Stop Using Term Loans To Finance Your Inventory

As a consumer products brand, managing your cash flow is paramount, especially when it comes to financing inventory. Debt can be an excellent tool for this purpose, but if not utilized correctly, it can lead to significant financial strain and put the unsuspecting founder on a slippery slope.

In this blog, we will explore the concept of debt efficiency and why facilities such as MCAs and Term Loans may not be the best option for financing inventory.

What is Debt Efficiency?

When using debt, you want to make sure that the cash flows generated (both incoming and outbound) are a good match for the specific needs and cash flow cycles of your business. Efficient debt management ensures that you are not over-borrowing or under-borrowing, thereby minimizing interest costs and avoiding cash flow issues.

The Pitfalls of Using a Term Loan for Inventory Financing

A Term Loan involves borrowing a fixed amount of money for a set period, with repayments starting almost immediately. For instance, if you borrow $100,000 for a two-year term, you begin repaying the loan right after drawing down the principal. This repayment structure can be problematic when financing inventory, particularly for consumer products brands dealing with overseas manufacturing.

Cash Flow Dynamics in Inventory Financing

Consider the typical cash flow scenario when purchasing inventory from overseas:

1. Initial Cash Outflow: You pay for the manufacturing and shipping of the product upfront.
2. Production and Shipping Period: There is a lag of one or more months while the product is being made and shipped to your local market.
3. Revenue Generation: Only after the goods arrive at your warehouse can you start selling them and generating revenue.

This is what the above cash flows might look like if we plotted them individually. 

Combining these cash flows into a singular cumulative series, and we'd get the below. 

Why A Term Loan Is Not A Good Fit

Now consider the cash flow demands (from above) with the cash generated from a typical term loan. A term loan generally works by being issued a principal up front, and then repayments will start immediately afterwards. 

The problem this generates is that we have to start repaying the term loan before we've started monetizing the inventory (i.e. generating sales from it). This leads to a cash shortfall. 

If this facility were part of a larger loan book and we had a steady base of operational cash flows to rely on this may not be a problem, but for many young brands this is not the case. Rather, they're operating on much more of a hand to mouth basis. 

Addressing the Cash Flow Mismatch

One way to address the cash shortfall identified about is by borrowing more money upfront. However, this leads to an oversized loan facility, where the borrowed amount exceeds the immediate need. Consequently, you end up paying additional interest on the excess funds, which is an inefficient use of debt.

The Ideal Solution: A Proportional Financing Facility

The best approach to financing inventory is a facility that aligns the cash outflows with the actual inventory investment profile. This can be achieved through options like a repayment holiday, where the loan repayments are deferred until the inventory starts generating revenue.

Even if the interest rate in this tailored financing option is slightly higher than that of a Term Loan, it is likely to be more economical in the long run. This is because the debt profile perfectly matches your cash flow needs, eliminating debt wastage and ensuring efficient use of borrowed funds.

Determining Your Cash Flow Needs

Understanding your cash flow needs is crucial for efficient debt management. Financial modeling can help you map out your cash flow cycles and identify the best financing structure for your inventory investments.

Conclusion

Debt efficiency is key to managing inventory financing for consumer products brands. By choosing a financing option that aligns with your cash flow cycles, you can avoid the pitfalls of oversized loans and unnecessary interest costs. If you need assistance in building a cash flow model for your business, or finding the right type of lender for your needs, we'd be happy to help!