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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?”
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.