written by: Alice Rovney•edited by: Jean Scheid•updated: 1/4/2011
When cash is tight, looking into a small business loan starts to sound more and more appealing to purchase needed inventory. Collateral is always a challenge, so here, we'll consider the pros and cons of inventory financing.
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What Is Inventory Financing?
Imagine the process of filling out an application for a bank loan. Cash is tight and in order to continue operating at full capacity or sustain growth, the idea of a business loan is sounding more appealing by the minute. That is, until the part about collateral comes up. Many small business owners do not have much to offer in terms of collateral for securing a loan.
More often than not, using the equity in their personal home or vehicle is out of the question. However, for businesses that carry an inventory there is hope. Inventory financing is the method of securing a business loan using on-hand inventory as collateral. Sometimes accounts receivable and other assets are considered toward collateral as well. Usually these are short term loans, meaning that they must be paid within a year. So, what are the pros and cons of inventory financing?
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Pros to Inventory Financing
Anyone in business knows that it takes spending money in order to make money. Core expenses such as rent, fuel, electricity, and payroll expenses still need to be paid, even when cash is tight. Sometimes a business has the potential for growth but lacks the cash it needs to make that growth happen.
For example, imagine operating a retail store that customers in the community love. Word of mouth has spread and the store continuously serves repeat and new customers. In order to sustain the growth, this business owner may need to purchase more inventory or rent a larger building which of course comes with higher utility costs. By securing a bank loan with inventory, the cash that is otherwise tied up in that inventory is now free to invest back into the business.
Financing inventory usually takes place over the short term. This means that loans are expected to be paid in full within a year. If inventory financing works well for the business owner, it can often be issued in the form of a revolving line of credit.
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Cons to Inventory Financing
Inventory financing also has its downside. Many banks are unfamiliar with inventory financing. Researching different banks and placing phone calls to business loan managers is a good idea before pursuing a loan with a particular bank. Of the banks that are familiar with inventory financing, many consider this type of loan to be high risk. For example, the Comptroller's Handbook for Accounts Receivable and Inventory Financing discusses at length the process of inventory financing and the associated risks from the National Bank's point of view. Inventory is a fickle thing. Fad items can go out of style just as quickly as they came into it. Merchandise can be stolen or damaged. Sales could take a downturn. Business owners should consider the risks as well. It is important to weigh the benefits of inventory financing against the risks to determine feasibility.
The Small Business Administration offers several resources to business owners that should be reviewed such as express loans. For further reading on small business credit topics read the article, Build Business Credit Ideas by Arun Kumar, MVP.