The Ultimate Guide to Purchase Order Financing
No one wants to turn away business from established or new customers. Purchase order financing is one way that companies can avoid that, by taking on orders even when the cash supply to fund delivery on those orders is low.
What is purchase order financing?
Purchase order financing is an advance that is used when a business’ cash flow is impeding the fulfilling of orders, such as during seasonal sales spikes. It may also be useful when a new business gets a big order and is unable to pay for all of the supplies, or when a business wants to expand but not deplete all cash reserves.
Also known as PO financing or PO lending, the tool is typically used in industries selling finished goods like distribution, importing, reselling, manufacturing, and trucking.
How purchase order financing works
PO financing can be an option when you have the orders from the customers, but you don’t have the cash to pay for the products they ordered. The funds are sent from the lender straight to your supplier in the form of a letter of credit or a bank draft, which takes one to two weeks. The advance usually covers the entire amount of the supplies.
The goods are shipped directly to your customer (with the lender covering shipping costs).
Then your lender invoices the customer, they pay your lender, who retains their fee, and sends the remaining profit to you.
This type of loan is not without limitations. The order must be non-cancelable. Also, PO financing can only be used for products that are finished and need no more assembling, installing, or customizing. (So direct manufacturers do not qualify.) Orders with guaranteed sale and consignment sale clauses are likely also not permitted.
There may be a minimum order amount, typically $50,000, or possibly lower, but in those cases additional expenses are tacked on. Lenders may also require a profit margin of 20% or higher, with 30% preferred.
Qualifications can vary from lender to lender. Some require that the clients on the purchase order be an established commercial or a government agency (these are preferred). But overall, this is an easier loan to get than other types of financing.
Additionally, the creditworthiness of the company initiating the PO financing is less important than that of the client that created the purchase order. A solid commercial credit history on the part of that client will go a long way.
How much purchase order financing costs
The high risk of purchase order financing and the ease of application come at costs steeper than bank loans. The lender’s fee for this service can range from 1.8% to 6% per month. (A 3.5% monthly loan rate works out to over 40% annually.) The riskier customer or supplier and the smaller amount orders may trigger the higher fee rates.
The loan is usually for 30 days and after that, rates are pro-rated by the day or week.
Purchase order financing is not a high-profile loan type. It has specific requirements for all the parties involved and they are used by a limited group. While it’s not prominent, you can find them offered by banks such as Wells Fargo and other loan providers. More alternative lenders offering PO financing arose after banks scaled down lending in the last downturn.
A few prominent lenders are King Trade Capital, Purchase Order Financing, and Paragon Financial, offering funding ranges of $50,000 – $20 million, $500 – $25 million, and $50,000 – $10 million, respectively.
Microlenders are a cheaper PO financing alternative to the for-profit lenders that normally issue PO loans, although the process works differently and the loan is repaid in monthly payments.
Advantages of purchase order financing
- New businesses and small startups can use it when they want to expand but don’t have the long history traditional lenders may want to see
- A business with just average credit should have no problem getting the funds as long as the customer making the purchase has a good commercial credit history
- Can be faster and easier than bank loans
Disadvantages of purchase order financing
- Limited user base due to restrictions on finished product types
- Limited use for funds– it’s only for supplier expenses
- Some lenders approve only transactions with gross margins of 20% or more
- You don’t get the total amount you are owed
- Customers know they are paying a lender, not your business
Shopping and applying for purchase order financing
So when shopping for PO financing, consider the variables, like: the lender’s fee, the length of the loan period, the gross margins requirement, and the minimum or maximum transaction amounts.
The application process typically begins with filling out an online form, or with a phone call. You will need to provide the lender with a purchase order from the customer and the pro-forma invoice from the vendor.
The next stage will take some time, possibly a few weeks, the first time a company applies for financing. (Subsequent purchase order loans may be quicker.) Through a process called “due diligence”, the lender evaluates five categories when considering your application:
- Does the transaction fill the requirements? (Are you funding the right type of products, is your transaction above the minimum amount, etc.)
- Is your customer creditworthy? (Does your customer have a good financial history? This is a key consideration.)
- Is your supplier reliable? (The lender wants to see an established company with no financial problems)
- Is your company qualified? (Your company should have no legal or tax problems.)
- Do you, the company owners, qualify? (The lender wants to see that you have relevant experience and no legal problems.)
The answers to these questions will also determine the lending fee rate that you are offered.
Because the funding process can take up to two weeks, if your business needs funds sooner, you may want to look at a short term business loan (which must be paid back within 3 to 18 months) or other alternatives like invoice factoring (explained below) or a business line of credit (which works much like a credit card, funds are available to withdraw on an as-needed basis). Direct manufacturers can also consider supply chain financing.
Learn more about small business loan options here.
Purchase order financing versus invoice factoring
Both purchase order financing and invoice factoring are processes that address a business’ immediate cash-flow issues in different ways. Invoice factoring, also known as accounts receivable factoring, is a loan or advance taken out after you’ve already invoiced. It helps to keep your business operating until invoices are paid for products or services already delivered.
The cost can be a bit lower than PO financing, with the factoring fee typically ranging from 1.5% to 5% monthly.
Unlike PO financing, it can be applied to both goods and services. It’s not available for B2C businesses, and the business must have B2B or government customers.
Purchase order financing has high rates. Due to the costly nature, PO financing is more of a Band-Aid fix to help businesses in the short-term. It’s not really a long-term solution for cash flow.