Small and medium-sized businesses often need help with proper cash flow management to sustain their day-to-day operations.
Business owners turn to financing options that suit their requirements in times like these.
There are many ways through which financing can help businesses, such as:
- Enhancing cash flow management,
- Expanding business operations and business profitability,
- Responding to market changes efficiently, and
- Acquiring better assets and pieces of equipment
A few sound financing options for businesses include inventory financing and accounts receivable financing.
Both these types of financing are short-term based. However, small businesses can make the most of them to ease their immediate cash flow constraints.
Businesses usually opt for inventory financing when they need to pay their suppliers to stock more inventory on an urgent basis.
Therefore, this type of financing is done before selling the products to the end users.
In accounts receivable (AR) financing, businesses sell their products to the end customers and create an invoice for a later date.
Businesses sell these outstanding invoices to third-party lenders and acquire immediate funding. Let’s explore each of these financing options in more detail.
What is Inventory Financing?
Inventory financing is a type of short-term borrowing that allows businesses to obtain funding to purchase inventory.
This type of financing is typically used by businesses that need to purchase inventory in bulk but don't have the cash flow to do so.
With inventory financing, the lender provides the business with the necessary funds to purchase inventory, and the inventory itself serves as collateral for the loan.
What are the Pros of Inventory Financing?
Inventory financing can be highly beneficial for businesses as they provide:
1. Improved Cash Flow
Inventory financing can help businesses maintain a healthy cash flow by providing funds to purchase inventory, which can be sold to generate revenue.
This can be especially beneficial for businesses that experience seasonal fluctuations in demand or have extended lead times for receiving payments from customers.
2. Quick Access to Inventory
Often, businesses get stuck in their sales cycle because they don’t stock enough or have adequate inventory.
With inventory financing, businesses can access the funds from an inventory financing company like Drip Capital, and purchase inventory quickly. This allows them to take advantage of opportunities to purchase inventory at lower prices or better terms.
3. Collateral
When businesses opt for inventory financing, the inventory itself serves as collateral for the loan, which means that businesses don't have to put up other assets as collateral.
This can be especially beneficial for small businesses or start-ups that don't have other valuable assets to pledge as collateral.
What are the Cons of Inventory Financing?
Despite the advantages, there are a few potential disadvantages of inventory financing.
1. Risk of Default
If a business is unable to sell its inventory or generate enough revenue to make payments to repay its lenders, it may default on its loan.
This can have a huge negative impact and result in the lender seizing the inventory and potentially taking legal action to recover the outstanding amount.
2. Potential for Overstocking
Businesses that rely too heavily on inventory financing may be tempted to purchase more inventory than they need, which can result in overstocking and tying up valuable resources.
If businesses fail to meet their target sales, they might end up wasting the available stock.
3. Limited Flexibility
Inventory financing can be less flexible than other forms of financing, as lenders may require businesses to use the funds specifically for inventory purchases and may restrict the types of inventory that can be financed.
A few examples of businesses that can benefit from this financing are retailers, wholesalers, manufacturers, etc.
What is Accounts Receivable Financing?
Small businesses often sell their products on a credit basis, which enables customers to purchase at that moment and pay later.
This sometimes leads businesses to experience cash flow constraints, and when they require immediate funding, they turn to accounts receivable financing.
The businesses in need of cash usually sell their outstanding invoices to these third-party lenders, known as factors.
The factor immediately pays around 80% of the invoice amount and the remaining 20% once the end user receives the final payment minus any fees.
What are the Pros of Accounts Receivable Financing?
There are multiple advantages for businesses when they opt for accounts receivable financing to acquire quick cash.
1. Improved Cash Flow
AR financing enables businesses with quick access to cash.
Businesses that cater to their customers on a credit basis can always leverage their outstanding bills to opt for this type of funding.
This helps to relieve their short-term cash flow issues.
2. No Need for Collateral
Small businesses can be stress-free about preparing a proper asset to put up as collateral to get financing. Here, the business is typically not taking a loan but rather selling the outstanding or unpaid invoices in return for cash.
3. Flexibility in Financing
Apart from being able to obtain collateral-free loans, businesses also have the flexibility to use the acquired money as they please.
Businesses can choose to either factor in an entire invoice or a part of it for the funding, and gain flexibility in financing.
What are the Cons of Accounts Receivable Financing?
There are a few cons to this type of funding that businesses should be aware of, such as:
1. Transfer of Ownership
Businesses need to sell their unpaid invoices to get money. When they sell the invoices, they also give up their ownership of those outstanding bills.
This means that the end users will now be responsible for making payments to the third-party lender instead of the business.
2. Impact on Customer Experience
This transfer in ownership can lead to the end users having a negative impression of the business.
There is also a possibility that they may not like the involvement of the third-party, which may ruin the customer experience and their overall commercial relationship with the business.
3. Lack of Suitability for Every Type of Business
Businesses who don’t sell products or services on credit may not have pending payments in the form of outstanding invoices.
In this case, a business may technically not be eligible to apply for this type of funding.
Examples of businesses that may benefit from accounts receivable financing include companies with a high number of accounts receivable, businesses with large amounts of money tied up in their outstanding invoices and start-ups and small businesses that need immediate cash to grow their business operations.
What are the Similarities Between Inventory Financing and Accounts Receivable Financing?
Inventory financing and accounts receivable financing share a few similarities, such as they both offer:
1. Working Capital
Both types of funding give easy access to better cash flow for businesses.
Inventory financing focuses on providing cash to ensure companies have enough capital to stock extra or enough inventory for the business, whereas accounts receivable financing gives capital to ease a business’ cash constraints.
2. Speedy Funding
Both types of financing may provide quick access to funds. Once approved, funds may be available within days, allowing businesses to use the acquired cash for immediate inventory or business development needs.
3. Asset-based Lending
Both inventory and outstanding invoices are considered an asset. Thus, they are both types of asset-based lending.
This means that the lender provides financing based on the value of the assets used to get the funding.
What are the Differences Between Inventory Financing and Accounts Receivable Financing?
Now let’s explore how inventory financing and accounts receivable financing are different:
Which Type of Financing is Better for Different Business Situations?
When companies face a financial crunch and require immediate monetary assistance, accounts receivable financing can be relied upon, considering these businesses have multiple outstanding invoices and are probably facing cash flow constraints because of the same.
However, when a business struggles with capital buying adequate or extra inventory, it should opt for inventory financing.
Conclusion
Inventory and accounts receivable financing greatly benefit enterprises to try to acquire quick money to achieve their business goals.
Businesses should assess their needs and requirements and choose the appropriate funding method to reach their objectives.