TABLE OF CONTENTS
- What Is Purchase Order Financing?
- How Does Purchase Order Financing Work?
- Advantages of Using Purchase Order Financing
- Common Concerns and Potential Downsides
- The Costs Associated with Purchase Order Financing
- PO Finance Examples
- Alternatives to PO Financing
- How to Qualify for Purchase Order Financing
- How to Get Purchase Order Funding
- Frequently Asked Questions (FAQs)
While receiving a large order is typically a cause for celebration among businesses, it can also present cash flow challenges. If your business lacks the necessary funding to fulfill the order, you may find yourself turning away paying customers. This issue is particularly acute for businesses whose suppliers demand upfront payment for materials or production.
Cash flow problems are a significant threat to the survival of small businesses—more than 80% fail due to insufficient cash flow.ForwardAI. “80% of Businesses Fail Due To a Lack of Cash. Here are 4 Reasons Why Cash Flow Forecasting Is So Important“. Accessed November 30, 2023. Fortunately, a variety of financing strategies are available to help businesses manage orders that require significant upfront investment. One popular method is purchase order financing, which allows businesses to pay their suppliers before invoicing their customers.
This guide delves into purchase order financing, detailing how it works, its benefits, alternatives to purchase order financing, and other relevant topics. If your business is looking for a funding solution to manage large orders, read on!
What Is Purchase Order Financing?
Purchase order financing is a form of commercial funding designed to help businesses access the cash needed to pay suppliers for large customer orders. If a business receives an order that it cannot fulfill due to limited cash flow, purchase order financing can provide the funds to pay suppliers. By doing so, purchase order financing enables businesses to accept substantial orders that might otherwise be unfeasible, thus avoiding cash flow disruptions.
This short-term financing option helps businesses bridge the gap between receiving orders and having the financial means to fulfill them, enabling growth without taking on additional debt or sacrificing equity. Likewise, it allows small businesses and businesses with limited credit history to access financing without collateral. The purchase order acts as a security for the loan rather than the business’s other commercial assets.
How Does Purchase Order Financing Work?
While the purchase order financing experience may vary by lender, most processes follow similar steps. Let’s explore how purchase order financing typically works:
- A Customer Places an Order: A customer selects a business and places a significant order for products.
- A Business Reaches Out to a Purchase Order Financing Provider: Upon receiving the order, the business realizes it lacks the necessary upfront payment to fulfill it. To avoid turning down the order, the business approaches a purchase order financing provider for short-term funding to pay suppliers.
- The Provider Approves the Financing Agreement and Pays the Supplier: The financing provider conducts due diligence on the order to ensure the risk is acceptable. Once the request is approved, the provider directly pays the supplier.
- The Supplier Fulfills the Order and Sends it to the Customer: After receiving payment, the supplier fulfills the order and dispatches the products to the customer.
- The Business Invoices the Customer and Forwards a Copy to the Financing Provider. The business invoices the customer for payment and sends a copy to the financing provider to verify order fulfillment and delivery.
- The Customer Pays the Purchase Order Financing Provider: The customer pays the invoice amount to the financing provider.
- The Business Receives Its Portion of the Order Value: After deducting its agreed-upon fees, the financing provider transfers the balance back to the business.
Loan vs Line of Credit for Financing Purchase Orders
While many businesses use loans and lines of credit for this purpose, choosing the right one can be challenging. Firstly, both loans and lines of credit often require an extensive business credit history and collateral, making them unsuitable for many small or new businesses.
Moreover, approval rates for traditional loans are currently low. Institutional lenders are only approving around a quarter of the small business loan applications they receive.Statista. “Approval rate of small businesses loans in the United States from September 2019 to March 2023, by lender type“. Accessed November 30, 2023.
However, both loans and lines of credit have their advantages. Small business loans usually have lower interest rates, especially when secured against collateral. On the other hand, with lines of credit, businesses only have to pay interest on the money they access. This makes it a much more flexible form of funding for purchase order financing.
Advantages of Using Purchase Order Financing
Cash Flow Benefits
Purchase order financing enhances cash flow by providing funds to cover the costs of fulfilling customer orders before invoicing. This approach allows businesses to meet demand without depleting their existing working capital reserves, making it a valuable solution for managing cash flow.
Increased Order Capacity
Purchase order financing enables businesses to accept larger orders by providing the necessary funds to pay suppliers and cover production costs. This ensures they can meet increased demand and fulfill orders that would otherwise be beyond their working capital capacity, thereby enabling growth and the potential for increased revenue.
No Long-Term Financing Commitments
With purchase order financing, businesses aren’t tied to long-term loans. Instead, financial commitments end when the customer pays the invoice to the financing provider.
No Collateral Requirements
Most purchase order financing agreements don’t require collateral, reducing risk and enabling smaller or newer companies to access financing. Since the purchase order itself serves as security, businesses don’t need to pledge assets or provide personal guarantees, making it a more accessible option for those without significant assets or long credit histories.
Common Concerns and Potential Downsides
Using purchase order financing involves reputational risk for your business because the purchase order finance provider receives payment directly from your customer. This means there’s a significant chance your customer will know your business uses PO financing. The use of this short-term funding may make customers worried about your ability to fulfill future orders. However, this is also a risk with invoice factoring, so this concern isn’t exclusive to purchase order financing.
Another disadvantage of purchase order financing is the cost, due to the relatively high fees and interest rates associated with this type of funding. Businesses may find it more expensive compared to other financing options.
A business may find itself ineligible for purchase order financing if it lacks a solid track record of successful order fulfillment or if its profit margins are too narrow to absorb the financing costs. Lenders typically evaluate the viability of specific purchase orders and the business’s capacity to execute them when making eligibility decisions.
