There is a great deal of misinformation and erroneous assumptions around purchase order financing. You know what a purchase order is but how do you finance it? This is so-called asset-based lending but a purchase order is not an asset. In short, your question is, “should I use purchase order financing and, if so, when?”

Scenario

You are ecstatic that you just landed a huge order from a corporate customer you have been chasing for months. You and your team celebrate this seminal moment in your company’s history. The next day, however, you feel a pit in your stomach. You realize the money your firm has in the bank and the small credit line you can tap are not enough to fulfill even half of this order. You run through the scenarios. You could cancel the order, but you know you will not get an opportunity like this again. You could divide the order in half and wait on pushing the second half until you get paid for the first. Although this is not as poor an option as cancelling, it is not good. You could request a deposit or require that the order be pre-paid, but you remember that your controller already made this request. The response was that the firm would consider it in the future but not right now. You believe that they want to make sure your firm is viable enough to handle orders of this size.

Since you are hitting a mental wall with your options, you convene with your team to brainstorm. You discard accounts receivable financing because you would have to work out an arrangement with your bank to exclude the A/Rs from this customer. That may be doable, but you will not actually have a receivable until you invoice your customer AFTER the product comes in from the manufacturer. Your vice president exclaims, “I wish we could finance the purchase order itself!” Something in that statement resonates with your controller and she googles “purchase order financing” and voila! You discover it does exist.

What exactly is purchase order financing?

Before we go any further, it is important that you understand both what purchase order financing is and what it is not. Purchase order financing is essentially an advance provided to you on a specific customer’s purchase order to purchase readily available inventory or manufactured goods from a supplier. Hence, this is potentially a viable option if you are a reseller or distributor or if you outsource all of your manufacturing. Typically used for a sizable order, your PO financing firm will either advance funds directly to your supplier / manufacturer or issue a letter of credit or payment guarantee to release funds when the goods are delivered. The PO financing then collects payment directly from your end customer, thus acting as an invoice factoring firm.

Basically, the PO financing firm acts as a substitute for you, ensuring payment to the supplier / manufacturer so that you can fulfill your order. PO financing is not a general inventory financing option for you as it does not allow you to buy and hold inventory to sell later. It requires a specific purchase order for a specific customer. Your PO financing firm will need a copy of both the signed PO from your customer and your signed purchase order to the supplier.

What PO financing provides

The PO financing option allows startups and other rapidly growing or cash-restricted firms to accept large, new orders for their products from credit-worthy customers. According to Entrepreneur magazine, “Purchase-order financing can be beneficial to small businesses because it relies mostly on the company that has placed the order with the startup, and not the startup itself.” Although most PO financing firms require the goods to be shipped directly to the end customer, there are some that will allow shipment to a third party warehouse and even to your facility for light assembly, packaging and distribution. In these cases, according to Entrepreneur, “purchase-order financing often covers a large portion of the requisite supplies (needed to produce those goods), and sometimes even all of them.” Furthermore, the PO financing process is often much easier to navigate – and more straightforward – than traditional bank financing.

How does it work?

  • The PO funder obtains a copy of your customer’s purchase order and your purchase order with the supplier / manufacturer. After analysis, the PO funder agrees to finance your customer’s purchase order.
  • The PO funder sends payment or issues a letter of credit directly to the supplier or manufacturer.
  • The supplier receives the letter of credit or outright payment from the PO .
  • The supplier fulfills the order and ships the goods directly to the customer specified in the purchase order.
  • The customer receives the order from the supplier and receives the invoice from you.
  • The customer pays the invoice directly to the PO funder. If the customer pays immediately, the PO funder accepts the payment, takes out its fees, then remits the remaining gross profits from the sale to you. If the customer has terms (typical for large corporations and government entities), the PO funder factors the invoice – buys the invoice at a discount – and provides you with the funds, less the discount.
  • The customer remits full payment in 30 days to the funding company. The funding company releases any reserves to you that had been held.

If your company does light manufacturing such as assembly, printing and/or packaging, additional steps will be necessary as the inventory and supplies will be delivered to you then you will deliver the finished products to your customer. This increases the risk to the PO funder and hence, increases the fees.

Benefits for Your Company

If your customer has a strong credit history and has a record for prompt payment, and if you have a reputable supplier or manufacturer, your lack of business longevity or your weak credit profile will matter little, if at all, to a PO funding company. As outlined above, only the administrative components of the transaction, the purchase order and later, the invoice, rely on you.

When asking yourself, “should I use purchase order financing”, consider this. According to Forbes, “purchase order financing provides “sufficient working capital to cover payroll and start-up costs for a new contract.” This funding can also provide you with negotiating leverage to obtain better terms and pricing from suppliers. “Taking the calculated risk of a working capital loan that enables the small business to accept a job and grow is often critical to succeeding in government contracting” and other arenas.

Risks for the Funding Company and Associated Fees

In purchase order financing, there is no interest rate quoted. Instead, you pay a discount rate and fees. This means that you receive less than 100% of the amount the customer pays on the invoice, typically 1.5% to 6% less or, put another way, 98.5% to 94% of the invoice. This embedded interest rate captures the higher risk that purchase order financing typically has for the financing firm. The risks vary. The supplier / manufacturer may not deliver the product. (This risk is greatly reduced if a letter of credit is used.) Your customer could refuse delivery or refuse to pay because of issues with the product. Furthermore, your credit worthy customer could have financial issues. If you take delivery of the product, the risk is even higher as more could go wrong. Thus, rates for light manufacturers that process and repackage the inventory are generally higher, at least initially until a strong track record is created. The PO funder will not get paid in all these scenarios, which drives up the risk and hence, the rate.

