Inventory Finance 101 - An Introduction to Inventory Finance - The Basics You Need to Know (AU)

A Cash Stream Financial White Paper

Inventory Finance 101

An Introduction to Inventory Finance - The Basics You Need to Know

By Tim Lea

Cash Stream Financial

http://www.cashstream.com.au/inventory-finance.php


All Contents © Cash Stream Financial 2007-2009 Last revision 19 April 2009 2

Cash Stream Financial is a boutique, independent commercial finance brokerage and advisory house, with a

speciality of raising working capital finance – primarily factoring, invoice discounting, acquisition finance and Inventory

Finance. Our objectives are to provide SME’s and their advisers with best in class advice and guidance. You may be

interested to know that we have created a Learning Centre within our web-site, which includes a variety of short

videos and articles on various aspects of commercial finance – to help companies and their advisers make more

informed decisions. We have also created a suite of working capital calculators within our Tools section.

Should you have any queries or observations regarding this whitepaper or any other matter, please do not hesitate to

contact us on 1300 79 30 60 or email us.

About the author: Tim Lea has specialised in Inventory Finance for the past 20 years and is a published author on the

subject of factoring and invoice discounting. He is managing partner of Cash Stream Financial a commercial finance

brokerage with a specialism of raising working capital finance. You have full permission to reprint this article provided

this resource box is kept unchanged.

http://www.cashstream.com.au/factoring.php




http://www.cashstream.com.au/learning.php

http://www.cashstream.com.au/tools.php

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All Contents © Cash Stream Financial 2007-2009 [Inventory Finance 101] 3

3

Table of Contents

Introduction to Inventory Finance ......................................................................... 4

The Working Capital Cycle For Importers ............................................................ 5

Importing With Inventory Finance ......................................................................... 7

Importing with Inventory Finance and Receivables Finance/factoring ................ 8

Cost Justification For Inventory Finance .............................................................. 9

Finance For In-situ Inventory .............................................................................. 11

Asset Based Lending .......................................................................................... 12

Inventory Finance - Floor Planning..................................................................... 13

Unsecured Inventory Finance ............................................................................. 14

Advantages and Disadvantages of Inventory Finance ...................................... 15

Companies Suitable for Inventory Finance ........................................................ 16

Conclusion ........................................................................................................... 17


Introduction to Inventory Finance

Inventory Finance (also sometimes known as Stock Finance) – is finance that is raised against

the inventory of a company, either in-situ or to fund the purchase of New Inventory from a supplier, usually overseas.

The one key thing to understand about Inventory Finance is that in a liquidation scenario,

Inventory is a poor quality asset (just go to any auction house and you will see the true value of

inventory in a distressed situation – where inventory might sell for 10% -15% of its market

value). This makes Inventory Finance a very high risk form of finance for a lender as they cannot

afford to be stuck with inventory they have funded that has little or no value. As a result, to

ensure repayment of the Inventory Finance lent to companies, the lender will carefully (and

prudently) monitor the cash flow performance of your business to reasonably ensure repayment can be made from your on-going cash flow.

As a result, because most Inventory Financiers do not take real estate security they manage their

risks very tightly in a “hands-on” way which means their charges will be higher as compared to

traditional overdraft facilities. A traditional banker will take a “hands-off” approach to managing your facilities – but of course in most cases, bankers can fall back on bricks and mortar security.

As a result of higher risks and no real estate security, inventory financiers will be very cautious

in regards the clients they take on, and that is before we take into account the current credit crunch and the economic downturn.

That said, the facility can work really well for those companies who have inventory holdings and especially for importers - so it is worth having a look at how it works.







5

The Working Capital Cycle For Importers

The cash flow implications of traditional importing can be very difficult, with extensive capital

to complete a given transaction. In the following examples we have tried to look at the model of

importing rather then trying to cater for every company’s specific needs. Naturally the model can

be adapted for individual companies’ needs, but hopefully it can paint the picture of how negative cash flow can inhibit the growth of many importers.

1. Goods are ordered from an international supplier.

2. Goods are usually purchased via Letters of Credit or Telegraphic Transfer of funds -

although with good experience many importers can negotiate open account trading terms

with suppliers.

