Can You Use Small Business Loans for Inventory?
- December 13, 2017
- Posted by: Jeff Gitlen
- Category: Small Business Loans
Any business doing well is going to eventually need financing if it wants to continue to grow. Getting to the next level means taking on more customers, bigger orders, more marketing, and hiring more employees, all of which takes capital. But capital is not always available when a business needs it.
That’s why it’s not at all uncommon for growing businesses to turn to financing to fund their growth. A good example is when a business takes on a new customer and must add inventory in anticipation of new and larger orders. Inventory financing is used to pay for it and the business repays the loan as the inventory is sold off.
Secured and Unsecured Business Loans
The most common form of financing for small businesses is a small business loan. These are generally fixed rate and fixed term loans that can be secured or unsecured. A secured loan is collateralized by personal or business assets. Secured loans typically offer better terms, and businesses that otherwise couldn’t qualify for one might be able to do so if they can put up collateral.
An unsecured loan is not collateralized, so the lender relies on the creditworthiness of the borrower. Unsecured loans are a higher risk for lenders, so they tend to have higher interest rates.
Online Business Loans
Until the emergence of non-traditional online lenders in the last few years, it was very difficult for a small business without any credit or collateral to qualify for a business loan. Many online lenders consider different factors for loan approval, including the operational and sales history of the business.
With some online lenders, a business can obtain financing if it has been operational for a year and has at least $50,000 in revenue. The loan is unsecured and typically has a three- to five-year repayment period. The upside of obtaining financing from an online lender is that the process is quick and easy, with funding available within a few days of submitting the loan application.
The downside of using a business loan for inventory financing is that it might not really align with the business need. Inventory is purchased and then sold. A company can pay back the inventory loan when it sells, but if it needs to purchase more inventory, it has to take out another loan. That can be an expensive and burdensome way to manage a business’s finances.
Another alternative for businesses without strong credit is asset-based financing. Unlike traditional lenders that rely heavily on the creditworthiness of the business to approve a loan, asset-based lenders rely on the financial strength of the business’s customer, while the assets are used as collateral. As long as the customer is financially reliable and the business has assets such as inventory for collateral, the financing is usually approved.
With inventory financing, the business leverages its inventory for immediate cash flow. In most cases, the financing is set up as a revolving line of credit, allowing the business to draw down funds as they are needed. The lender advances up to 80 percent of the appraised value of eligible inventory. When the inventory is sold, the lender is repaid along with finance charges. The credit line is linked to the amount of inventory the business has on hand, so it can increase or decrease depending on customer orders.
To qualify for inventory financing, a business typically has a minimum $500,000 of inventory to finance and the inventory must consist of finished products or marketable raw materials. Lenders usually require a business to have dependable financial statements and an effective inventory management system in place.
Inventory financing tends to be more expensive than fixed loans. However, the advantage to the business is the process of drawing down funds and repaying through the sale of inventory is automatic and easier to manage. If the business sells its inventory quickly, it can minimize the costs. However, if the business has difficulty moving the inventory, it can become very costly.
Which Should You Choose?
Generally, if your business is growing, has very good credit and strong sales, you would be better off with a line of credit from a bank. That would provide the best combination of cost control and flexibility. If your business can’t qualify for a line of credit, a secured or unsecured loan would be the next best option, but that creates a long-term obligation for a short-term need. Inventory financing can be your most expensive option, but it might also align best with your needs. As your business grows, you won’t always need to finance your inventory, so it is important to choose the best financing method available at the time.