Summary: Invoice factoring allows companies to improve cash flow by leveraging their accounts receivable. Inventory financing, on the other hand, enables companies to leverage the funds tied to their inventory. However, most small business owners misunderstand each solution’s role in their company. This misunderstanding often leads to expensive mistakes.
Invoice factoring is more flexible and cost-effective. In most cases, it should be deployed first. Inventory financing is more complex and expensive. Consequently, it should be added only if the factoring line cannot improve your cash flow sufficiently. In this article, you will learn:
- What is inventory financing?
- Why is inventory financing expensive?
- What is invoice factoring?
- A/R factoring is easier to obtain and set up
- How do these solutions work together?
- Differences
1. What is inventory financing?
Small companies often get short payment terms from suppliers. Consequently, a large percentage of their funds are tied to their inventory. This situation can create cash flow shortfalls since funds tied to inventory (or raw materials) can be accessed only after the end product is sold.
Inventory financing is a form of asset-based finance that allows your company to leverage its inventory or raw materials. It helps companies that have cash flow problems and have substantial funds tied to their inventory.
Most inventory financing lines work much like a revolving line of credit. The line allows you to request draws as inventory is bought and paid. This payment provides the funds you need to operate the business. The line is settled by financing receivables, either by factoring them or through an asset-based loan. To learn more about this solution, read “How Does Inventory Financing Work?”
2. Why is inventory financing expensive?
Inventory financing lines are expensive compared to other financing products. The reason for their expense is that setting up and operating them is labor intensive. Financing companies need to determine the quantity of inventory in your warehouse, appraise its value, and track your sales.
Due to the risk, lenders usually finance only up to 75% of the Net Orderly Liquidation Value (NOLV) or 50% of the purchase price – whichever lower. Keep in mind that the NOLV is usually lower than what you paid for the inventory.
Inventory financing companies finance only marketable inventory that can easily be sold. They are unable to finance custom-made inventory with a limited market. Additionally, your company must use a perpetual inventory system, must use a minimum of $700,000, and not be at risk of default.
3. What is accounts receivable factoring?
Accounts receivable factoring is a form of asset-based finance that allows you to leverage your accounts receivable. It can be useful if you work with commercial and government clients who pay their invoices in 30 to 60 days. Financing your receivables improves your cash flow and provides funds so you can operate your business. Accounts receivable factoring lines operate similarly to a line of credit.
You can withdraw funds from the line as soon as you invoice customers. You pay back once your customer pays the invoice, which settles the transaction. To learn more, read “How Does Accounts Receivable Financing Work?”
4. A/R factoring is easier to obtain and set up
Accounts receivable factoring lines have simple qualification criteria and are easier to set up than inventory financing lines. Most lines can be set up in a week or two. To qualify, your company must:
- Work with creditworthy commercial clients
- Have unencumbered invoices
- Not have serious financial or tax problems
Additionally, accounts receivable factoring lines are cheaper than inventory financing lines. Most lines cost from 1.15% to 4.5% per month, though that cost varies by transaction size, industry, and general risk. To learn more, read “How Can Factoring Companies Help You?”
5. How do they work together?
Companies that have cash flow problems should first consider using accounts receivable financing. This solution is simpler to implement and is more cost-effective than inventory financing.
If factoring your invoices does not solve your problem, and you have funds tied to inventory, consider inventory financing as well. Most inventory financing lines settle through the sale of your product. The sale creates an invoice, which can then be financed. The funds from financing the invoice are then used to settle the inventory line.
6. Differences
Here is a list of the six most important differences between an invoice factoring line and an inventory financing facility:
a) Different but complementary objectives
Both tools are designed to improve your cash flow. Factoring can make the greatest and most cost-effective impact. Consequently, it should be implemented first. Inventory finance, on the other hand, is an add-on option that can be used to improve working capital further.
b) Asset valuations and advances
Invoices are financed by advancing 70% to 90% of their face value. Funding is done net of any credit memos, returns, or retainage. Inventory is usually financed by advancing 70% to 80% a percentage of the inventory’s appraised value. This last point is very important since the appraised value can be lower than the market value. In turn, this valuation affects the amount of financing you can get. Lenders usually appraise inventory using the Net Orderly Liquidation Value or the Forced Liquidation Value.
c) Qualification requirements
Qualifying for invoice factoring is relatively simple. Your invoices must be free of liens and payable by commercially creditworthy companies. Factoring can be provided to companies with financial problems and are in turn-around mode. Qualifying for inventory financing, on the other hand, is more difficult. Your company must have:
- A minimum trading history of two years
- A reliable inventory tracking system using perpetual inventory
- Reasonably good financial statements
- A minimum need of $700,000
- Marketable inventory/raw materials
d) Due diligence costs
Except for very large factoring lines, factoring due diligence costs are usually minimal. The due diligence for an inventory financing line is more complex and time consuming and is, therefore, more expensive. The lender must perform a field examination at your facility (or plants). They also need an appraiser to visit your facilities to review your inventory. These out-of-pocket expenses can add up. Depending on the size of the line, type of inventory, and number of facilities, the due diligence cost can range from $10,000 to $20,000 and up.
e) Maintenance
Accounts receivable financing lines require minimal maintenance, though some lines require a yearly field examination. Inventory financing lines, on the other hand, usually require quarterly field examinations. These examinations are paid for by the client, which adds to your operating costs.
f) Flexibility
Both lines are flexible and can increase as your business grows. Increasing a factoring line is relatively easy. All you need to do is sell to new creditworthy customers. If your customer’s credit is approved by the lender, your line increases automatically.
Increasing an inventory line can be somewhat more complicated. Approving the increase may require additional due diligence, especially if you sell new inventory.
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