3. Under normal circumstances, banks allocate 100% risk weighting to Letters of Credit and

will normally therefore require 100% security to support the facility – usually bricks and

mortar.

4. Once the Letters of Credit or Telegraphic Transfer has been paid to your supplier, goods

are then shipped, arriving at port, passing through customs and on to the importer’s

warehouse.

5. This can typically take 45 days or even longer – dependent upon the location of the

international supplier.

6. Goods are then delivered to the end customer which on average takes 55 days to pay.

7. The end result is that capital is tied up for up to 100 days for a single transaction, with

negative cash flow seen for the whole period. In other words everything has to be funded

UPFRONT before any cash comes back.


With such negative cash flow, a lack of capital or access to capital can constrain the expansion

possibilities of an importer. Equally given the traditional banks reliance upon 100% security for

the funding of Letters Of Credit, limited levels of real estate security can also inhibit access to

additional cash flow to fund the purchase of new inventory.

So let’s see how Inventory Finance can help.



7

Importing With Inventory Finance

The traditional “Stock Confirmation” model of Inventory Finance is shown above.

1. Goods are ordered from the supplier overseas in the same way, usually on the basis of confirmed

purchase orders from your customers.

2. Once the goods are ready for shipping – usually having been inspected and loaded on to the boat

– the inventory financier can get “title” to the goods. At this stage they raise a Letter of Credit to

your supplier.

3. At the same time a debt instrument is raised to the importer (usually a trade bill of exchange – of

between 60-120 Days maturity (i.e. the date at which the monies need to be re-paid).

4. The goods are then shipped across the water, arrive at port, clear through customs and on to the

company’s warehouse.

5. The goods are then shipped to the end customer, who pay usually in around 55 days.

6. The Trade bill is then re-paid to the inventory financier, usually out of the importer’s cash flow, on

maturity date (i.e. due date) – in the above case 90 days.

7. So instead of the importer funding the whole transaction (and tying up capital) the purchase order

is funded by the inventory financier and negative cash flow is reduced substantially.

8. In this way the importer can import more product to fund growth opportunities.

9. The major restriction, however, tends to be the facility level the inventory financier makes

available – which will be determined by sales, profitability and the track record of the importer.

10. Equally, the levels of finance available may relate to the individual credit policies of the inventory

financiers - Some may require real estate security to support at least part of the Inventory

Finance.

There are some providers that have a further enhanced solution that can speed up growth even further,

and reduce the level of security required by adding factoring into the mix.








Importing with Inventory Finance and Receivables Finance/factoring

1. Goods are ordered from the supplier overseas in the same way, based upon confirmed purchase

orders from your customers.

2. Once the goods are ready for shipping – usually having been inspected and loaded on to the boat

– the inventory financier gets “title” to the goods and raises a Letter of Credit to the supplier.

3. At the same time a debt instrument is raised to the importer (usually a 60 – 120 day trade bill of

exchange).

4. The goods are then shipped across the water, arrive at port, clear through customs and on to the

company’s warehouse, where the goods are shipped to the end customer and invoiced.

5. At this stage a copy invoice is sent to a factoring Company, once the goods have been delivered.

6. The factoring Company – releases up to 80% of the invoice value (in certain industries up to

90% can be released).

7. The funds generated from the factoring facility are used to RE-PAY the Inventory Finance –

thereby freeing up your credit limit, enabling more product to be ordered from overseas.

8. Your customer then pays the factoring company - usually in around 55 days.

9. To complete the cycle, the unfinanced portion of the invoices is paid to the importer when the end

customer pays.

Whilst the combined facility has great potential power to help you expand your business and with

reasonable expectation will more than cover the costs of the facility - just be mindful of the additional

costs associated with both facilities.









9

Cost Justification For Inventory Finance

The cost justification for Inventory Finance comes from the ability of a company to achieve increased sales, and therefore greater gross profit, by having access to additional finance. Let’s consider the following example, where we will assume the following:

$200k of existing capital is available to the importer. The Working capital cycle is 100 days as per our earlier examples. Over the year this equates to

the inventory being able to be turned 3.65 times. The Gross Margin of the importer is assumed to be 25% (i.e. 50% mark-up on goods purchased) Supplier terms are assumed to be 100% up front on goods being shipped from overseas. An Inventory Finance facility is made available at $400k.

