Small business financing is in a tough spot.
As of Q4 2023, only around 13.2% of small business bank loan applications were approved by big banks. In 2020, that figure was closer to 28%.
Rates are rising, lending standards are tightening, and small business owners everywhere are feeling the crunch.
Whether you’re a small manufacturer, an ecommerce retailer, or a distributor, maintaining liquidity in your working capital is vital. If you’re feeling the liquidity crunch, like so many other businesses are, you may be looking for alternative funding sources.
Heard of inventory factoring? This guide will help you understand what small business inventory factoring is — how it works, its pros and cons, and everything else you need to know.
What Is Inventory Factoring?
Inventory factoring is an alternative funding source that allows businesses to leverage their inventory and pending purchase orders to raise cash. Small business inventory factoring is a bit different in terms of the specific options available but, by and large, it works the same way.
I’ve explained the process in detail below, but here’s the quick gist of it:
- You sell your purchase orders or accounts receivable to a company known as a “factor”
- The factor gives you a chunk of the purchase order amount upfront; usually 70-90%
- The factor then owns that short-term debt and collects payment from your customer
- Once payment is collected, the factor sends you the rest of the money (less fees)
Inventory factoring opens up your free cash flow sooner so that you can cover more inventory or other expenses while waiting for customer payments. It’s often used when businesses need liquidity in order to fulfill a large purchase order.
Benefits Of Small Business Inventory Factoring
Small and medium-sized business (SMB) inventory factoring is non-dilutive, quick, and (relatively) easy to get approved for. I’ve explained the key benefits in greater detail below.
Factoring is rapid and responsive to a business’ needs. Usually, firms will establish a relationship with a factor (which initially could take several days to a week). But once that initial relationship is established, getting cash from inventory and accounts receivable factoring is very quick (as fast as 1 business day for the best factoring companies).
Once established, some factoring agreements can function similarly to a line of credit. That means it’s easy to get immediate cash as needed, on a revolving basis.
Money Without Debt
Unlike traditional business funding methods, you don’t have to go into true* debt to gain liquidity via small business inventory financing.
This is really two substantial benefits in one:
- It’s easier to get approved for inventory factoring (compared to traditional loans), even if your business credit profile is less than stellar
- It’s a source of non-dilutive funding because you’re not selling equity
In today’s tight SMB lending environment, this unique form of financial leverage is perhaps more useful than ever before.
*Now, I do need to add a disclaimer here that technically, you are still going into a form of debt by factoring your invoices. If your customer ends up defaulting on the debt, you are responsible for paying the factor that money back. In other words, it isn’t a good idea to throw your collections problems at a factoring company, as you’re going to be eating the factoring fees and losing out on the invoice value.
Look at it this way: If you’re facing a cash crunch, it wouldn’t be surprising if your customers were too.
The harsh reality is that SMBs have fewer levers they can pull for financing, compared to large firms. James Carron of Flatirons Pharmaceuticals in Longmont, Colorado recently saw his SMB line of credit APR double from 6.99% to almost 14%.
“We can’t issue corporate bonds or have other money available to us,” he said. “Large corporations have multiple avenues for them to secure reasonable rates for funding. A small business owner doesn’t have that ability.” Carron explained.
But the thing is: If you can offer flexible financing for your clients and customers, you’ll drive more sales, plain and simple. Extending credit to your customer base can increase sales, build customer loyalty, and enable success for your business partners.
But offering 30-day or even 60-day payment terms can be rough on your liquidity. Small business inventory factoring can help.
Small Business Inventory Factoring Requirements
Each factoring company may have slightly different requirements that must be met. But generally speaking, in order to qualify for inventory factoring, your business must:
- Have high-quality invoices, purchase orders, or accounts receivables to factor. Factoring is not a way to pass off questionable collections.
- Have invoices/POs from businesses or governments. Factoring generally is not available for businesses serving direct consumers.
- Have invoices from companies/government agencies with good commercial credit ratings. The factor may run credit checks on your customers during the application process. Your own firm’s creditworthiness and credit score matters less, but may still be used in the application.
- Have invoices that are free of liens and other encumbrances. You can’t factor outstanding invoices that have been used as collateral with other financial institutions (via invoice financing or any other financial product) unless the lender has formally agreed to invoice factoring subordination ahead of time. Keep in mind that certain types of business funding may be subject to so-called “blanket liens/UCC-1 liens”, which technically place a lien on all assets a business owns.
- Have physical inventory (kinda). Small business inventory factoring is a type of invoice factoring, but as the name suggests, it’s meant for businesses selling physical inventory (or manufacturers with physical raw materials). With that said, most factors also offer traditional invoice factoring, which can be utilized by service providers too.
- Not have an open bankruptcy. While your company’s credit rating is not a substantial variable, most factoring companies won’t factor AR from companies with open bankruptcies.
