Getting a large purchase order can be a great opportunity if the company has the funds to fulfill it. Unfortunately, small companies often miss these opportunities because they lack the funds to execute the transaction. In this article, we discuss a way to finance purchase orders. We cover the following:
- How are purchase orders financed?
- Common misconceptions
- Transaction structure
- Advantages and disadvantages
- Is this solution for you?
- PO financing vs. supplier financing
1. How are purchase orders financed?
One of the challenges of managing a large purchase order is handling the supplier payments. In most cases, suppliers want to get paid before manufacturing your product or shortly after shipping the goods. On the other hand, end customers usually pay their invoices on net 30 to 60 terms after receiving the goods.
Small business owners face the financial problem of paying the supplier for a large order a few months before the end customer pays them. Many small companies don’t have the resources to manage this situation and must use financing to fulfill the order.
A common way to finance orders is to use purchase order financing. This solution handles the supplier payment associated with the order. It enables the small business to fulfill the order and book the revenue. Learn how purchase order financing works.
2. Common misconceptions
Purchase order financing programs are often described as “loans” in the printed media. This misconception can create the wrong impression on prospective clients who assume the finance company will give them money to use it as they see fit. Unfortunately, this is not how purchase order financing works.
a) Types of orders
The first limitation of purchase order funding is that it can be used only to fulfill orders for the sale of a product. Furthermore, the order cannot involve any assembly or installation. Finance companies apply this restriction to reduce the risk that an installation or assembly problem will jeopardize the order’s fulfillment.
b) Supplier payments
The second limitation is that the finance company will pay your supplier directly. PO financing uses a supplier payment structure that is common in international trade. The finance company opens a letter of credit to benefit the supplier at the start of the transaction. However, the letter of credit pays the supplier only after the goods are shipped. This arrangement guarantees that you will get the goods and the supplier will get paid.
3. Transaction structure
PO financing transactions can have four or five parties, depending on how the transaction is structured. The participants are:
- Finance client
- End customer
- PO financing company
- Factoring company (sometimes)
This structure can be confusing, since some transactions use only one finance company while others use two finance companies. Let’s start with the simplest transaction model. In this transaction, the client uses only a PO financing company. The transaction flows like this:
- Client gets a large purchase order from the end customer
- Client places an order with its supplier
- PO finance company pays the supplier
- Supplier delivers the goods
- End customer receives goods
- Client issues invoice to the end customer
- End customer pays the invoice
- PO financing company settles the transaction
Some transactions can use factoring with PO financing to yield a lower total cost. In these cases, clients should consider adding factoring to the financing mix. These transactions are more complex than conventional transactions. The transaction flows like a regular transaction until the end customer receives the goods. At that point:
- Client issues invoice to the end customer
- Client factors the invoice
- Part of the factoring advance is used to settle the PO financing line
- Transaction proceeds as a factoring transaction
- End customer pays the invoice
- Factoring company settles the transaction
Using factoring can have advantages, especially if the gross margins are high and the factoring rates are structured correctly. Clients can use factoring to minimize transaction costs. However, they can also request a full advance and apply it to their next order. This process minimizes their use of PO financing and usually results in a lower cost of funds. Since each transaction is different, review the specific details of your transaction to ensure these benefits apply to your situation.
The average rate for a PO financing line is 3% per 30 days. However, rates can be slightly higher or lower based on specific transaction details. Also, rates can have different timings and be pro-rated to match payment schedules.
PO financing is considered an expensive source of financing, especially when compared to bank financing products. Consequently, it should be used only with transactions that have high margins. High-margin transactions limit the effects of financing on transaction profitability.
5. Advantages and disadvantages
Purchase order financing has several advantages and some disadvantages to consider if you are planning to use this solution.
The solution has the following advantages.
a) Available to new companies
Purchase order funding is one of the few financial alternatives available to new companies. Companies that have only done a few previous transactions can qualify in many cases.
b) Can cover 100% of the supplier costs
Purchase order financing can cover up to 100% of the supplier costs for some transactions. This coverage enables companies to handle very large transactions while conserving their cash.
c) Can finance very large transactions
The solution has no maximum limit, per se – at least not in the way that other solutions have maximum credit lines. Most finance companies limit your line based on the credit quality of your client, the capabilities of your supplier, and your ability to fulfill the order.
d) Easier to obtain than other solutions
Purchase order financing is more accessible than most other financing solutions. Its qualification requirements are fairly simple, without the demanding requirements associated with lines of credit.
This solution also has some disadvantages to consider. They are as follows.
This solution is expensive compared to other types of financing. Consequently, it should be used only in transactions that have sufficient margins to cover the cost of financing. In general, transactions should have a minimum margin of 20%, though higher is better.
b) Narrow focus
Purchase order financing can only help a narrow set of clients. Specifically, it can only help companies that re-sell finished goods to commercial or government customers.
Most PO finance companies have minimum transaction and annual volumes. Setting up and managing a PO financing line is labor-intensive for the finance company. Most finance companies work only with clients who can finance a minimum of $100,000 per month, though this amount varies.
6. Is this solution for you?
Purchase order financing is designed to help a particular set of companies that face a very specific challenge. PO financing will likely help you if your company meets these criteria:
- Company re-sells products
- Gross margins higher than 20%
- End customers have good commercial credit
- Reliable suppliers
7. PO financing vs. supplier financing
While PO financing is easier to get than most solutions, it also has some limitations. Suppliers can be paid only via a Letter of Credit, and transactions have to follow a very specific set of steps.
Larger and more established companies may be better served using supplier financing. This solution is available to companies that have been in business for a few years, have a minimum of $500,000 of monthly revenues, and can be credit insured. Supplier financing is more flexible than PO financing and can be used in a larger variety of transactions. To learn more, read “What is Supplier Financing?‘
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