Inventory Financing

Inventory financing is a form of secured lending in which a business borrows against the goods it holds for sale or production: raw materials, work in progress and finished stock. Retailers, wholesalers, distributors and manufacturers use it to buy stock ahead of sales, smooth seasonal peaks and free up working capital that would otherwise sit on shelves. Lenders range from banks and specialist asset-based lenders to manufacturers' captive finance arms.

Most inventory finance is a revolving line whose limit moves with the value of eligible stock, often alongside receivables in a single asset-based facility. It is broader than warehouse receipt financing, where specific goods are held by a third-party warehouse, and different from purchase order financing, which pays a supplier before stock exists. In the United States, the lender's security interest is taken and perfected under Article 9 of the Uniform Commercial Code.

A bookshop needs to fill its shelves before the holiday rush, but the money from those sales will not arrive until December. The bank agrees to lend against the books on the shelves, but not their full price, because if the shop fails the bank would have to sell them quickly and cheaply.

So the bank says: we will lend about half of what the books cost you. As the shop buys more stock, it can borrow more; as it sells and repays, the loan shrinks. Now and then, someone from the bank comes to count the books and make sure they really exist. The shop gets breathing room, and the bank has something it can sell if things go wrong.

Lenders do not lend against all stock. They first exclude ineligible items, such as slow-moving or obsolete goods, stock held at third-party sites without a waiver, goods on consignment and items already subject to another creditor's lien. They then apply an advance rate to the eligible value. The available credit is:

• $B$ is the borrowing base, the most the borrower can draw.
• $I$ is the total inventory value, usually at the lower of cost and market value.
• $X$ is the value of ineligible stock.
• $a$ is the advance rate, as a decimal.

A distributor holds 2,000,000 of stock, of which 300,000 is obsolete or held off-site. With a 50 percent advance rate, the borrowing base is (2,000,000 − 300,000) × 0.50 = 850,000. Some lenders instead lend up to 85 percent of the net orderly liquidation value, an appraiser's estimate of what the stock would fetch in a managed sale, which ties the advance more closely to the real haircut they would face.

• Asset-based revolving lines. A revolving credit facility secured on inventory and receivables, with a monthly borrowing base certificate.
• Floor plan financing. Used by car, boat and equipment dealers: the lender pays the manufacturer for each unit, and the dealer repays when that unit is sold.
• Inventory term loans. A fixed loan secured on stock, used less often because stock levels change.
• Vendor and channel finance. A manufacturer or its bank extends credit to distributors so they can carry its products.
• Warehouse and collateral-managed finance. Lending against goods controlled by a warehouse or collateral manager, common in commodities.

Because stock can be sold, moved or spoil, lenders monitor it closely. Typical controls include monthly stock reports, periodic field examinations and appraisals, and a financial covenant package. Sales proceeds may be swept into a controlled account under a bank account control agreement or a lockbox, so that cash from selling the collateral repays the loan. Lenders also track days inventory outstanding, because stock that turns slowly is both less valuable and harder to sell.

For borrowers, inventory financing can unlock cash that a bank would not lend on an unsecured basis, and the limit grows with the business. It suits firms with large, resaleable stock and a short cash conversion cycle. The costs are higher interest than plain senior secured debt backed by fixed assets, monitoring fees and reporting work.

For lenders, the risks are valuation and fraud. Fashion, electronics and perishable goods can lose value quickly, and inflated stock counts or goods pledged twice can leave the lender under-secured. Inventory is usually the weakest collateral in a business after cash and receivables, which is why advance rates are lower than in factoring, where the lender buys a debt that a customer already owes.

• Uniform Law Commission
• US Small Business Administration