The answer to the question, “should I use purchase order financing” is multi-layered. It depends on what type of firm you have, what your growth stage is, and what your current sources of funds are. Be aware of the risks but fully understand the benefits. According to Medium, if you can monetize your inventory by eliminating or reducing what you actually hold onsite, this will allow you “to sell more goods, grow the company, employ more people and feed more families.” Purchase order financing provides an asset-based form of working capital that, if used wisely, ultimately allows you to invest in your firm and its future.

Albert McKeon

After writing more than 5,000 bylined articles as a newspaper reporter and receiving leading journalism industry recognition – including the New England Press Association's Journalist of the Year honor – I'm now a freelance writer. I shape organizations' undeveloped and sometimes complicated ideas into understandable and persuasive marketing content, and I continue to write insightful stories for magazines and news services. I've long approached writing and editing with originality, a nuanced curiosity, persistence and creative flair – and that's the way I'd approach writing content for your organization.

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Need financing for your business but can’t qualify at a bank? There are various financing alternatives to keep your operations running.

Borrowing money is an essential part of building a small business. But when you need a loan, traditional lenders like the bank might not be an option. They tend to have strict small business lending standards. For example, you need established business credit, collateral and detailed financial statements for bank loan approval. This is a difficult hurdle for companies that have only been around for a couple years.  Fortunately, as a business owner, you have other options, with a number of business alternatives for bank loans on the market today.

These alternative options can be your financing lifeline until you build enough of a financial track record to qualify for more traditional financial products.

LET’S TAKE A LOOK AT THESE BUSINESS ALTERNATIVES FOR BANK LOANS AND WHEN THEY MAKE THE MOST SENSE.

1 – Online Loans

Banks aren’t the only ones lending money. Alternative and online lenders are also a quality source of small business financing. They offer stand-alone cash flow loans that you can invest into your business and spend however you choose. If you want more flexibility, you could also open a line of credit.  A line of credit lets you borrow, pay the money back and re-borrow again as many times as you want.

It’s easier to qualify for loans from alternative lenders because their requirements are not as strict as with banks. Another advantage is you often don’t have to secure the loan with your future business revenue or other collateral. However, your business will need to meet some standards like stable revenue and a good business plan for how you will use the loan proceeds.

Best fit for: A business with stable revenue looking to borrow cash quickly, without putting up collateral.

2 – SBA Loans

Another way to borrow is through the Small Business Association. This government organization assists small business owners and one of their services is to help them qualify for loans. The SBA doesn’t actually lend money. Instead they agree to back a certain percentage of the loan, guaranteeing repayment to the lender. This makes the lenders more likely to accept your application.

SBA loans can be a great tool provided you can qualify. The process does take time and you’ll need to submit, at minimum, similar documents that you would include as part of a bank loan application – such as a business plan, bank statements and your credit report.

Understanding the SBA system can improve your chances of qualifying so be sure to work with a lender that regularly works with these types of loans.

Best fit for: A business that can meet the SBA standards for a loan and also knows a lender that understands the application process.

3 – Equipment Financing

If your small business needs money specifically to buy a new piece of equipment or machinery, then equipment financing could be the answer. These small business loans can only be used to buy an asset, which also counts as the loan’s collateral. This makes it easier to qualify because if you end up not paying off the debt, the lender can take back the equipment as repayment.

With this type of financing, you can often buy new equipment with no money down but you’ll still receive the full tax break for the business investment, as if you bought the equipment with cash. You can also set up the financing as a lease which would let you replace the equipment earlier with new versions as they come out.

Best fit for: Buying or leasing new equipment for your business.

4 – Purchase Order Financing

A lack of cash can put even thriving businesses in trouble. 52% of small business owners had to forgo a project or sales worth $10,000 because of insufficient cash, according to an Intuit Quickbooks survey (slide 2). If you’ve got a project lined up but need some extra money to make it happen, purchase order financing could be the answer.

These short-term loans cover up to 100% of your supplier costs if you can show that you’ve got an order that will turn things around. Once you make the sale, the lender will deduct their fees from the proceeds. That way you still fulfill your order without taking on any extra debt. And since you can prove that you’ll be able to pay the money back quickly this financing is easier to qualify for. You just need to prove the upcoming purchase order.

Best fit for: When you’ve almost completed a sale and need a quick cash infusion to reach the finish line.

5 – Invoice Factoring

After you make a sale, your job still isn’t done because you you’ll need to collect payment. This can take between 30 to 90 days, depending on your payment terms.  And, as many know, it could take even longer when customers miss payment deadlines.  Not to mention there’s always the risk they don’t pay.

If your invoices are piling up and you need cash, invoice factoring could be the solution. You transfer over an unpaid invoice to a financing company, called the factor, and they’ll give you an advance on the payment.

From there, the factor takes over collecting from your clients. Once they get paid, they’ll give you the rest of the invoice amount minus their fee, which could be as little as 1.5% of the invoice amount.

Best fit for: A business with unpaid client invoices that wants to improve cash flow.

6 – Revenue Based Financing

Revenue based financing is the last of our business alternatives for bank loans. These loans have a simplified and fast application process, a great solution if your business needs money now. Lenders can approve this financing quickly because they just look at your historic revenue and how long you’ve been in business. They use this to forecast your future cash flow.

Based on that, they’ll give you a lump sum of cash. The lender will then collect a set percentage of your future sales on a daily or weekly basis.

Best fit for: A business with a proven history of revenue that needs money but does not want to go through a lengthy loan application process.

Don’t let a bank loan rejection discourage you from raising the money your business needs. As you can see, there are plenty of alternatives. If you have any questions to figure out which of these solutions is the right fit, reach out to a loan specialist today.