Alternative Small Business Financing: Inventory Loans vs. Accounts Receivable Loans

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Small businesses often run short of cash. When they do, and they need to borrow money to cover a temporary cash squeeze or to take advantage of a buying opportunity, it can be tough to get regular bank loans.

In fact, many small businesses don’t have the time, credit rating or even the desire to take on a conventional business loan to provide the capital they need in those situations.

That’s when inventory financing or accounts receivable financing can fill the gap.

Below, we’ll walk you through these two kinds of alternative financing. We also give you the information you need to decide if invoice financing or accounts receivable financing make sense for your particular small business.

Inventory financing

What is inventory financing?

Inventory financing is an asset-based business loan. The asset is your business’s inventory.

There are two main kinds of inventory financing: a short-term loan or a line of credit. The line of credit is more flexible because it allows you to borrow money when you need it, up to an approved limit, but in return the interest is usually higher.

Inventory financing is not a step to take lightly. If you can’t pay back the loans, the lender will sell off your inventory to recover the money you borrowed, which could strangle your sales and force you to close your doors.

How can inventory financing help my small business?

Inventory financing can help your small business get the money it needs to operate when it has a short-term cash crunch.

A cash crunch can hit when a business is in a seasonal sales slump, has slow-paying customers or a temporary hitch in its supply chain or its own manufacturing schedule that means it doesn’t have goods to sell when it expected to.

Inventory financing also can help if your small business needs to restock ahead of a seasonal sales rush but doesn’t have enough cash because it is still in its slow season. Or your company may have an extra-large order for goods that its regular cash flow can’t cover.

Another common scenario: You may need working capital for other business operations but most of your money is tied up in inventory.

Is inventory financing a good option for your small business?

Answer these questions to help you decide: Do you have inventory? (Or are you ready to purchase inventory?) Inventory financing is an option for product-based companies like retailers, wholesalers and manufacturers. Do you have an existing product that has a consistent track record of strong sales? Inventory finance companies want to be sure your inventory is valuable  enough before they risk lending you money. Do you keep accurate records of your inventory? A finance company wants to see a good inventory management system in place so it has an accurate picture of the status of your inventory as to products moves through your system. Does your inventory sell quickly? You don’t want unpopular product and neither do finance companies when they are deciding whether or not to lend you money based on your inventory. Have you been in business a year or more? Although some inventory finance companies will consider start-ups, most want to do business with existing companies with a history of successful sales. Does your business already have a lot of debt? If so, an inventory finance company will think twice before lending you more money if your company doesn’t have the revenue to comfortably cover the new debt payments.

What else do I need to know about inventory financing?

  • Lenders want monthly or annual sales minimums. That can be as low as $25,000 a year, but you then you’ll qualify for a relatively lower amount of financing.

  • You’ll still have to go through a loan application process and share your business’s financial picture with a potential lender.

  • Inventory financing interest rates can range from the high single digits into triple digits, depending on how current and marketable your inventory is, how long you have been in business and the financial health of your business. Some online lenders also consider your own personal credit score, typically requiring at least a 600.

Accounts receivable financing

What is accounts receivable financing?

Accounts receivables are a business asset: They represent the money your customers owe your small business. They also can be used to get financing for your small business. Your business will get cash up front for part of the value of the accounts receivables, even before your customers pay their invoices.

There are two main kinds of financing you can get based on your accounts receivables — factoring and straight financing.  

In accounts receivable factoring, a finance company, called a factor, buys your accounts receivables outright for part of what they are worth. Your business gets part of that in cash upfront, and another, smaller, portion when your customer pays the invoice. The factor company gets to collect the money your customer owed you, hoping to get paid 100% of the invoice.

Or, with accounts receivable financing, you can borrow money against the value of one or more of your accounts receivables. This could be a lump sum loan or a line of credit. You are still responsible for billing and collecting on your accounts receivables.

How can accounts receivable financing help my small business?

Whether you sell or finance against your accounts receivable, you can get the money you are owed faster than if you wait for a customer to pay you.

Factoring your accounts receivables has been more common in some businesses, typically those that sell to other businesses. Unless you prepare your  customers, whether consumers or businesses, they may see factoring as a sign that your small business is in financial trouble.

Is accounts receivable financing a good option for my small business?

Answer these questions to help you decide:

  • Do I have straightforward sales of consumer goods, preferably to major retailers?

  • Do my customers have good credit?

  • Do my customers pay me fast and reliably?

  • Do my customers typically pay at least 90% of what they owe me?

  • Is my gross margin large enough to cover the fees and interest payments I will owe if I sell or borrow against my accounts receivables?

  • Do I have a positive working relationship with my customers?

If your answer to most of these questions is “yes”, then this type of financing would be a good fit for your business.

What else do I need to know about accounts receivable financing?

You don’t have to include all your accounts receivables. Factors typically buy a single accounts receivable.

You need a minimum sales volume for a loan. Lenders typically let you borrow against a package of your accounts receivables. And you can set up an ongoing relationship, so as your business generates accounts receivables, it can borrow against them. As the invoices are paid, you pay the lender. So a lender will look for a certain level of monthly sales to make the deal worthwhile. That could be a minimum of $50,000 a month. Lower levels are possible, but a loan against them will be more expensive.

Factoring is riskier for a finance company. Selling an accounts receivable to a factor company can be more costly than getting an accounts receivables-based loan because, for the factor, it’s riskier. That yet-to-be-paid customer invoice is its only source of recouping the money it paid you.

And since the factor now owns the account — and factors typically buy individual accounts receivable — it also has to handle collections.

By comparison, a lender has the receivables as collateral, but also will have recourse for repayment through a claim on some part of your small business’s other assets.

And your business is still responsible for making sure your customers pay their invoices.

Factor first, if you have to, then finance. Companies often start with factoring their accounts receivables, then as their financial position strengthen, they switch to the less-expensive option of accounts receivable financing.

How much money you will get depends on the size and quality of your accounts receivables. Older invoices, for example those that are 90 days past due, won’t be considered by a buyer or finance company.

For a current invoice, a factor will typically pay you about 80% of the face value upfront, and charge you interest until the invoice is paid. Then, once the invoice is paid, you will get paid the rest of the money, less the factor’s fee, which can be 1% to 5% of the invoice total.

Your small business has choices when it needs cash to cover short-term inventory or working capital needs.

Next steps

If you decide that one, or both, of these alternative financing options might be the solution, your next steps should include checking with your accountant or business financial advisers. You want to be sure they agree.

Then you’ll want to compared what specific asset-based lenders offer, because each will have a slightly different package of fees and terms. Some online-platform lenders that make assets-based loans are OnDeck and Kabbage. Established finance companies that specialize in asset-based loans include Commercial Capital LLC.

Alternative financing, including inventory financing and accounts receivable financing, are two established sources of money for your small business. But they aren’t risk-free. So be sure to weigh your options and compare the costs and the risks vs. the benefits before you choose.

Running a small business includes managing risk, and successful alternative financing may be just the spark your small business needs to grow.

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Related article: Small Business Finances: Should You Hire a Bookkeeper, an Accountant, or Both?

Cyndia Zwahlen, a former small-business columnist for the Los Angeles Times, is a freelance business writer and editor for media, academic and business clients. She founded the Small Biz Mix blog.

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