Inventory is a relatively illiquid asset and ties up cash flow.
With fast growth and/or seasonal businesses, inventory growth can create a significant demand for working capital financing as illustrated in the video below.
However, inventory is also one of the most difficult working capital assets to finance, esepcially for Small & Medium Businesses (SMBs).
The Impact Of Inventory Holdings On Cash Flow.
Credit Issues With Inventory Financing
The reluctance of banks to lend against inventory is because of the inherent business risks of this asset class, including:
- Shrinkage such as theft, damage etc.
All these issues have potential impact on profitability, cash flow and the balance sheet.
For example, obsolescent inventory cannot be sold for their cost price (not to mention recover the associated holding costs). Sale at a loss hurts profitability and cash flow. But then again, hanging on to them ties up cash and you still have to pay for storage etc. Selling them at a loss – if they are at all saleable – at least frees up some cash even if a lot less cash than what you paid for them. And of course, any write down of obsolescent stock to realisable value hurts the balance sheet.
These business risks hit the hot buttons of the 4 C’s of Credit: Collateral, in particular the realisable value in a fire sale; Cash Flow and to a lesser but no less important extent, Capability and Character.
There are specialised inventory financing facilities such as Floor Plan facilities for vehicle, heavy equipment or boat dealerships. The nature of the inventory in these types of businesses in combination with the facility structures help mitigate in part the credit issues associated with inventory. But the availability of these types of specialised facilities has been harder to come by since the Global Financial Crisis (GFC).
So how can your business finance your working capital requirements arising from inventory holdings? This is one of those situations where you need to get more creative.
3 Possible Inventory Financing Strategies
1. Cash Flow Financing Facility
This is usually a revolving working capital facility (draw and repay) where the amount you are allowed to utilise at any point in time is based on a specified formula. That formula sets out the LVR (or loan to value ratio) for the assets on the balance sheet, in particular debtors and inventory. (Other assets like Plant & Equipment and Land & Buildings would (should) be financed with appropriate facilities that match the useful lives of these assets.)
Only businesses with a track record of profitability, strong cash flow and a sound balance sheet; and solid management information systems will qualify for this type of lending.
- What Types Of Inventory Are Eligible?
The only categories of inventory that would be included in the formula calculation are Finished Goods and Raw Materials.
Work-in-Progress is not deemed acceptable security: these are not saleable without spending more money and time to turn them into Finished Goods.
Whether the Finished Goods and/or Raw Materials will qualify as part of the lending formula depends on a number of factors:
- Marketability: Do the goods have an established and deep market? Examples: white T-shirts have a bigger market than purple checked taffeta trimmed mini-skirts; iron ore is easier to sell than speciality pigments for paint manufacture. Obsolescent goods are not acceptable inventory. If the goods are perishable, they would not be acceptable as security unless there is adequate insurance over these.
- Location: Small holdings of inventory in a wide number of locations would not be acceptable. Consignment goods are not acceptable.
- Systems: You must have sound inventory systems in place. In some instances, lenders will require the inventory being funded to be held in bond stores. The last thing they want is to discover that the inventory has gone “walk-about” when they look to realizing their security.
- How Much Can Be Borrowed Against Inventory?
Even with eligible inventory, the advance ratios against acceptable inventory are not high. Even with the most marketable goods, don’t expect much more than 30% against the value.
At a push, you MIGHT get 50% (rare for SMBs) but in the tight credit markets that have prevailed since the GFC, it’s highly unlikely unless you can make a strong case for mitigating key business risks. For example, you might be able to get more for a seasonal stock build where the finished goods are against firm orders by credit-worthy customers and you have a track record of meeting the deliveries without quality issues and on time (if contracts allow customers to reject deliveries on because you are late).
2. Optimize Financing Of Balance Sheet
First, let me state that this is NOT a recommendation to leverage your balance sheet to the hilt. A business should only ever undertake a sustainable level of debt – that is a level where debt service (interest and principal repayments) can be met even if there are “shocks” to the business’ operations.
Inventory holdings, particularly seasonal build ups, create major working capital financing requirements. With lending value against inventory being relatively low, you need to figure out how to fill the gap.
Review the total financing structure of your balance sheet (or balance sheets if business assets are spread across different entities). Given the low advance rate against inventory, would it be more efficient to put a specialized stand-alone debtor financing facility in place instead of going the “cash flow lend” route? Is there equity build-up in plant & equipment and land & buildings from aggressive debt repayment against these assets in the past? Could cash be released from re-leveraging these assets or restructuring the repayments on the related financing facilities?
If your business is relatively young and in fast growth mode, an equity injection rather than more debt may be what is required to fund the working capital demands of growth. Profits should be retained and reinvested to fund on-going growth.
3. Minimise Inventory Stage of Cash Conversion Cycle
By minimizing the amount of inventory you have to hold and the length of time you have to hold it for will help reduce the amount of working capital you have to fund.
- Are there ways of improving supply chain efficiency? The internet has enabled significant efficiencies in logistics.
- Is it possible to negotiate longer credit terms from your supplier(s)?
- Is it possible to get up-front deposit payments from customers for large orders?
You should be doing all of these things anyway as it improves your cash flow.
What Are Your Business Financing Challenges With Inventory?
I am interested in hearing about your experience in financing growth in working capital, especially when your business has to deal with significant inventory holdings. Share your story in the comments section!
Contact me if you have a specific query that you want to discuss in private or would like a one-on-one finance review.
If this article has been useful, I’d really appreciate it if you would click the Like and Share buttons.