What You Need to Know About Inventory Financing
Inventory financing is ideal for enterprises dealing with rapidly moving inventory and expanding working capital. An entrepreneur should take the time to understand what this financing option is, how it can help, and what it requires from the borrower.
Defining Inventory Financing
Inventory loans for small businesses are secured forms of financing. This means that the lender will require collateral from you if you decide to apply for this. However, the lender will not force you to pledge any of your personal or business assets. Instead, the lender will consider the inventory on your shelves as collateral.As its name suggests, inventory financing is a loan that provides you with funds that you can use for various purposes. You can use the money from inventory financing to pay off upcoming bills, debt repayments or make your cash flow more robust. You can also use it to purchase new inventory, but only if you’re expecting the existing ones to turn into cash soon.The only condition is that your inventory is quickly liquidated. You need to move that inventory as soon as possible after acquisition. This will improve your cash flow. In the eyes of the lender, you’ll be in the right shape to settle your monthly obligations under the loan.
Who Can Apply for Inventory Financing?
As mentioned earlier, businesses that move inventory constantly are best suited to apply for this business loan. These include retail stores, restaurants, beauty salons, jewelry manufacturers, and many others. Any business that maintains an inventory from which they earn income can apply for inventory financing.
Lenders have particular requirements that the borrower needs to comply with before being approved for a loan. These criteria include cash flow, business, and personal credit, tax and lien history, inventory turnover rate, profitability, and customer diversity.
What Is an Advance Rate?
Aside from the interest rate, the advance rate is also a figure that’s vital in inventory financing. The advance rate is the maximum amount an inventory financing lender can extend to the borrower. It’s a percentage of the collateral’s appraised value and an indicator of the lender’s assessment of your risk for default or non-payment of your obligations.For example, you’re pledging inventory worth $50,000 as collateral for your financing. The lender decides that you can have a 50% loan-to-value advance rate. This means you’ll get only 50% of $50,000 as a maximum loanable amount. You’ll be receiving only $25,000 as a loan from the lender.Lenders decide the advance rate by looking at three factors: the borrower’s type of business, the quality of the inventory, and the liquidation rate. Liquidity is important because it measures how quickly the business can convert physical inventory into currency.The inventory quality refers to how the item can be reused or repurposed to be sold quickly. A jeweler that pledges an upcoming inventory of new jewelry is likely to receive a lower advance rate than a manufacturer of raw materials. The jewelry is already a finished product, which limits its saleability. On the other hand, raw materials serve various purposes and are quickly sold out to other manufacturers. Raw materials also earn the manufacturer or seller more money at a lesser time.
The Various Criteria Considered by Inventory Financing Companies
Here are some of the criteria commonly used by inventory financing companies to pre-qualify applicants. Business owners should study these to look at their financial statements and see if they’re eligible.
Personal and Business Credit Scores
These two are the first indicators that lenders will check. These two credit scores are generally separate, but there are cases where the owner’s personal credit history is treated the same as business credit. For example, a sole proprietorship cannot build business credit because it is not incorporated. The business credit is tied directly to the entrepreneur’s personal credit score.
These two scores indicate a business’s debt management and repayment capabilities. Creditors will only assign poor credit scores to a business if they cannot settle on time or miss several payments.
The formula is not publicly known. However, what is understood is that consistently paying before or on the due date nets you the highest score on the lender’s report. A slight delay means a slightly lower score. Debtors who are consistently delayed or missing out on several payments receive the lowest scores.
Personal credit scores are continually updated by your lenders. On the other hand, business credit scores are not always reported to the credit information bureaus. As an entrepreneur, it’s important to get updated credit reports regularly. This way, you’ll know which debts were not reported so you can take action yourself. You need accurate credit scores if you plan to take out inventory financing or any other loan.
Profitability is measured by how much money you’ve got left after deducting the requisite taxes and paying off your expenses. There are three kinds of profits that your business financial statements list down. These are, namely, the gross, profit, and net profits.
Gross profit results from deducting the expenses incurred in producing the inventory from the revenues earned. These expenses include labor costs, expenses for acquiring material, delivery fees from supplier to vendor, and many others.
Operating profit shows how much money the business has left after production costs and before taxes and interest payments. Some accountants use the term Earnings Before Interests and Taxes (EBIT) to refer to this section of the profit statement.
Net profit is the final figure in your profits statement. This is the result after all deductions have been made from your revenues, including taxes and interest on debts, leases, and other forms of financing. It could be referred to as the difference between the revenues and the two types of profits listed above.
