How Does Purchase Order Funding Work?

Purchase order funding is one of the most misunderstood products in the factoring industry. In part, this is probably because the name is both generic and very enticing. Most companies assume that purchase order funding simply gives your company money (directly), using your purchase orders as collateral. Unfortunately, this is not accurate. This article will help you:

Is your company a good candidate for purchase order funding?

Let’s start with a simple question: is your company a good candidate for purchase order funding? Generally speaking, your company is a good candidate for purchase order funding if all the following are true:

  1. You buy and then resell products without any modifications or customizations
  2. Your company does not directly manufacture the products that you sell
  3. Your gross margins are at least 20%
  4. Your suppliers have a good track record of delivering products and are in good financial shape
  5. Your customers have good commercial credit
  6. Your purchase orders are non-cancelable and have no consignment or guaranteed sale terms
  7. Your orders are for a minimum of $100,000

As you can see, purchase order financing has very specific requirements and can only help a narrow set of customers. Basically, purchase order funding helps resellers/distributors that have received a purchase order exceeding their current funding abilities and need financing to fulfill it.

If your company is a direct manufacturer, consider supply chain financing. This solution offers many of the same benefits.

Transaction structure

Here is how a purchase order financing transaction is usually structured. Let’s assume that your customer has placed a purchase order to buy $100 worth of widgets. Let’s also assume that your supplier charges you $70 for those widgets. Additionally, your supplier wants you to prepay the $70, and your company does not have the money to prepay for the goods. This is where purchase order financing comes in. The financing company can help you complete this sale by structuring the following transaction (assuming you have a financing contract in place):

  1. The purchase order financing company reviews the transaction to ensure that it complies with the funding requirements.
  2. The purchase order financing company pays $70 to your supplier directly. Depending on the circumstances, payment is made by letter of credit or, if the transaction merits it, by wire transfer. Note that payment to foreign suppliers must be made by letter of credit only.
  3. Once the payment has been received, your supplier manufactures the widgets.
  4. The widgets are delivered to the customer, who inspects and accepts them.
  5. At this point you can invoice your customer. The transaction can proceed in one of two ways. You can factor the invoice and use the factoring proceeds to pay the purchase order financing company and close that line. The transaction would then proceed as a conventional factoring transaction. Alternatively, if factoring is not an option, the transaction can settle once your customer pays for the end goods.

Lowering total transaction cost

Business owners sometimes get confused at point #5. Why bring in a factoring company? The reason is simple: combining purchase order financing with factoring often yields a lower total transaction cost than using purchase order financing alone because factoring is usually cheaper than purchase order financing. However, given the fluid nature of these transactions, you should double-check the numbers to make sure that combining factoring and purchase order financing is the best solution for your transaction.

Get more information

We are a leading purchase order financing company and can provide competitive rates. For information, get a quote or call (877) 300 3258.

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.