The Costs Associated with Purchase Order Financing
The costs of purchase order financing can vary but are often significantly higher than those of a traditional loan, particularly when considered in terms of annual percentage rate (APR). Rates for PO financing can reach up to 6% per month, and this does not include other administrative fees charged by the lender. While a monthly rate of 6% might seem manageable, it equates to more than 100% annual interest when compounded.
PO Finance Examples
Here are two examples illustrating why a business might need PO financing:
Paint Supply Business
A paint supply business receives a large order for a custom paint color from a commercial customer. However, the paint supply business can’t pay their supplier for the custom color order upfront. The paint supply business contacts a PO financing business and requests a loan to pay for the paint supplies.
A software company receives an order for customized software but needs to hire an external development team to meet the deadline. The business approaches a PO financing provider for a loan to cover the cost of hiring an external team.
When to Consider Purchase Order Financing
A business should consider purchase order finance when it lacks the necessary capital to fulfill a large customer order. This financing option helps cover production and supply costs. However, there are also other loans to consider if you have an established business credit history or collateral to offer to a lender.
Alternatives to PO Financing
Other funding arrangements exist beyond purchase order financing. Some alternatives include:
Invoice factoring is a financing method where a business sells its accounts receivable (unpaid invoices) to a third-party financial company, known as a factor, at a discount. This provides immediate cash flow as the factor advances a significant portion of the invoice value to the business. The factor is then responsible for collecting payment from the customer. Once the customer pays the full invoice amount, the factor pays the remaining balance to the business (minus their fees). Unlike PO financing, which occurs before invoicing, invoice factoring helps manage cash flow after invoicing.
Merchant Cash Advance
Merchant cash advances are a financing option offered by payment processors to merchants. They involve an upfront lump sum provided in exchange for a percentage of future credit card sales. Repayment is made daily or weekly, with the amount varying based on sales. While they offer quick access to capital, they often come with high fees and can be costly. Businesses with consistent credit card sales can benefit from using merchant cash advances to fund purchase orders, but the expense should be carefully evaluated.
How to Qualify for Purchase Order Financing
To qualify for purchase order financing, businesses typically need to meet the following criteria:
- Valid Purchase Orders: You must have confirmed purchase orders from creditworthy customers.
- Profit Margins: The orders should have sufficient profit margins to cover the financing costs and still generate a profit.
- Established Business: Lenders often require you to be an established business with a track record of successful order fulfillment.
- Reliability: Your supply chain and production capabilities should be reliable and capable of fulfilling the orders on time.
- Credible Customers: Customers should have a history of paying invoices promptly, as their creditworthiness is a key factor in approval.
How to Get Purchase Order Funding
With more than half of small businesses suffering from unmet funding needs, purchase order financing can play a critical role in helping fund order fulfillment. Most purchase order financing providers will have online or telephone application processes. Assess a range of lenders before you lodge an application, as fees and interest rates vary significantly across the industry. Likewise, some purchase order finance providers specialize in specific industries, so make sure your business qualifies before proceeding with a particular provider.
Alternatively, consider obtaining a merchant cash advance or invoice finance loan. Both of these alternative options don’t require collateral or extensive credit history, so they’re a reliable option for small or new businesses. Speak to a business funding provider about obtaining the necessary loan to help fund your next purchase order!
Frequently Asked Questions (FAQs)
What is the difference between invoice financing and purchase order financing?
Invoice financing and purchase order financing are two distinct forms of business financing. Invoice financing involves selling unpaid invoices to a lender at a discount to provide immediate cash flow.
In contrast, purchase order financing covers the costs of fulfilling customer orders before invoicing. It’s essentially a short-term loan secured by the purchase order itself.
While both methods aid in cash flow, purchase order financing is used to secure inventory and production, whereas invoice financing leverages existing invoices to improve liquidity.
What are the risks of purchase order financing?
Firstly, it may negatively impact your business’s reputation with customers. Also, purchase order financing is more expensive than other funding options, so it might not be viable for your business.
What is the interest rate for purchase order financing?
Interest rates for purchase order financing can vary based on industry and other risk factors. Generally, the higher the risk associated with your purchase order, the higher the interest rate charged by lenders. Rates typically range from just under 2% to up to 6% per month.
What are the requirements for PO financing?
Requirements will vary depending on the PO financing provider, but most will request the following information:
- Your business’s details
- Your ownership or management team’s experience
- The purchase order’s details
- Information about your customer
- Information about your supplier
Who uses purchase order financing?
Purchase order financing is commonly used by businesses facing cash flow constraints, such as manufacturers, wholesalers, and distributors. It enables them to secure the funds needed to fulfill large customer orders or contracts, particularly when they lack the working capital to purchase necessary materials, manufacture products, and meet customer demands without compromising financial stability.
What is the difference between purchase order financing and factoring?
Purchase order financing and factoring are both methods to improve cash flow, but they serve different purposes. Purchase order financing provides funds to cover the costs of fulfilling customer orders, including payments to suppliers. In contrast, factoring involves selling existing unpaid invoices to a lender at a discount in exchange for immediate cash. Purchase order financing is used prior to issuing invoices, while factoring is dependent on having outstanding invoices.
- ForwardAI. “80% of Businesses Fail Due To a Lack of Cash. Here are 4 Reasons Why Cash Flow Forecasting Is So Important“. Accessed November 30, 2023.
- Statista. “Approval rate of small businesses loans in the United States from September 2019 to March 2023, by lender type“. Accessed November 30, 2023.