The term “profitability” mainly looks at net profit. From their perspective, lenders will compare your net profits against your total expenses and decide if you’ve got enough left over to pay off other obligations as they come along. Having a significant profit margin means that you’ve more than enough working capital to settle all of your bills, including the loan that they’ll extend to you.
From the lender’s perspective, a company constantly showing profits has enough cash flow to pay off its obligations under the potential loan agreement. That’s why it’s also essential to demonstrate consistent profits. Fluctuating between income, loss, and breaking even makes the business a risky client to the lender.
Some lenders may not decline an applicant right away if their profit margins are barely above the breaking even point. However, the applicant may contend with high interest rates and a low advance rate.
Profitability and cash flow go hand in hand. Cash flow is defined as the measure of how money moves within your organization. A typical cash flow looks like this: cash flows into your business from revenues, after which it moves towards operating expenses and taxes. A profit means that your cash moves to your reserves or working capital, from which it is either retained or disbursed as dividends to investors.
There are three types of cash flow that your financial statements demonstrate. These are:
- Operating cash flow
This refers to cash that has been earned from business operations. Accounting considers the net income or the money from which expenses have already been deducted. Lenders see positive operating cash flow, or profits, as a sign of a company’s good health. However, they also look at how growing companies use their working capital.
- Investing cash flow
The investing cash flow demonstrates how much of the company’s working capital has been diverted to income-generating assets. This will show if the business has invested money in real estate, securities, and fixed assets like equipment. The investing cash flow statement also indicates if the business made money from selling any of its assets and if the investors have reinvested their earnings back to the enterprise.
- Financing cash flow
By looking at the financing cash flow, lenders can see how much of the business’ money is flowing from its working capital to its lenders, investors, and owners. This cash flow effectively demonstrates how deep the company’s debt is, which is one indicator of its ability to repay any future loan.The financing cash flow also shows how much of the investors’ earnings have been redeemed or reinvested back into the company and how much of the profits were claimed as dividends. Some lenders even view investors reinvesting into the company as a sign of good financial health.
The cash flow statement has all of this information merged into one document. This statement contains all three sections laid out.
As an entrepreneur, it would be beneficial to spend time going over your financial statements and understanding how your business’ money is used. These statements include your balance sheet, profit statement, and cash flow document. Pick a time to go through this information and keep on top of your business.
Inventory Turnover Ratio
The inventory turnover ratio is simply a numerical measure of a business’s ability to turn existing inventory into quantifiable sales. In other words, it measures how fast a business can turn existing inventory into cash.
This rate applies to both the manufacturing and retail sectors. The main difference between the retail and manufacturing turnover ratio is that manufacturing companies include the production rate in the calculation.
Turnover in retail means selling the inventory at each store’s shelves to earn cash and then replenishing its stocks. In manufacturing, it refers to the rate at which the company consumes the raw material in its inventory to turn them into sellable items sold to clients. Clients purchase these items and pay the company, then order new materials for its inventory.
To calculate the turnover ratio, you only need to take the total cost of acquiring or manufacturing the goods and divide it by the average amount of inventory during the applicable period.
You cannot use absolute figures in inventory levels because inventory levels rarely remain constant. Instead, you take each month’s inventory levels, add them all together, and divide by the number of months in the period you’re measuring.
On the other hand, the cost of goods and services (COGS) includes expenses on materials and labor and expenditures related to the facility like lease, mortgage, and maintenance. COGS is a sum of all those applicable figures.
There are many reasons lenders would like to look at your turnover ratio. It helps them decide if the company can gain cash quickly from liquidating existing inventory.
A high turnover ratio means positive working capital and enables the business to pay off its debt obligations and other expenses. It is also an indicator that the business enjoys good demand for its goods or services. On the other hand, a low turnover ratio means slow sales or a low demand for the company’s products.
Inventory turnover ratios also quantify other aspects of the company’s operations. For instance, sales forecasts play a part in the actual turnover ratio. The company may expect fast turnover at certain months and acquire significant amounts of inventory. However, the demand suddenly inclined. Instead, the business struggled to sell off its inventory and suffered a low turnover ratio.
In financing, lenders will typically look at the turnover ratios for various periods to measure the company’s ability to realize sales. Some companies naturally see low turnover ratios at certain months or quarters and high turnover ratios at others. This is true for retailers, who have high and low seasons throughout the year.
Tax and Lien History
A business should continually be updated on its tax obligations with the government. Otherwise, a business could be ineligible to seek out inventory financing or any form of funding in general. Some lenders will also look at a business’s tax or lien history. It’s safe to say that you should not owe the government any debt on taxes as much as possible.
