What Is Inventory Financing & How Does It Work?

Last Updated February 29, 2024

For many new businesses, figuring out how to increase inventory while appropriately managing cash flow can be a major challenge. However, even in situations where acquiring a line of credit or other forms of funding isn’t possible, businesses can still obtain the necessary funding through inventory financing.

Here’s a closer look at how inventory financing for startups and other businesses works so you can determine whether it is an appropriate option for your needs.

What Is Inventory Financing?

Inventory financing is a form of asset-based lending that involves either a short-term loan or a line of credit. The company that needs the funding assistance receives the loan or line of credit for the specific purpose of purchasing products or raw materials so they can make sales to their customers.

By using inventory as collateral, inventory-based loans and lines of credit make essential financial resources more readily available to small- and medium-sized businesses that might otherwise have trouble obtaining financing.

How Does Inventory Financing Work?

Inventory financing can be obtained through banks and other lenders for inventory-related purposes, such as increasing inventory supplies, purchasing raw materials that will be used to manufacture finished products, or even addressing cash flow concerns during seasonal increases and decreases in demand.

The lenders offering inventory financing will evaluate a variety of factors related to the products in question to determine whether they will provide a loan. Some of the factors that can influence inventory financing availability and terms include the product’s resale value, theft risk, depreciation, and perishability, as well as broader economic trends, inventory cycles for your industry, and potential logistics concerns.

When the recipient of the loan sells their products, they use that money to pay off the loan. If they can’t pay off the loan, unsold inventory will be claimed as collateral by the lender.

Types of Inventory Financing

Generally speaking, there are two primary types of inventory funding options available to businesses.

The most commonly used inventory financing option is an inventory loan, in which financing terms are based on total inventory value. The lender provides a fixed sum, after which the company will either pay off the loan in a series of fixed monthly installments or as a lump payment once inventory has been sold. These types of inventory loans are good for when a business needs a one-time loan or only needs inventory financing assistance periodically.

Sometimes, businesses might obtain an inventory line of credit instead. This revolving line of credit gives businesses ongoing access to inventory financing, though they must be able to keep up with regular monthly payments and keep their total withdrawals below the limit established by the lender. An inventory line of credit is good for businesses that consistently need inventory financing assistance.

Why Do Businesses Use Inventory Financing?

There are several reasons why businesses may use inventory lending. First, there are the goals and operations of the business to consider. When a business is struggling to figure out how to improve inventory when they have insufficient cash flow, financing can provide the needed support to purchase supplies without running out of cash.

For inventory financing specifically, businesses generally use this option to improve their working capital when they have bad credit or an insufficient financial history that could prevent them from being able to use other lending options. This ensures that businesses don’t have to put other assets (including personal assets) up as collateral to obtain a loan.

What Types of Businesses Benefit Most from Inventory Financing?

Small- to medium-sized businesses, particularly newer businesses with bad credit or a shorter operating history, tend to benefit the most from retail inventory financing. This enables them to get the necessary cash to make inventory-related purchases so they can continue generating revenue, even when other forms of lending aren’t an option.

Retailers, wholesalers, and seasonal businesses are among the top types of businesses that use this option to receive a cash infusion.

Benefits of Inventory Financing

The following are some of the top benefits of using inventory financing:

1. Enables a Business to Meet Customer Demand

The most immediate benefit to a business is that it will quickly get the cash infusion necessary to make crucial inventory purchases. This ensures that businesses are able to meet customer demand for their products. The ability to consistently have inventory in stock will drive steady sales that allow you to grow your business.

2. Enables a Business to Obtain Funding With Poor Credit

Many new businesses struggle to obtain funding because they don’t have a strong business credit score. However, because inventory financing uses inventory as collateral, it doesn’t matter what your personal or business credit history looks like. As long as you have sufficient collateral in the form of inventory, lenders are likely to provide funding. Inventory financing is often funded without a credit check, which also allows loan approvals to be completed much faster than other lending options.

3. No Personal Collateral Is Required

Because your business’s inventory is being used as collateral to obtain financing, you don’t have to worry about using any of your personal assets (like your home or car) as collateral. If the business fails or you default on the loan, you will be required to give up any unsold inventory – but you don’t have to worry about losing personal assets.

Risks Associated With Inventory Financing

While inventory financing certainly has its advantages (especially for new business owners), it isn’t without risk:

1. Approval Can Still Be Challenging

While you don’t need a strong credit history to qualify for inventory financing, the approval process can still be tough. Lenders will assess how risky your business is – especially when it comes to your ability to sell your products. Lenders don’t want to claim your unsold inventory if they’ll have a hard time selling it themselves. You must be able to prove the sales potential of your products and the overall viability of your business to get approved for funding. As such, there’s no guarantee you’ll get approved for a loan.

2. High Fees and Interest Rates

Because your inventory is the only collateral used for this form of financing, lenders typically charge higher fees and interest rates than they would with other loan products. The added liability can make it harder to repay your loan, which could result in major business disruptions if you can’t manage your cash flow well.

3. No Guarantee You’ll Get What You Need

Even if you are approved for an inventory financing loan, lenders aren’t necessarily going to provide the full amount you need to make your desired inventory purchase. This is especially common for newer businesses with unproven products. This could keep you from being able to manufacture as much inventory as planned or cause production delays. You’ll have added debt – but still not enough revenue from inventory sales to fully cover your operating needs.

How Factoring Can Be Used as Inventory Financing

Invoice factoring is a viable alternative to inventory financing that presents less risk to your business, while helping you get access to quick cash. With invoice factoring, you sell your unpaid invoices (or accounts receivable) for cash. The factoring company provides 80-90% of the value of the unpaid invoice up front, and when they collect payment from your client, they provide the rest of the funds, minus the factoring fee.

This gives your business fast access to cash with minimal credit qualifications and no collateral. That cash can then be used for the same purposes as an inventory financing loan or line of credit.

With this inventory financing option, you’re not taking on additional debt that requires you to put up collateral. You’re essentially receiving an advance on the money you are already owed by your current clients. This option is also highly flexible – you only need to sell the invoices you want.

While you need an existing client base to use this method, it can be a much lower-risk (and lower-stress) way of addressing your inventory financing needs.

Inventory Financing FAQs

Is inventory financing a loan?

Yes. Inventory financing is typically offered as a short-term loan or as a line of credit. The business’s inventory is used as collateral for the loan.

What funding options can help increase inventory?

There are several funding options you can use to improve your cash flow and increase inventory. In addition to inventory loans and lines of credit, businesses may use equipment financing, purchase order financing, invoice factoring, or even a business credit card to help increase inventory.

Can I qualify for inventory financing loans with bad credit?

Yes. Inventory financing loans use inventory as collateral. As a result, when making a lending decision for an inventory financing loan, lenders are much more concerned with issues like the resale value, perishability, and depreciation of the products that will be used as collateral. Your credit history doesn’t really come into play.

Can inventory be used as collateral?

Yes. Inventory is regularly used as collateral for inventory financing loans. This means that if you are unable to repay the debt from a loan in accordance with the term agreements, the lender can claim the unsold inventory.