Inventory Financing as a Solution to SME Cash Flow Pains

Inventory Financing solves the dilemma of small and medium businesses between the struggle to maintain inventory to sustain, and grow their business and meet business expenses.

Inventory is an important component of assets, more specifically current assets, in trading, retailing, and manufacturing businesses. Efficient management of inventory - finished goods and materials - is very crucial for the sustainability and profitability of any organisation. During volatile and uncertain economic conditions like recession, pandemic, or demand slowdowns the turnaround time to convert inventory to cash increases, resulting in a liquidity crisis. 

In situations like this, the companies that have not availed of traditional working capital loans against their inventory resort to a form of financing named inventory financing to tide over their immediate cash flow problem. It is a type of credit obtained by businesses against goods that are not intended for immediate sale or cannot be sold immediately thanks to the prevalent market conditions.

What Is Inventory Financing

For starters, inventory financing is a type of loan against the collateral of a business’s inventory. It is asset-backed, short-term finance that a business can access from financial institutions to take care of their non-inventory related recurring business expenses aka operating expenses (OPEX). This becomes necessary because the cash otherwise needed for opex is blocked in inventory. 

Inventory financing is technically a secured loan because inventory itself is the collateral for the loan. However, the lenders usually consider it to be unsecured as the lending financial institutions may not be able to recover their money by disposing of the inventory when a situation arises. This is because such loans are taken during a time when there is a demand slack or no demand for the inventoried goods.

The Beneficiaries of the Scheme

This kind of finance is mainly offered to small and medium-sized (SME) manufacturers or retailers or wholesalers with large inventory. This type of financing scheme may not be suitable for companies that are new in the business or those in the service business that don’t have tangible products in their inventory. 

Inventory financing is beneficial to smooth out the financial effects of seasonal fluctuations in sales, in turn, the cash flows. This can help a company grow their topline by allowing it to maintain extra inventory for use when the demand arises.

Inventory loans are ideally suited for the following types of business enterprises and activities

• Kirana Store Owners
• Distributors and Retailers
• B2B Buyers
• MSME Manufacturers

How Inventory Financing Works

This kind of financing is common for small to mid-sized manufacturers, retailers and wholesalers, especially those with a large amount of available stock. That's because their cash is locked in inventory but cannot meet various criteria to secure the traditional loans from banks and financial institutions. 

Since most SME companies cannot raise funds from the market or financial institutions in traditional ways, they may use all or part of their existing inventory of the goods or the material as collateral or security for a loan that can be used for general business expenses.

As noted above, inventory financing helps businesses to purchase, and maintain inventory and as well to meet their business expenses to keep business moving. The reasons why they rely on this kind of financing include:

• Keeping cash flow steady through all seasons - up, steady, down
• Updating and expanding product lines
• Having enough inventory to meet an increase in demand
• Unlocking funds blocked in inventory
• Funding between 90% and 100% of the inventory value.

In case a company fails to repay the loan on time or defaults on any repayment schedule, the lender has the full right to seize the inventory of the value of the loan plus the accrued interest if any. However, some banks are wary of inventory financing because they don't want the burden of recovery in case of default. 

Requirements for a loan against inventory:

The banks and financial institutions that provide inventory finance in India rely heavily on the quality of inventory management for a diligent appraisal of the financial needs of the borrower. Check out what all the Banks, NBFCs, and Online lenders like GripInvest consider before they approve such credit lines:

• Inventory Management: An organised and properly managed inventory is proof of the efficiency of the handling of the inventory and the enterprise as a whole. A duly audited inventory statement makes validation easy for lenders
• Protection from Elements: The shelf life of inventory in the business is an important factor for getting inventory finance. Hence, it is important that you protect your goods against the elements of nature
• Inventory Inspection: The loan applicant must be ready for surprise visits by the lender. The readiness is an endorsement that the company follows best practices making it an eligible applicant for the loan
• Sales Records Accuracy: Accurate sales records will help create confidence about the repayment ability of the business. It is an indicator of a well-managed business.
• Redundant Inventory: Slow or non-moving inventory that is not cashable reflects the poor management skills of the business. Management with business acumen does not waste resources on such dead or non-performing assets.
• Depreciation: Inventory of any kind are prone to depreciation in value over time. That is why lenders don’t give loans for the full value of the inventory. As such, any potential value depletion is factored into determining the quantum of loan amount and setting an interest rate on the inventory loan.

Pros and Cons of Inventory Financing

In many cases, businesses resort to inventory finance out of urgency without even evaluating its cons but it is important to know about the pros and the cons of inventory finance. We've listed some of the most common ones below.

Pros:

1. This helps to maintain sufficient stock to enhance your top line. The business cycle of inventory and sales are complementary

• Since the inventory loans do not stipulate how to use the funds, a business can use additional funds to meet business expenses, expand product lines, and equip sales channels to grow business opportunities
• It offers loans to small and medium businesses that cannot otherwise access traditional loans
• Newer businesses of a minimum of six years to one year old are eligible and can access credit quickly 
• Businesses don't need to rely on the credit ratings/history of businesses and owners to qualify for loans

Cons:

• This being a short-term credit, the long-term needs of the companies cannot be funded
• It is not particularly suited to the needs of large enterprises.
• The full value of the inventory may not be advanced by the lenders
• Higher fees and interest rates compared to traditional loans

Types of Inventory Financing in India:

There are two types of inventory financing in India:

• Inventory Loan: It is a one-time loan offered to borrowers to manage emergency cash requirements against the cashable value of the inventory. The company agrees to make fixed payments every month or to repay the loan in full once the inventory is sold.

Inventory Line of Credit: It is an ongoing financing solution primarily to take care of unforeseen business expenses. In this arrangement, the lender offers extra money to the borrower on an ongoing basis whenever there is a requirement for the fund.

Which one is suitable for a company depends on the nature of your business and the condition you are in because of which you are looking for finance.