Looking to buy supplies or products, but don’t have the money to do so? Inventory financing is just one of the many business financing options to consider.
You may assume that because your business is fairly new or you don’t have stellar credit that you don’t qualify for any type of loan. But in fact, you may qualify for secured loans using collateral.
There are two types of loans: secured and unsecured. If you have great credit, you can get an unsecured loan, meaning you don’t have to provide collateral to be approved. But if not, you’ll probably only qualify for a secured loan, where you offer some sort of asset against the loan. Should you not be able to pay off the loan, the lender can take your assets and sell them to cover what you owe.
If you are looking to purchase inventory, it could be just the collateral you need to guarantee a short-term loan to make that purchase.
What Is Inventory Financing?
Inventory financing is a short-term loan or a revolving line of credit used to stock inventory — or products a small business owner plans to sell to customers. Retail businesses, manufacturers, or wholesale companies use inventory financing most often. The items you buy with the funding act as a form of collateral on the loan. Nav’s guide to inventory loans is another useful resource for explaining inventory financing.
Why Use Inventory as Collateral to Get a Small Business Loan?
When business credit cards aren’t enough for your inventory financing needs, it can be smart to look elsewhere. There are two main benefits to using an inventory loan or inventory line of credit: being able to keep your inventory up during your high season and to buy products in bulk to receive a lower price per item. You can also cover short-term gaps in cash flow as they come up.
Pros and Cons of Using Inventory as Collateral
- Makes purchasing inventory easier. You can respond to increased customer demand and inventory turnover or add to your product lines more quickly and efficiently.
- No collateral needed. Your inventory acts as collateral for the funding, so you usually don’t have to put down personal assets. Inventory is considered an asset on your balance sheet.
- Easy to apply. The applications for these types of loans are usually online and take only a few minutes to fill out. Lenders typically look at a combination of your personal credit scores and your business credit scores when considering your application.
- High cost. Interest rates may be higher than other options, so it may cost you more in the end to borrow money in this way.
- Limited amount of money. A financing company typically won’t fund the entire cost of the inventory you’re planning to buy, which we explain below.
How Collateral Loans Work
If you seem high risk for a loan, meaning your credit history, revenues, or time in business don’t give lenders confidence that you would be able to pay off a loan, you might be required to provide collateral for asset-based lending. Essentially, that reduces the risk for lenders you seek to borrow money from.
If you can’t pay back the business loan, the bank or lender could take ownership of the collateral you pledged. Usually, this doesn’t happen if you just miss one payment, but if you continue to struggle, the bank may do so.
The collateral you use to secure the loan could be one of any number of things (we’ll go into types of collateral in the next section), but you can use the inventory you plan to buy as the collateral. An inventory loan is one type of loan that’s great if you don’t qualify for traditional types of financing, and it’s cheaper than using a credit card when it comes to your interest rates.
Traditional banks, including those that offer the SBA loan, may offer collateral loans for inventory purchases. They will assess the value of the inventory you plan to purchase and determine the loan amounts you’re eligible for.
Once you agree on the amount, you’ll be told what your monthly payments are. As you repay the loan, you’ll begin to build your credit. It’s a good idea to check in on your free business credit scores to watch them increase over time.
Pay off your secured loans without incident, and you may soon qualify for unsecured loans.
Types of Collateral for Inventory Funding
When you apply for inventory funding, the lender will look at things like your business credit report, company history, and revenues, as well as the inventory you want to put up as collateral, particularly if you have bad credit.
Let’s say Oprah’s been talking up your unique purses, and you can’t keep up with orders. You need to order a million of them, but you don’t have the cash. Taking out a secured loan with your purse order as collateral can give you the cash you need to cover the purchase. You can pay it back as soon as those purses fly off the shelves.
Or maybe you run a car dealership. Buying even a handful of cars can cost a pretty penny, so you use the cars you want to buy as collateral.
No matter what type of inventory you’re buying, it likely can be used as the asset against your loan. Here are some examples of types of inventory you can use as collateral:
- Beauty products
- Office supplies
You should be confident that you will be able to sell your inventory fast enough to keep up with your monthly loan payments.
Assessing the Value of Your Assets
One important note: The bank will assess the value of your assets, and you will only get a portion of what the bank deems to be the value as your business loan. This is called the loan-to-value ratio, and typically you can borrow about 50-80% of that determined value of your collateral.
Why don’t you get the full value? Should the bank have to sell your inventory, it won’t be able to sell at market value, so it bases the amount it’s willing to loan you on the liquidation value. Some products have a higher liquidation value than others, so take how easy it would be for the bank to sell your inventory into consideration when looking at lending options.
The Benefits of Inventory Financing
Inventory financing is particularly helpful for businesses like retailers and wholesalers. These businesses can have a high level of perceived risk in the eyes of a bank, and a loan of this nature could be less costly than seeking a loan from a non-bank lender or taking on credit card debt.
Inventory financing can be used to restock merchandise before an upcoming busy season. Prior to the holiday shopping season, for instance, some businesses may go through a slump and lack the funds necessary to replenish their products before consumers are ready to shop. Companies can get small business loans for their merchandise, rack in holiday sales, repay their loan amounts, and pocket whatever’s left.
Another benefit to inventory financing is that your credit score and credit history may play less of a factor into whether you qualify, the way they do with unsecured loans. Because you’ve got that collateral, the bank knows it will get its money back, one way or another.
And as you repay the loan, you’ll build your business credit, which will qualify you for better financing options down the road.
The Challenges of Inventory Financing
While this option may appear attractive to business owners, there are still things to be aware of. You get the funds with the expectation that you can sell the merchandise within the prescribed repayment period. But if you end up not being able to pay back the loan, you default on the loan and the lender can seize your inventory and any assets that were pledged to obtain the funding, putting you in even more of a bind in your business.
Inventory financing isn’t the cheapest form of financing. Likely you’re considering it because you don’t have a better option. Just be aware that you’ll pay for the privilege of being able to finance your inventory through a secured loan with higher interest rates. You may also have to pay a service or origination fee, which can add to that cost outlined in your repayment terms.
Also, know that lenders may require regular reports on the values of some inventory to ensure it can be sold at a price sufficient for loan repayment.
Requirements for Getting a Loan with Collateral
If, after reading so far, you think secured loans are your best option, either because you have little to no credit history or a low credit score, here’s what you need to know about your loan application for a secured inventory loan.
First, some companies offer inventory loans, while others offer lines of credit. There’s not a huge difference other than the fact that, with a line of credit, you’re approved for one amount, and then you can take out what you need (up to the approved amount) any time and pay back just that amount.
Each lender will have its own requirements for a secured loan, like the minimum amount you need in financing, as well as maybe how long you’ve been in business or your revenues. In general, though, you’ll likely be required to:
- Have marketable and saleable inventory
- Have up-to-date and accurate financial statements
- Use a reliable inventory management system
Check with a lender before you start the application process to ensure that you qualify, then gather any documents you will be required to submit.
Best Inventory Financing Options
Here’s a look at your best funding options using your inventory as collateral.
Nav’s Final Word: Using Inventory for Loans Collateral
Inventory financing can be a good short-term business loan option if you need to place a large inventory order but lack the money to do so. Loans secured by your inventory may not be the cheapest lending option, but they’re definitely more affordable than using a credit card. Like with any financial decision: know what you’re getting into. Read the fine print. Ask questions. As the borrower, it’s your responsibility to educate yourself.
This article was originally written on February 5, 2020 and updated on February 2, 2023.