The results for this simple example are shown below:

Total Working

Capital

Available

100% Deposit

Payable For

Product

Total Value Of Imported

Product

Purchased

Additional Gross Profit

Generated

Per

Transaction

Total Purchases

per annum

Annualised Gross Profit

Without Inventory

Finance

$200k $200k $200k $100k $730k $365k

With Inventory

Finance

$600k $600k $600k $300k $2.19m $1.085m

Inventory Finance

with factoring Finance

$600k $600k $600k $300k $4.38m $2.19m

Without Inventory Finance an importer’s to fund stock is limited to the level of capital the importer has – with all product having to be paid up front before the goods leave the exporting country’s shores. As a result annual purchases are $730k and Annualised Gross Profit = $365k

With Inventory Finance the volume of additional stock that can be imported is increased by 3 fold

by using the financier. We can see in the enclosed example that Inventory Finance has the potential to generate an additional $720k of gross profit by funding additional purchases. Now whilst Inventory financiers are not cheap, the costs can more than be compensated by the additional gross profit being generated. Even if the Inventory Financier charged the equivalent of 20% interest per annum (total interest costs $80k on facilities of $400k), the additional gross profit

generated more than covers the costs of the finance borrowed. By adding factoring finance into the finance structure as well, as soon as imported product is

delivered to the end customer, the inventory financier is re-paid from the proceeds of the factoring finance (a more secure asset for a financier). In our original example it was assumed product took 45 days to arrive from the overseas supplier. As a result, assuming purchase orders are already in place the working capital cycle is reduced from 100 days to 50 days (assuming it takes 5 days to deliver product to customers).


















As a result, not only does the inventory financier increase the volume of cash available but the factoring facility means the Inventory Finance facility can be turned over in 50 days rather than 90 days (i.e. the maturity date on the trade bill of exchange), which means inventory can be turned is turned 7.3 times per year generating even more additional gross profit – we call it Inventory Finance on steroids!

Now - not all companies are importers – so how can we finance companies with stock on their showroom floor or in the warehouse?







11

Finance For In-situ Inventory

3 types of in-situ Inventory Finance exist in the marketplace:

Asset Based Lending

Floor planning Unsecured Inventory Finance

Let’s consider each of these in turn.




Asset Based Lending

Internationally Asset Based lending is increasingly being used by many lenders to take a full

view of a company’s balance sheet. The Lender offers a Revolving line of Credit facility

primarily secured against the Receivables (Aged Debtors) and the in-situ Inventory of a business.

Other assets such as Plant and Equipment and Property can also be added into the mix as well.

Usually asset based lenders use receivables finance as the very core of their facility offerings – i.e. Receivables finance has to be part of the funding mix.

• Under normal circumstances up to 90% is made against receivables

• Up to 60% against inventory (less employee entitlements – as these rank ahead of any

financier’s funding in a liquidation scenario).

• Using the Receivables and Inventory Assets as the basis of the security, Letters of Credit

to pay for international inventory purchases can be raised (usually the value of the Letter

of Credit is deducted from the “line of credit” made available by the financier – usually in

the form of a “retention”).

• Once the goods have arrived from overseas and shipped to the end customer, the invoices

are raised to the end customer and discounted via the receivables finance facility.

• The funds generated by the receivables finance facility (up to 90% of the face value of

the invoices) is used to re-pay the Letter of credit raised to pay for the inventory

purchases, and the cycle continues. • These facilities are generally for larger SME’s (usually $5m turnover upwards)


13

Inventory Finance - Floor Planning

Floor Planning is suited for large value item retail showrooms – e.g. motorcycles, cars,

boats, caravans etc.

Floor Planning uses the showroom Inventory itself as the primary source of security and

as the means of re-payment of the inventory financiers facility. (although other security is

likely to be taken to support the facility)

The client company orders stock from suppliers, usually overseas, which the financer

directly pays for.

The financier is then directly re-paid out of the proceeds of the sale of inventory from the showroom floor and the cycle repeats itself.

With the current credit crunch and economic downturn increasingly fewer lenders are offering

floor planning facilities



Unsecured Inventory Finance

Unsecured Inventory facilities do exist in the marketplace, but are increasingly rare given the credit crunch and weakened economy – as the facilities rely strongly upon the quality of a company’s balance sheet - as balance sheet quality is used as the basis of an “insurance wrap” to support the finance facility.

