the following processes:

• Inventory appraisal: Evaluation of the market value and liquidity of your stock (ease of sale)
• Field examination: Physical inspection of your warehouse or storage facilities to verify that the inventory exists and is properly managed
• Accounting system review: Evaluate how effective your business’s inventory tracking and record-keeping practices are
• Inventory turnover analysis: Assets on how fast your goods sell, which helps indicate the level of repayment risk

For larger facilities, this due diligence process can require additional time and may involve a cost. This process will be easier for businesses with organised inventory management systems and record keeping.

Types of Inventory Finance

Inventory finance offers different types of products. Different types of structures depend on the different business requirements and purchasing patterns.

1. Inventory Loans

An inventory loan is a lump-sum facility. This means that you will receive a fixed amount of capital as per the value of the inventory that you wish to purchase. You have to pay back in instalments along with the interest within a fixed time period.

This structure is suitable for businesses that have a clear and one-off purchasing need. such as a seasonal bulk purchasing, a large shipment from a supplier or a heavy stock purchase before peak season.

For example, your inventory is valued at $300,000. Your financial provider offers an advance rate, meaning that you get a one-off payment of $150,000. You repay this amount with interest over 24 weeks.

However, the key drawback is the lack of flexibility. You will not be able to get additional funds once you have drawn down the loan. Since repayments are fixed, they will go on even if sales are high or low.

2. Inventory Lines of Credit

Under the inventory line of credit, you will have access to funds within the limit approved by the financial provider. This is the amount that you can withdraw, pay back when sales are made and the repaid amount becomes available again. The interest charged depends on the withdrawn amount instead of the credit limit.

This structure is suitable for businesses with ongoing or unpredictable purchasing needs, such as importers handling multiple purchases, retailers restocking frequently or e-commerce sellers who need flexibility while handling their customers.

For example, you have access to a line of credit of $250,000. You withdraw $100,000 in the 1st month to buy inventory. In the next month, you pay back $60,000 and your balance goes back up to $210,000.

The line of credit system is more flexible than a term loan and is a better choice for businesses with seasonal or unpredictable inventory cycles. 

3. Floor Planning

Floor planning is a specialised form of inventory finance, which is mainly used by businesses that sell high-value individual items, such as vehicles, boats, heavy machinery, or large appliances. Under a floor plan agreement, each inventory is financed individually and repayment is triggered when a specific unit is sold rather than on a fixed schedule.

This is different from standard inventory finance as repayment is based on a schedule rather than on item-by-item sales. Floor planning is common in car dealerships and equipment retailers, but does not apply to other businesses, such as retail or e-commerce companies.

4. Inventory Finance vs. Purchase Order (PO) Finance

These two products are often confused but have different purposes and operate in the supply chain process. 

Purchase order (PO) finance provides funds to pay your supplier before the manufacturing or shipment of products. It is pre-production funding based on a confirmed customer order.  The lender pays the supplier directly and you repay the loan after receiving payment from your customer for the purchase order.

However, inventory financing is used once goods are ready to be purchased or have already arrived at your company. It finances existing or incoming stock, not production.

If your cash flow gap happens before the products are available, or you have an order but cannot provide funding for the manufacturing and delivery of the product by the suppliers, purchase order finance would be the better choice. If the gap happens after purchase, inventory financing is the right fit.

Who Should Consider Inventory Finance?

However, inventory financing may not be suitable for all businesses. It is suitable for businesses that depend on inventory management systems for generating revenues.

Types of Businesses that Suit Inventory Financing

• Businesses involving products: Any business that buys and sells physical products, from appliances, household items, to clothing, would be ideal for inventory financing. If capital keeps getting tied up in stock, inventory finance can directly address the problem.
• Seasonal retailers: Businesses that generate most of their revenue during specific periods (e.g. Christmas, end of financial year, back-to-school or summer) have to purchase stock before they can receive any cash from customers. Inventory financing helps them to stock up before sales occur without losing on working capital.
• E-commerce sellers preparing for peak events: Online retailers getting ready for high-demand periods, such as Black Friday, need to build up inventory well before the period. An inventory line of credit gives them the flexibility to build their stocks according to demand signals.
• Wholesalers and importers with long supplier lead times: Businesses purchasing from overseas suppliers face a significant gap between payment for inventory and receiving revenue. Inventory finance fills that gap without forcing the business to keep large cash balances.

Pros and Cons of Inventory Finance

Like all types of financing products, inventory finance comes with pros and cons. Understanding both sides is crucial to determine whether this type of financing is right for your business or not.

Advantages of Inventory Finance

• No need to pledge property or equipment as collateral: The inventory itself secures the loan. This is significant for asset-light businesses that do not have any hard assets that traditional lenders require, especially e-commerce operators and smaller retailers.
• Easier qualification for businesses with limited credit history: Since the process is based on the valuation of your inventory instead of your credit rating, businesses that are too young or have too few assets to get loans from banks will be able to obtain this type of loan. Some providers require as little as six months of operating history.
• Faster financing compared to traditional bank loans: Businesses may wait for months before getting their bank loan approved. However, inventory financing will be faster, especially from non-bank and alternative lenders. It can help business owners during supplier discount periods and when there are large orders to be filled.
• Flexibility through a line of credit: With a line of credit for your inventory, you can draw funds, repay and redraw as your business needs evolve without having to reapply each time. This is very helpful for businesses that experience many purchases per year.
• Preserves working capital for other business needs: Instead of deploying your own cash reserves into a large stock purchase, you will be able to preserve your capital for other uses, such as payroll or marketing, through inventory financing.

Disadvantages of Inventory Finance

• Advance rates cap borrowing well below total inventory value: The advance ratio of 20-65% means that you will be given only a percentage of the actual value of your inventory. This may be insufficient for businesses requiring finance for the full cost of inventory.
• Higher interest rates than secured bank loans: Since it is considered a higher risk than a loan secured against property or equipment, interest rates charged on them will be higher.  Businesses that have a good credit rating and physical collateral would find bank financing cheaper.
• Restrictive loan covenants: The providers may restrict the use of money (purchase of stock only), require you to purchase an insurance cover for the collateralised inventory and specify rules around how proceeds from sales are handled. 
• Due diligence can be extensive and costly for larger facilities: For significant credit lines, providers may conduct due diligence, involving field examinations, third-party inventory appraisals and an accounting review. All these processes cost time and may carry a fee. 
• Cash flow pressure if inventory does not sell as expected: Inventory loans carry fixed repayment schedules. If sales underperform due to a slow season, market shift or supply chain issue, you still have to pay the instalments, adding more pressure on your financial liquidity.

Is Inventory Finance Right for Your Business?

Inventory finance is a practical and accessible option for any business that sells products and needs to purchase inventory but is unable to allocate funds from its own sources or provide property as collateral. It works best when your inventory records are in order, your goods are liquid and easy to value and a predictable source of revenue. One of the most important practical decisions you need to make is timing. Applying for an inventory facility before you are under pressure and facing a financial crisis will provide you with bargaining power to get better terms and the time to complete the due diligence process. 

Choco Up can help you find the right structure if you are considering other options of working capital compared to inventory financing. We help Australian SMEs to find financial products tailored to their business objectives. Explore your financing options with Choco Up now.