What’s the Difference Between Inventory Financing and Invoice Financing?
What Is Invoice Financing?
Invoice financing is a way for a business to borrow money against the amount due from its customers. It generally helps a business improve its cash flow to pay for its expenses or pay its suppliers and employees. It also helps a company reinvest in its operations and for its growth since it does not have to wait for its customers to pay back in full.
What the business does is that it pays its lenders a percentage of the invoice, which is due as a fee for borrowing the money.
Invoice financing is quite useful for those businesses where customers take a long time to pay back and when there are difficulties obtaining other forms of business credit. Invoice financing is also known as “receivables financing” or “accounts receivable financing.”
What Is Inventory Financing?
When a business uses an asset-backed or a revolving line of credit or a short-term loan in order to purchase products for sale, it is referred to as inventory financing. These products or inventory act as a collateral for the amount of loan the business has taken from the lender in case it is not able to sell its products or cannot repay the loan.
This form of financing is useful for those businesses that need to make payments to suppliers in a shorter period of time than it takes for the business to sell its inventory to customers. It also acts as a solution for the seasonal fluctuations that happen in the cash flow of a business. Inventory financing also helps a business achieve a higher level of sales volume, for example, by allowing it to obtain additional inventory that it can sell during times of high demand, such as the holiday season.
Invoice financing is also known as invoice factoring, where the business sells its accounts to a third party (who is called a “factor”) at a discount.
Similarly, inventory financing is also known as inventory factoring where a business sells its purchase orders on a discount to a “factor” so that it can obtain inventory from suppliers. This may also be referred to as purchase order financing or import financing. The factoring company ends up paying the business 70-95% of the purchase orders upfront and the remaining 5-30% along with the deduction of its factoring fees after it has received the payment on the purchase order. The fee for factoring is usually 3-5%.
Factoring is done when a business is in immediate need of cash flow in order to meet its current expenditures.
Inventory Financing vs Invoice Financing
These are the major differences between the two types of financing:
- Inventory financing helps a business have access to cash flow by using its inventory as collateral, while invoice financing helps by selling the company’s account receivable invoices at a discount.
- It is easier to obtain invoice financing and inventory financing as compared to a line of credit or a traditional bank loan, with invoice financing being the easiest of the two.
- Inventory financing is useful for the business to pay its suppliers before it is able to sell its products, while invoice financing is useful for a business to obtain money before its customers can pay.
Pros and Cons of Invoice Financing
- Steady Cash Flow
This form of financing is ideal for businesses that have a high cost of sales. It helps boost a company’s cash flow, which does not have to wait for payments to arrive or chase creditors for payments.
- Confidential Finance
This type of finance can be confidential if the business is a good risk and there is a high level of turnover. This means that the customer would never know the business is using this option, so you can strengthen your customer relationship as well.
- Quick Process
Before a lender buys an invoice from the business, they will check its invoices to make sure the company can pay back. This is a quick process, so you won’t have to wait to get a loan.
- A Portion of Profits Is Lost
If you have decided to get this form of financing, you must remember that these services are not free and you will be charged a flat rate on your invoices.
- Cash Flow Issues
In the worst-case scenario, a company may be forced out of business due to one disputed invoice and a sudden withdrawal of funds.
Businesses which use this form of financing are generally considered high risk by their customers.
- Customer Relationship
When a business hands over its invoices to a third party who is only interested in getting money from customers and have no interest in maintaining a relationship with them, there is a risk of alienating the customer base.
- High Charges
It is quite an expensive form of financing.
- Chasing Payments
Even with invoice financing, most businesses end up chasing customers in order to make sure they do pay up before the 90-day period.
Pros and Cons of Inventory Financing
- Provides Cash Flow
The most obvious advantage that this form of financing provides a business is the cash flow that is needed for the company to function and stay operational. In many cases, a business may require this cashflow in order to pay the rent, electricity, wages and other expenses.
- Helps a Business in the Busy Season
Inventory financing is especially helpful for businesses when sales are high and the company would need a lot of inventory at hand.
- It Grows with the Business
If you are using this form of financing as a line of credit, it can grow with the business. For example, if the level of sales is low for a business in the first year but grows by the second or third year, inventory financing limits can also be increased accordingly.
When a business is able to buy more inventory using this form of financing, they may now be eligible for high discounts by suppliers since they would be purchasing in bulk.
- High Minimum
Some lenders may require a business to borrow at least $500,000 as a minimum amount, which may not be feasible for small businesses.
- Short Term
These loans are generally short term in nature and have to be repaid within a year. Thus, any business which is interested in getting this form of financing should make sure they are able to repay it within a small period of time.
- Not Very Popular with Lenders
This form of financing is still not popular with lenders, and it may be difficult to find a bank or another financial institution that is offering it.
- High-Risk Loan
Most lenders consider inventory financing as a high-risk loan because the value of the inventory is not easy to assess. Again, this leads to low popularity of inventory financing among lenders. Moreover, merchandise can be damaged or stolen, which ends up reducing the overall value of the inventory. As a result, many lenders may not be willing to give a loan on this basis or include unfavorable terms and conditions with the financing.
Inventory financing may be more expensive and offer higher levels of interest than traditional loans.
- Tedious Paperwork
This form of financing may require the lender to do a lot of paperwork and due diligence, which makes loans harder to approve.
Which One Is Right for Your Business?
Whether invoice financing or inventory financing is right for your business depends on your business and its circumstances. Both types of credit options are good alternatives for a business to use when it is unable to obtain traditional financing from banks or other lending institutions due to insufficient credit or an inability to provide collateral. Both these types of financing help a business owner avoid using lending products which put their personal assets as collateral or their business assets at risk.
Inventory financing can be beneficial for you if you need to buy extra inventory during times of high sales. If you get this type of financing as a form of credit line, this credit line can grow as the company grows and offer more benefits in the long run.
Invoice financing, on the other hand, is much easier to qualify for than inventory financing. This is because a lender is able to verify a company’s invoices quite quickly.
When it comes to being approved for inventory financing, most lenders would generally perform a rigorous review of the business and its inventory. Thus, in order to qualify for inventory financing, your business must keep an accurate record of the inventory and maintain financial statements. Most lenders also require a business to borrow at least a minimum of $500,000, which makes inventory financing unfeasible for those businesses which are relatively small.
Conclusion – Ideal for Trade Finance
Even though both invoice and inventory financing are great option for businesses to use when they are short on working capital, no matter which industry they are in, they are generally quite expensive. These forms of financing are more suited for businesses involved in import and export or trading. After all, these loans are sometimes known as “trade finance” as well.
Trade finance works on a confirmed order basis where a business may have a purchase order from a client and would factor that purchase order so that they can purchase the required inventory. This means the goods can be shipped as soon as possible. The business could also use invoice financing in order to have the money at hand to handle expenses such as utility bills and wages.
You can get both invoice and inventory financing from the same lender for simplicity or even from separate lenders. You may simply opt for trade finance and it would cover the finance needs of your business involved in trading. Inventory financing would solve cash flow delays in paying suppliers, while invoice financing would solve cash flow shortfalls in getting paid through invoices. Hence, getting both types of financing will take care of all your capital requirements.