A tax lien is a claim the government attaches to your assets if you refuse to pay off taxes that the Internal Revenue Service thinks you owe them. There are many reasons why the government would believe that you owe it more than you have paid. However, the IRS will only put a lien on your property if you’ve been served a Notice and Demand for payment, but you willfully neglected to pay the taxes due.
In this case, the IRS will publish a Notice of Federal Tax Lien attached to all of your existing assets. Applicable assets include real estate properties and fixed assets. The IRS will also do the same for your personal assets, usually apart from your business’ properties.
Unfortunately, the Notice will alert creditors that the government is claiming your property for non-payment of federal taxes. This will negatively affect your ability to secure financing and credit.
Most entrepreneurs may not know this, but having a diverse customer base is more advantageous than focusing on a specific demographic. Customer diversity is actually one of the factors that lenders base their decisions on for those applying for a loan.
A business that has a very diverse customer base, theoretically, caters to more customers at any period than those who limit themselves to specific groups or demographics. A larger customer base means potential for high revenues and higher chances of consistent profits. All these translate to a better cash flow and capability to settle obligations.
Of course, lenders will always compare customer diversity figures with the actual numbers of the borrower’s financial statements. They will be looking for reliability and consistency from your customer base. Your sales and income statements demonstrate all these.
The tax lien does not appear on either your business or personal credit scores. However, as mentioned earlier, creditors can see any published Federal Tax Lien Notices because it is a public document. For example, you won’t be able to pledge your assets as collateral. This is because you’re not the sole claimant of your properties anymore.
A Federal Tax Lien also sends the message that you might be having financial difficulties. A tax lien may just be a result of accounting mistakes or a miscalculation. However, it might make lenders think that you don’t have enough cash flow to settle your tax obligations like a good citizen.
Liens are pervasive. A bankruptcy may clear some of your debts or, at the least, arrange comfortable repayment terms. The lien, however, remains effective beyond a declaration of bankruptcy. After the procedure, any new assets you or your business acquires will bear the government’s claim.
Tips to Improve Your Eligibility For Inventory Financing
There are ways to improve your eligibility to receive inventory financing from your lenders. The first and most important advice is to take the following steps when you don’t need a loan. You need to go over these data with a clear mind, one that’s free of stress from cash flow problems.One, make sure that you’re on top of your finances. Get together with your accountant and go over the numbers. Is your cash flow healthy? Are there problems with the cash flow? Asking these questions from your accountant while going over the financials will help you spot deficiencies that you can correct later.As a small business, it’s important that you also identify what expenses you can cut or reduce to improve your cash flow. Analyzing your financial statements is an excellent method to achieve that end. You might also have to remove some expenses to free up your cash flow in some cases.Find out if you have any pending tax liens with the government. You will want to settle those as early as you can. The IRS will typically release the liens on your property within 30 days of paying the tax due. Recalculate your taxes and settle the differences as soon as you can.If you think there was a mistake, you can file a tax appeal with an IRS manager. However, you can only file a request or a Collection Due Process hearing within 30 days of receiving Notice of the Lien.Build your credit score. Request copies of both your personal and business credit reports and check them for errors. These include duplicate reports of bad credit, which can bring your credit scores down. As mentioned earlier, good repayment records that are not reported to the credit bureaus should be addressed. You’ll need every piece of good credit that you can get.Finally, you should keep track of your financial obligations. Keeping up with your debts starts by always referring to the documents you have at hand. Manage your debts, pay off as many on time as you can, and you can see your credit scores going up and your eligibility for a loan improving.
The Bottom Line
Inventory financing is a great way to free up cash flow that is otherwise unrealized from unsold inventory. It is a method to advance cash against the future sales of these items on your shelves. However, you’d have to satisfy several criteria before you can successfully take out an inventory loan from your creditors.
First, you have to be of outstanding credit score. Both your business and personal credit scores must be mostly positive. You must have sufficient working capital to take care of the loan’s repayment and other obligations your business has. You also have to prove to the lender that your inventory is high quality and can be quickly disposed of. You’ll need the cash to pay off what you have borrowed.
You should also avoid any tax liens from the Internal Revenue Service or settle any existing liens on your property as soon as you can. Creditors will refuse to grant you an inventory loan if the government has a current claim on your property.
Satisfy these criteria, and you can expect to be extended a loan by your creditors when you need to. Your lenders will be more than confident in your ability to pay your loan, the quality of your collateral, and your business’s ability to liquidate these assets into cash.