Inventory – How to Finance
In financing a small business, there are a multitude of tools available. One way to finance inventory is by using the 30 day pay program with your vendors. Another tool is seasonal payment program and a third tool is exercising a line of credit tied to receivables or sales history.
The following sections describe and illustrate these three different methods of financing your inventory.
Inventory Turnover – 30 Day Vendor Financing
Really large operations use this method to their advantage. The concept is simple, if your vendor allows you to pay for the inventory 30 days after receiving the product and you can sell that product within 30 days; then the effect is the vendor is financing the inventory. Wal-Mart turns its inventory eight times a year. They get some financing from their suppliers. But if Wal-Mart could turn the inventory 12 times a year, then Wal-Mart would save millions of dollars in interest on borrowed funds to purchase inventory.
As a seller of product, you don’t pay for that product for 30 days. This is true in the majority of small businesses. If you can turn that product over, i.e. sell the goods within 30 days; you will then have the cash to pay the vendor for his goods. In effect, your vendor is providing the inventory for free.
Notice the key here? You have to be able to turn the inventory within 30 days. This means you will need a turnover rate of at least 12 to be successful. For more information in understanding inventory turnover read the following article: Explanation of Inventory Turnover.
I urge some caution here. As a retailer, you should analyze your sales program to truly understand what sells and what sits on the shelf for extended periods of time. If the cost of the slow selling items exceed the ability of the fast paced items to turnover enough times in the monthly cycle; then you will need to finance the difference. The following is a simple illustration of this concept:
You own a convenience store and you stock the typical coffee and soda drinks. In addition, you have items that take some time to sell. These include auto fluids (radiator, brake, transmission fluids etc.) and wine. This group of inventory cost you $4,500 on the shelf and turns over every three months. Your coffee and soda is valued at $9,000 and you turn this inventory every month.
Based on this, you can cover all $9,000 of the fast paced items and one-third of the slow inventory or around $1,500. Therefore, you will have to finance the slow turning items to the tune of $3,000 for an indefinite period of time (you have to restock the slow selling inventory and thus the core $3,000 has to be continuously financed).
If the fast paced items contribute $1,500 of margin, then how fast must we sell the fast paced group to cover the costs of the slow paced group? The key is that we need to cover the $3,000 of longer term costs. Therefore, $3,000 divided by $1,500 equals two. You must turn over the fast paced items twice per month in order to generate the necessary dollars to pay for the cost of the inventory that remains on the shelf after 30 days.
In reality the formula is much more complex due to other issues such as overhead costs, revenue taxation and more. But the concept is simple, the fast pace inventory must turnover at a faster rate to offset the cost associated with the slower inventory. The key is to look at the inventory average overall in order to get as much of the inventory financed by the vendors.
Many retailers are seasonal based operations. Think of a toy store. They have one significant season per year. They use a different tool to purchase their goods. They use a seasonal repayment program. The supplier wants their product on that store’s shelf early in the season allowing for the early shoppers to purchase the item. Let’s not forget that the suppliers have a stake in your business. Without you selling their product, then they will end up with excess inventory over time and a reduction in production and ultimately serious issues. They want you to succeed.
At the same time, you don’t really have an interest in stocking seasonal items too early because there is little to no sales generated from the early shoppers. Negotiate an extended payment program. Get the supplier/vendor to agree to a 90 day payment program allowing you plenty of time to stock, display, and sell the product on your shelf. Examples of products that are seasonal in nature:
- Christmas items
- Holiday items – Thanksgiving, Easter, July 4th (fireworks),
- Sports – baseball, football, golf
- Recreational – summer activity products
- Education – 9 month year
- Love – February 14th, Weddings, Anniversaries
Line of Credit
A third option to finance inventory is using a line of credit. A line of credit is similar to an equity line at a bank for a home. Instead of real estate, other types of assets are used to act as collateral for the loan. For more information about different types of bank loans including a line of credit, go to: Different Types of Bank Loans. In the small business world, you will use your receivables as collateral. In effect, if the inventory is sold and if your margin is reasonable, then the receivables will be much greater than your inventory value providing adequate collateral to the bank. If you review the current assets section of your balance sheet, read An Explanation of Current Assets for more information about current assets, and have two or more times the value of inventory, then a line of credit tied to your receivables may be appropriate.
There are costs involved. The bank charges a set-up fee and interest on the borrowed funds. In addition, the bank has minimum standards of performance or maximum usage of the line; in many loans the bank requires the line to be at a zero balance for at least 30 days annually. This works well if you are a seasonal operation like landscaping or a retailer tied to a holiday season.
In its entirety, the line of credit is an additional step in the business cycle. The business cycle is cash purchases inventory, inventory is sold, the customer pays cash or is provided credit, the receivable is paid and the cash is then used to purchase more inventory. The line of credit is a temporary insertion between the issue of credit to the customer and that customer’s payment to you. Below is an illustration of this concept:
A small metal fabrication shop makes tanks of all sizes for different purposes. Some tanks are used to hold oil based products; others hold food or potable water. Purchasers of these tanks are extended 30 days of credit to pay for the custom made tank upon delivery. Most customers pay a 20% deposit upon issue of a purchase order. The tanks require raw material of various types of ferrous and nonferrous steel.
On average, this shop carries around $23,000 of raw materials in the storage area. The shop generates around $110,000 per month in sales of which there is about $82,000 in receivables at any given moment. The shop has been extended a $25,000 line of credit with the receivables as collateral.
When a customer issues a purchase order, the 20% deposit is applied against the materials for the project. Materials are ordered and they customarily are 35% of the total project’s sales value. The 15% difference is financed with the line of credit. The tank takes about a month to build and is delivered to the customer. The customer pays for the balance 30 days later. Altogether, the line of credit is used for a period of 60 days to finance the 15% material difference. Upon receipt of the check from the customer, the line of credit is paid for the portion associated with that particular project.
In the above example, the bank is provided at least two times the maximum line of credit as collateral. The company carries around $82,000 in receivables and they act as collateral for the bank. Furthermore, the 15% material cost is 18.75% of the total amount owed to the company from the customer (15% divided by 1-.20 – the deposit percentage- or 80% of the sales value). Anytime your line of credit balance is less than 25% of your collateral value it is considered good cash management in the eyes of a bank.
Summary – Inventory Financing
There are three primary options to finance inventory at a low cost or no cost to an owner of a small business. By using vendor extended credit or also known as vendor financing the small business owner has an easy to use method. However, this method requires a high turnover rate in order to manage the cash appropriately. The second tool available is the extended payback method or seasonal payment method. In this situation, the small business owner is negotiating extended terms of payback tied to the seasonal nature of the product sold. The third tool and most commonly used method is exercising a line of credit with the bank using receivables as collateral. When an entrepreneur thinks about his situation and works with his creditors, it is easier to finance inventory. Act on Knowledge.
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