The Inventory financier pays a supplier (domestic or overseas – some lenders restrict the

countries they will finance) directly on day 1 of the goods being delivered.

The Inventory Financier raises a debt instrument to the company – usually requiring

repayment within 60-120 days (e.g. trade bill of exchange).

This debt instrument is then re-paid through the cash flow of the business.

This facility is ideal for seasonal companies who need excess Inventory during peak

times.

Because of the “insurance wrap” the inventory financier can in the right circumstances

make the facility available without security – other than directors and substantial shareholders personal guarantees.



15

Advantages and Disadvantages of Inventory Finance

Advantages

Increased sales through access to increased funding to purchase additional Inventory.

Increased Gross Profitability through enhanced sales.

Increased profitability through increased economies of scale of larger volume purchases.

Real Estate Security is generally NOT required. Letters of credit from traditional bankers

usually require 100% risk cover from security – usually bricks and mortar. In many cases

for Inventory Finance real estate security may not be required – however, with the credit

crunch and recession credit criteria are changing regularly so check with you professional

brokers or advisers such as (www.cashstream.com.au) for the most up to date position.

Inventory Finance increases the level of working capital within a business and has the

potential to free up other security – e.g. overdrafts Some can look at unsecured under the right circumstances

Disadvantages

Increased costs – but easily offset by increased gross profit.

Increased paperwork and processes.

Almost always Fixed and Floating Charge required – presents additional exposure to risk

– together with Personal Guarantee of Directors and Significant Shareholders.

Tough Credit criteria - not available to all companies

Some may ask for real estate to support part of the facilities Some may insist on debtor finance being involved to pay their facility out earlier.



http://www.cashstream.com.au/



Companies Suitable for Inventory Finance

As we saw earlier Inventory Finance is a high risk form of finance – just by going to any auction

we can see the TRUE value of inventory in a distressed situation. As a result, inventory

financiers are VERY cautious. As a result the financiers need to be satisfied that they would not

be left holding inventory which they cannot sell. As a result for them to support your business they generally need to see:

Profitable Trading with excellent management systems in place.

Well managed businesses – usually NO Tax arrears, well managed aged payables and

aged receivables

Track Record – generally 2 years successful trading is required (like so many credit

decisions if there are mitigating circumstances this criteria can be varied)

Track Record/Experience in importation – in other words you know the problems of

importing and distributing so that it reduces the financier’s risks.

Good, credit worthy customers.

Confirmed Purchase Orders – so that the inventory has with reasonable expectation has a

“home to go to” – in other words your existing inventory levels are not just being added

to. Varying Companies have varying criteria but generally they will require at least 80%

of your inventory to be pre-sold for Inventory Finance to be provided for importers.

Products with reasonable gross margins – typically a minimum of 20% gross margins.

The higher the gross margin the less the risk to the inventory financier – this increases the

margin the Inventory Financer has to negotiate with customer if it needed to sell the

product in a distressed environment.

Generic products – if products are easy to sell it reduces the risks to the financier – e.g.

steel and base metals are commodities and therefore easy to re-sell. Highly specialised

Inventory or high fashion goods are hard to finance (Unless additional security were available).






17

Conclusion

In this whitepaper we have just focused upon the introductory aspects of Inventory Finance. The

facility has the power to help you expand your business, often without needing to put up real

estate security and without giving up equity in your business. Whilst the facility is more

expensive than traditional bank overdrafts, its flexibility for companies in a growth phase is

marked, enabling your business to expand quicker.

We have seen the facility work so well for so many companies, especially importers. It can

however also be used to supplement other key areas of financing where additional leverage can

help make a transaction work – e.g. those considering an MBO or an acquisition.

I hope you can use it to make your business more successful too.

Tim Lea

Partner,

Cash Stream Financial

[email protected]

www.cashstream.com.au

PS We actively welcome your comments regarding this whitepaper so please do get in touch even to

offer us advice as to how we can improve it.


mailto:[email protected]

http://www.cashstream.com.au/

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Inventory Finance 101 - An Introduction to Inventory Finance - The Basics You Need to Know (AU)

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