What is Inventory Financing? How Does Inventory Financing Work?

How Inventory Financing Works
How Inventory Financing Works. Tetra Images/Getty Images

Your inventory of products your business has made or bought to be sold is a valuable asset. This inventory value can be used to finance your business without having to be sold.

The concept of financing business assets applies to both inventory and accounts receivable assets. The two types of financing are compared and inventory financing is explained in this article.  

What is Inventory Financing?  

Inventory financing uses your business inventory as collateral for loans.

Inventory financing is used by manufacturers of consumer products and by dealers (including automobile, truck, RV, motorcycle), because they have significant amounts of money tied up in their inventory. The business can use the value of the inventory to secure business credit for expansion of the business. 

How Inventory Financing Works - An Example

Let's say a car dealer wants to increase inventory, buying more cars because of an expected increase in new car sales. The dealer must purchase the inventory from the car manufacturer, but vehicles are expensive.  

The dealer gets a loan from a financing company, based on the value of the cars. When the a car is sold, the dealer can pay off the portion of the loan related to that car, or purchase more inventory to sell. As you can see, inventory financing is part of the production cycle of buying, making, and selling.

Because inventory depreciates in value, it is less liquid (less likely to be turned into cash at full value),than accounts receivable, so you will not be able to get full value on your financing.

When to Consider (and Not Consider) Inventory Financing

If your inventory is selling well and you are in need of more money to keep selling, you may want to consider inventory financing. If your inventory is out of date or not selling (you have slow turnover), it may not be wise to attempt inventory financing, because you may not find a willing lender.

What Else Is Needed for Inventory Financing

As with other forms of financing, you will need a good credit record and a list of the inventory you want to finance, along with values. You'll need to be able to explain the inventory valuation method you use (LIFO or FIFO or average cost).

You will also need a business plan to show what your plans for using the proceeds of the loan and how you will pay it back. The lender will give you an estimate of how much you can borrow on the inventory.

While Inventory is Being Financed

While your inventory is waiting to be sold, you will need to keep track of it and make sure it is in good repair and in shape. Your lender has the right to inspect the inventory to make sure it has retained its value.

Inventory Financing vs. Accounts Receivable Financing

Accounts receivable (amounts owed to your business by customers) are financed by being sold to a company called a factoring agent. The factoring company attempts to collect the funds. The loan is heavily discounted from the original amount of the receivables, because of the difficulty and cost of collecting.