Inventory Financing and How it Works
Your inventory of products your business has made or bought to be sold is a valuable asset that can be used as collateral to finance your business without having to be sold. Manufacturers and dealers of consumer products (i.e. automobile, truck, RV, motorcycle) avail themselves of this method of financing because they have significant amounts of money tied up in their inventory, which can be used to secure credit for business expansion.
The U.S. Ofice of the Comptroller of the Currency (OCC) explains that inventory financing in the more general concept of accounts receivable financing (ARIF) and says that this type of financing combines elements of secured lending and short-term business loans. In ARIF loans, a business borrower uses the value of receivables and inventory to get the money to produce and market their products and services.
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, and vehicles are expensive.
The dealer gets a loan from a financing company, based on the value of the cars. Inventory financing is part of the production cycle of buying, making, and selling. When a car is sold, the dealer can pay off the portion of the loan related to that car, or purchase more inventory to sell.
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. In a similar way, the funding you get from accounts receivable financing will be significantly reduced because of the difficulty of getting payments.
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 If your inventory is out of date or not selling (you have slow turnover), it may not be wise to attempt inventory financing, because you may not find a willing lender.
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 against the inventory.
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.
Accounts Receivable Financing
Accounts Receivable, or AR (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.
How an Inventory Financing Agreement Works
Inventory financing is a financial arrangement, which means the two parties must put their agreement in writing, with an inventory financing agreement.
In addition to the usual terms in a business loan agreement, here are the major parts of an auto industry inventory financing agreement:
Extension of credit. The lender may extend credit from time to time to the dealer.
Financing terms. The terms include the interest rate and how it's applied.
Security interest. The "personal property" of the dealer (in this case, specific vehicles) is the collateral that's used to secure the transaction.
Office of the Comptroller of the Currency. Accounts Receivable and Inventory Financing. (Download) Accessed Oct. 18, 2019.
Office of the Comptroller of the Currency. Accounts Receivable and Inventory Financing. "Factoring," Page 33. (Download) Accessed Oct. 18, 2019.
Securities and Exchange Commission. EDGAR System. "Inventory Financing Agreement." Accessed Oct. 18, 2019.