Inventory Financing

Inventory Financing is a short-term loan or a line of credit that keeps revolving after a pre-decided period used to finance the inventory of the company and the purchased inventory acting as collateral for the availed loan. If the company fails to repay the debt, the lender has full authority to seize and sell that inventory to recover the lent capital.

Inventory forms a significant part of the company's current assets as it constitutes the goods held for a short-term duration to meet the expected demands. But if the number of days of receivables is high, the company's capital may get locked, and it'll not have sufficient funds to purchase more inventory.

1. Inventory financing is using a short-term loan or a line of credit that continues to revolve after a predetermined period to finance the company's inventory. The acquired inventory serves as collateral for the loan that was made available. 
2. The lender has complete authority to seize and sell the merchandise to recoup the lent capital if the company fails to pay the debt.
3. Since they frequently have their capital restricted due to a lengthier cash conversion cycle, companies that manufacture and sell consumer goods, such as cars and FMCG products, are more likely to employ inventory finance. If accessible, this financing can be used to increase sales.

Inventory financing is a mode of securing funding for a part of or complete inventory. Organizations secure an inventory financing loan based on the estimate value that will be secured by selling the inventory put forth for securing the loan. Lenders decide the repayment schedule and provide the loan based on these values.

The companies involved in consumer products such as automobiles and FMCG products most often avail inventory financing since they often have their capital tied up due to a longer cash conversion cycle, which, if available, can be used to expand sales.

To secure such a loan, the organization must have a few pre-requisites; a few of the most important ones are as mentioned below:

• Good Credit Record: If the customer has defaulted on his payables in the past, the possibility of getting inventory financed is low.

• Inventory Value: The customer also needs to provide the bank with the list of inventory they are willing to purchase and its value. They may also need to explain the inventory valuation method (LIFO, FIFO, or weighted average). (Note: Last In First Out Accounting and First In First Out Inventory are two inventory valuation methods).

• Business Plan: The business plan provides an overview of a customer's plan to pay off the loan. Based on the plan, the bank can decide the amount sanctioned as a loan.

We shall discuss the different types of inventory financing loans, which are as follows:

#1 - Short Term Loan

A company may avail of a short-term loan from a bank to purchase the inventory, but it is a tedious process as the company will have to go through the whole process of loan sanctioning every time it needs that.

#2 - Line Of Credit

A Line Of Credit is an agreement between the company and the financial institution. Both entities agree upon a maximum amount to which the borrower can access funds as long as it does not exceed the maximum limit.

Let us understand the crux of why inventory financing companies carry out these financing methods through the examples below:

Example #1

A car dealer is expecting increased demand for cars in the upcoming season. To cater to this demand, they decide to ramp up their inventory. But unfortunately, there is a need to purchase more cars from the supplier, which will require huge capital.

To meet their capital needs, a loan is applied for and sanctioned from a national bank based on the value of the cars for which the purchase will be made. Inventory financing is a key part of the business cycle, as whenever the firm is selling a new car, they can use that money to pay off a portion of the loan.

Example #2

Tata Motors is one of the largest automobile companies in the world. The range of brands under their management range from economical brands such as Volkswagen to luxury cars such as Range Rover and Jaguar.

The EV space in the market has been growing at a rapid pace, especially in the sub-continent region. Therefore, a huge capital requirement is a priority for automobile companies to remain on top of their competitors.

In January 2023, ICICI Bank and Tata Motors entered into an agreement that a certain part of the electric vehicles’ inventory would be presented against securing a loan against inventory.

Inventory financing loan is an arrangement between the financial institution and the company. Following are the major parts of the agreement:

• Extension of Credit: It may specify under what conditions the lender may extend the customer's credit limit.
• Financing Terms: They indicate the interest rate and its payment schedule.
• Security Interest: This indicates the collateral that the customer uses to avail the loan. It can be the inventory that the customer already holds or the inventory he will purchase.

• Nature of Inventory: Inventory financing may not be a good option for companies with a low inventory turnover ratio (which means the inventory takes time to convert into revenue) because it will be difficult to repay at times. That's why it is mostly the FMCG companies that use this facility.
• Credit Score: If the companies do not have a good credit score, they will find it difficult to get capital. Even if they manage to get that, the interest rate will be relatively high because there are chances of default.
• Confidence Level in Inventory: The lender has the right to inspect the inventory to ensure it has maintained its value, and it can also track the inventory level.

Let us understand the advantages and disadvantages from the perspective of both the borrower and the inventory financing companies through the discussion below.

Advantages

• Every company requires working capital to meet its day-to-day expenses, including purchasing the inventory. Inventory financing can help in managing the working capital efficiently.
• This is especially beneficial for seasonal businesses because these businesses' demand is not stable. To meet unforeseen demand, inventory financing is a good option.
• The companies involved in trading goods also get significant benefits from inventory financing. The import and export of goods involve significant delays. Depending upon the terms settled between the two parties, the sender's payment of the goods may get delayed as the receiver will pay the amount only after receiving his order. In this case, the sender will not be able to serve its other customer, and hence he can utilize inventory financing options to serve others.

Disadvantages

• Any unexpected event such as an economic slowdown that may reduce the demand or a natural calamity that may impact the company's inventory can make it difficult for the company to pay back the loan.
• It can impact the company's cash conversion cycle as the company will keep relying on loans to meet short-term requirements.
• Usually, when a company avails a loan, it is obligated to pay regular interest payments. While in the case of inventory financing, it needs to regularly stay in contact with the lender. At times, it is also required to report its inventory levels and its valuation every month.

Thus, inventory financing can be a useful option for businesses involving longer cash conversion cycles or seasonal demand or trading of goods. But they must choose their lender carefully after considering all the repayment terms. And companies should try to shorten their cash conversion cycle to avoid too much reliance on short-term loans.

This has been a guide to what is inventory financing. Here we explain its examples, agreement, types, and advantages & disadvantages. You can learn more about accounting from the following articles –

• Shrinkage Formula
• Inventory Shrinkage
• Perpetual Inventory System
• Is Inventory a Current Asset?