Inventory financing: a practical guide for smart SMBs

Many commercial and industrial activities involve stockpiling before selling. Whether your inventory includes raw materials, work in progress, or goods for resale, this item in your accounts is money lying idle. 

At the same time, having inventory on hand is essential. So how can you build up stock if you don’t have cash available?

That’s where inventory financing comes into play in all its various forms. In this article, we look at traditional banking solutions, as well as alternatives such as invoice financing, reverse factoring or BNPL (buy now pay later) methods. 

We'll explain why you need short-term credit to fuel your inventory, when you need it, and in what form. If you process and hold inventory as part of doing business, this article is for you.

1 - What is inventory financing?

Inventory is a crucial part of your operating cycle. Inventory financing means finding the money to build up stocks, usually via a loan or credit. This type of credit is used to pay suppliers or finance their invoices.

Note: some publications mix up stock financing and inventory financing. But these are two completely different types of short-term credit. We'll explain shortly.

1.1 - Definition of inventory financing

Stock financing is a means of obtaining cash to build up stocks of raw materials or goods. It involves a short-term loan or cash advance in order to purchase products for storage. Taking out such a loan can take various forms, and the lending organisation often requires collateral.

1.2 - Difference between stock financing and inventory financing

Borrowing to build up stock in advance should not be confused with the financial technique of stock financing. This second process consists of finding financing using your existing assets — in this case stocks you’ve already paid for.

You pledge the products or materials on your balance sheet as collateral in order to obtain a loan for other purposes.

A company's inventories represent future sales. And just as you can optimise your working capital requirements (WCR) using customer credit (factoring), stock financing is a similar process based on existing stocks.

2 - How to grow via inventory financing

How does borrowing money in the short term facilitate business growth? It's a kind of leverage solution that speeds up business.

2.1 - Your business model relies on inventory

Most companies hold stocks at some point. A trading or retail business consists of buying goods, storing them and then reselling them. Only in cases such as dropshipping is there no need for stockholding, as you source products only once they’ve been ordered by the customer.

The manufacturing cycle of an industrial company requires raw materials, inputs, packaging, etc. to produce finished products and prepare them for customer delivery.

Even service companies can have production work in progress. They call on suppliers or service providers, as well as their own employees, to design services to be invoiced to customers on time. These time-consuming operations require cash.

2.2 - To sell products, you must first spend money

The presence of these inventories, whatever their nature or activity, ties up cash. You need to pay for purchases or production. In all cases, these cash outlays are made upstream of promotion. In most business models, this is an essential stage in securing sales.

So finding a solution to finance your stocks quickly becomes crucial if you don't have enough cash. Without a loan, there's no money. No money, no stock. No stock, no sales. Without sales, no sustainable business.

3 - When should you finance your inventory?

If you’re lucky enough to have negative working capital requirements, you generally have free cash to build up or increase your inventories. Otherwise, looking for a stock financing solution is vital. 

This is the case for a business start-up project, for business development or when sales are seasonal. Here’s what this looks like in practice.

3.1 - Financing your first stock when you set up your business

Getting credit from a bank can be complex when you're starting out. However, the minimum is to calculate your cash runway. That way you know how many months you can last with the amount of cash on hand. 

Some new businesses fail to include their initial working capital requirements (WCR) in their financing plan, particularly the purchase of their first stock. The lack of cash flow in the first few months accounts for the majority of business failures.

There is also public assistance available, not to mention negotiating payment facilities with suppliers.

3.2 - Inventory in seasonal businesses

Companies that experience peaks in activity due to their seasonal nature see the level of their WCR fluctuate sharply over the course of the year. Commercial organisation of the Christmas season, like Black Friday or Mother's Day, is vital. 

By seeking stock financing, you can anticipate cash flow needs. Specific solutions exist, such as campaign or seasonal financing.

3.3 - Sales growth often means increasing your stock of goods first

The third classic case where you need to look for financing for your stocks is when you are planning to expand your business. As your company goes up a gear, you need to resize stocks accordingly. 

It's hard to imagine selling more without having the products in stock. You run the risk of being out of stock, which can drive customers away. Financing your stock is precisely the way to plan ahead.

4 - Conventional solutions for financing stocks

There are a number of solutions available to find the cash you need to build up your stock. Let's start with the traditional types of financing offered by banks.

4.1 - Bank cash advances to buy stock

The first option is a classic credit facility. This is a simple financing solution for a one-off need. It’s usually not suitable for seasonal or longer-term campaigns, which often require cash over several months to buy stock.

You can also find offers such as a short-term loan specially designed for supplies. 

An overdraft facility, on the other hand, is a temporary bank overdraft facility with no long-term viability and a prohibitively high interest rate. For this reason, it’s best viewed as a last resort.

4.2 - Seasonal credit and loans

The period before the peak of seasonal sales can be stressful, and it’s often when your cash reserves are lowest. In the months or weeks leading up to peak season, you might access short-term credit, known as a campaign loan, to pay expenses. 

This lets you buy stocks in advance. It’s the same process for activities with a long production cycle, such as agricultural activities or some service-based projects (production agencies, for example).

This type of stock financing by a bank generally works by taking out a guarantee, such as a warrant or pledge on the goods. This is a way of protecting against the risk of non-repayment of the financial advance on the due date.

5 - Alternatives to bank stock financing

In addition to the traditional financing options offered by financial institutions, you can also finance inventory in innovative ways that go off the beaten track. In our article on short-term financing options, we already discussed those that involve financing inventory or suppliers. Let’s go through them again briefly here.

5.1 - Reverse factoring

Factoring involves transferring your trade receivables to a company that gives you a cash advance immediately, before maturity. Reverse factoring, on the other hand, involves financing transactions on the supplier side. You ask the factoring company to pay your supplier invoice on your behalf. When the invoice is due, you repay the financing organisation. 

With reverse factoring, you can buy inventory without having the cash. Your suppliers receive their payments on time, directly from the factor. It is therefore a type of inventory financing.

Setting up this process generally involves transferring the supplier's claim on your company to the factoring company. But a simpler scheme also exists, which we explain below.

5.2 - Financing supplier invoices using the BNPL principle

Buy Now, Pay Later is an interesting financing process for inventories. You buy from suppliers but don’t actually have enough cash to pay for these purchases. Instead, a financing organisation or platform pays these invoices on your behalf.

You then repay the short-term advance at a later date, when you receive the money from the sale of stocks. 

These new forms of financing offered by fintechs have a number of advantages over traditional loans. More flexible and transparent, they are simple solutions to activate if you are planning to stock products. 

Some sellers or suppliers even build this facility directly into their platforms so consumers — including professional buyers — can take advantage. Afterpay and Klarna are two such examples. 

Finance your inventory & pay suppliers on time

You likely don’t have the luxury of waiting for sales to come in before considering the next stage of growth. A successful operating cycle requires cash, including payment upfront for returns you’ll see in future. 

But with the wide range of inventory financing options now available to every SMB, you shouldn’t be slowed down. There are great solutions like Defacto, sure to be a fit for your business. 

Find out how Defacto can help you finance inventory and pay supplier invoices, for a healthy and fruitful cash flow cycle.