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
 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 advic e 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.

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 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

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 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.

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 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.

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 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.

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 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.

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 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.

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 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 100% Total Value Additional Total Annualised

Working Deposit Of Imported Gross Profit Purchases Gross Profit
Capital Payable For Product Generated per annum
Available Product Purchased Per
Transaction

Without Inventory $200k $200k $200k $100k $730k $365k

Finance

With Inventory $600k $600k $600k $300k $2.19m $1.085m

Finance

Inventory Finance $600k $600k $600k $300k $4.38m $2.19m

with factoring
Finance

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).

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 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?

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 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.

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 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)

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 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

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 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.

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 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.

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 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).

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 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
tim.lea@cashstream.com.au
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.

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