Purchase order financing is one of the most misunderstood products in the finance industry. Most companies assume that purchase order funding simply gives your company money (directly), using your purchase orders as collateral. Unfortunately, this assumption is not accurate. This article helps you understand what PO financing is and how it works. In this article, we discuss:
- What is PO financing?
- Are you a good candidate for this solution?
- How does purchase order financing work?
- Will you need to use factoring as well?
- Advantages of PO funding
- PO financing example
What is purchase order financing?
Getting a large order can be a great opportunity for small resellers. However, the order can become a problem if your suppliers demand a pre-payment that your company can’t afford to pay. This situation leaves you with few options and may cause you to miss the opportunity.
Purchase order financing is a solution that helps companies in this situation. It helps cover the supplier expenses associated with a PO. This solution enables the client to pay their supplier, fulfill the order, and book the sale.
Who is a good candidate for this program?
Generally speaking, your company is a good candidate for purchase order funding if all the following are true:
- You buy and then resell products without any modifications or customizations
- Your company does not directly manufacture the products that you sell
- Your gross margins are at least 20%
- Your suppliers have a good track record of delivering products and are in good financial shape
- Your customers have good commercial credit
- Your purchase orders are non-cancellable and have no consignment or guaranteed sale terms
- Your orders are for a minimum of $100,000
Purchase order funding has very specific qualification requirements and can help only a narrow set of customers. Basically, this solution helps resellers/distributors that have received a purchase order that exceeds their current capital abilities and requires financing to fulfill it.
If your company is a direct manufacturer, consider supply chain financing. This solution offers many of the same benefits and works for direct manufacturers.
How does PO funding work?
The following section explains how purchase order funding works. The process is separated into seven steps.
Step 1: Submit an application and information
The first step in the process is to submit an application along with supporting documentation to the finance company. Each finance company has its own requirements but most usually ask for:
- Copy of purchase order
- Supplier information
- Backup documentation showing a previous similar transaction
- Accounts payable / accounts receivable report
If the transaction is approved, a contract is executed and the process to get funding starts.
Step 2: Supplier payment
The finance company sends a pre-payment to your supplier. Note that finance companies never pre-pay a foreign supplier via a wire transfer. Instead, the supplier is paid using a letter of credit or a similar instrument. These instruments are common in international transactions. A letter of credit guarantees payment to your supplier as long as they fulfill their obligations.
Payment to suppliers in the US and Canada depends on their size and creditworthiness. Finance companies are usually able to pay up to 100% of the supplier cost as long as the gross margin of the transaction is at least 30%. Transactions with a lower gross margin may require client contribution.
Step 4: Goods are inspected
Most finance companies require that the goods be inspected by a third-party inspection company such as SGS. The inspection helps ensure that the goods produced by the supplier meet the purchase orders requirements and specifications. In most cases, inspection is performed before the goods are shipped.
Step 5: Product delivered to the end-customer
After inspection, the goods are shipped to the end-customer. In most cases, the end-customer performs their own inspection to confirm they received all the goods.
Step 6: Invoice sent to end-customer
The customer gets an invoice for the sale. At this point, you have fulfilled your obligations to the customer and must wait for payment. The transaction can follow one of two paths. You have the option to factor the invoice or to proceed without factoring.
a) With factoring
If you choose to factor the invoice, the factoring company calculates the advance, settles the PO financing line out of the advance, and remits the difference to your company. From this point forward, the transaction proceeds just like a regular factoring transaction.
Combining factoring with PO financing can provide advantages in some situations. Examine your transaction details to determine if it will help in your case.
b) Without factoring
If you choose not to use factoring, you don’t need to take any further steps. The transaction accrues fees at the PO financing rate.
Step 7: End-customer payment and settlement
If you factored the invoice, the factoring company handles the settlement. The factor deducts the factoring fee from the invoice value and remits any remaining funds to your company. If you did not factor the invoice, the purchase order financing handles settlement. The finance company deducts its advance and fees from the payment and remits the difference to your company.
Will you need to use factoring as well?
Combining factoring and PO financing may result in lower costs in some transactions. This result depends on the details of the transaction and does not apply to all transactions.
For example, if your margins are high enough and the factoring rates are low enough, you can use factoring to close the PO financing line out of the factoring line. Any excess advance is forwarded to your company, which provides additional funds for operations. This strategy can be useful because the cost-per-dollar of factoring is usually lower than the cost-per-dollar of PO financing.
Advantages of purchase order financing
Purchase order financing has several benefits over other financing solutions. Some benefits include:
- It allows small businesses to take on large orders
- The line grows with your business
- The line is based on the strength of the transaction
- It can cover up to 100% of supplier expenses (in some cases)
- The line can be set up quickly
Purchase order financing example
Note that this example has been simplified for illustrative purposes and does not represent an actual transaction. This transaction does not use factoring for settlement.
A small business wins a $100,000 government purchase order for widgets. The widgets are manufactured in Asia and cost $70,000 to produce. This transaction represents a major opportunity for the entrepreneur. However, the business does not have $70,000 to pay the supplier.
The small business engages with a PO financing company that offers to fund the transaction at a rate of 3% per 30 days. The small business owner determines that their profit margin is sufficient to cover the finance expense and decides to proceed.
The finance company determines it can pay the supplier up to 70% of the $100,000 purchase order value. In this case, 70% amounts to $70,000, which covers 100% of the supplier’s expense. The transaction proceeds as follows:
- PO financing pays the supplier with a letter of credit for $70,000
- The supplier takes 30 days to manufacture goods
- After manufacturing, the supplier ships the goods to the US. The goods take 30 days to reach the end-customer
- The customer receives the goods
- The small business sends an invoice to the customer for $100,000
- After net-30 days, the end-customer pays $100,000
- The finance company settles the transaction
The transaction lasted 90 days. It took 30 days to manufacture the goods, 30 days to ship them, and an additional 30 days to get paid. The fee was set for 3% per 30 days. Consequently, the cost is 3% x 3 x $70,000 which totals $6,300. The following chart explains the transaction in more detail.
The PO financing company settles the transaction by deducting the $70,000 supplier payment and the $6,300 fee from the $100,000 payment. The remaining $23,700 is forwarded to the client.
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Disclaimer: This article is for information purposes only and does not intend to provide legal or financial advice. Please get competent advice from a CPA or attorney if you require it.