Each company will have its own procedures, requirements, and factoring rates, so be sure to check with the factor(s) you are considering.
How Does Inventory Factoring Work?
The term “inventory factoring” is a bit of a misnomer that can lead to some confusion.
In reality, “inventory factoring” can mean one of two things:
- Invoice factoring specifically for retailers, manufacturers, and others with physical inventory (this is most common, and primarily what’s discussed in this article).
- A form of inventory financing, similar to a line of credit, that’s settled by factoring receivables.
These are technically different financial products, but the terms are sometimes used interchangeably. Let’s break both down.
How Invoice Factoring Works
Invoice factoring is when a company sells its unpaid invoices to a third party, called a “factor”. The factor buys the invoice, usually for an upfront payment + an additional payment once invoice payments are settled.
(Keep in mind that these are recent, high-quality invoices. Invoice factoring companies will not buy your bad debts or past-due invoices, and this is not debt collection).
For example, say you’ve received a purchase order for $80,000 worth of product from an established customer. You issue a $80,000 invoice with net 30 terms. But in order to fulfill the order, you need liquidity.
In this case, you could factor that invoice. A factoring company would pay you upfront, usually somewhere in the realm of 60-90% of the invoice amount. The factor would then collect payment from the customer, at which point they would send you the rest of the invoice amount, minus their fees (which can range from 1 to 10% or more).
How Inventory Financing Works
Inventory financing is a form of asset-based financing that lets you leverage raw materials and/or inventory as collateral. Most inventory financing functions similarly to a line of credit, providing a revolving credit limit backed by the value of your inventory.
For instance, say you’re an established manufacturer and typically have $1-$1.5m of raw materials and finished goods on hand. An inventory financing company may extend you a line of credit of perhaps 50-75% of the appraised value (or net purchase cost, whichever is lower).
For simplicity’s sake, let’s say you’re extended a $500,000 line of credit based on your $1m+ inventory level. You could then draw on this line of credit on a revolving basis.
Here’s where it gets interesting. Instead of settling with cash or an asset-based loan, some providers allow you to factor receivables to settle your line of credit.
So, say you draw $150,000 on your line of credit, then go on to receive a $100,000 purchase order. You could then factor that receivable to your financing provider, settling a chunk of your line of credit. Depending on many factors, that $100,000 invoice would likely lower your LoC balance by anywhere from $90,000-$99,000.
These financial products can be complex, and each company offers different terms and details. But essentially, the key to understanding this form of small business inventory financing is that it basically combines a traditional line of credit with invoice factoring.
Common Misconceptions About Inventory Factoring
The big confusion about inventory factoring is discussed above (the difference between inventory financing vs. invoice factoring). But that’s not the only misconception — there’s more that can cause confusion.
Advances and Asset Valuation
Both invoice factoring and inventory financing can help reduce cash flow problems by advancing funds. But the structure of these advances — as well as the percentages floated — can vary.
For traditional invoice factoring, a factor will likely float you 70-90% of the value of the invoice (face value) upfront. You’ll receive the remainder (less factoring fees) once the invoice is settled.
For inventory financing, a factor might extend you a line of credit worth up to 50-75% of the inventory’s appraised value or net purchase cost, whichever is lower.
Note the distinction here. An inventory with a purchase cost of $1m could fetch a line of credit worth $500-$750k. But that same inventory, once sold, could produce AR worth $1-$2m+, depending on your gross margins.
Invoice factoring is often billed as a simple financing solution. And it's kind of true; if you’re dealing with qualified buyers and have a relationship established with a factor, A/R factoring can be relatively simple.
When inventory gets involved, it can get a little more complex. Factors and financing companies can have relatively stringent requirements for firms’ inventory levels.
For instance, factors will typically require robust inventory records using perpetual inventory management standards. Inventory must be marketable, as well — you may not be able to utilize this form of funding if you’re selling custom or obscure products. Firms may be subject to inventory audits or inspections on an annual (or even quarterly) basis.
Inventory and invoice factoring is often billed as a low-cost funding method. And factoring rates can indeed be competitive. The discount rate is the primary cost driver — but, as always, it’s vital to keep an eye on servicing fees and any additional fees that may be added.
Pricing for small business factoring varies substantially. The industry you operate in, the size of your business, and the quality of the companies you work with will have huge impacts on your cost of borrowing for this type of financing.
SMB Inventory Factoring Is A Unique Option
If you’re the strategic finance leader at your company, it pays to be aware of all your options. When it comes to avoiding cash flow issues and maintaining liquidity, small business inventory factoring is definitely a viable option for many firms.
Is it the best option? Only a rigorous cost/benefit analysis with your own specific variables can tell you that. For some, factoring is cost-effective and flexible. For others, traditional lines of credit or even SBA loans may be a better choice.
As always, knowledge is power in the small business world. Compare your funding options, get some quotes, and run the numbers to see what’s best for your firm.
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