Generally, companies don’t use purchase order financing as a stand-alone product. Instead, they combine it with another financing solution, such as factoring. The reason both products are used together is that combining them often reduces total transaction costs. These savings benefit the client and drop directly to the bottom line.
The purchase order financing line is used to pay for the initial purchase order costs. Once the order is delivered and the customer receives an invoice, the line is closed and paid back from the proceeds of the factoring line.
However, not every customer has – or wants – a factoring line. For example, certain clients may already have an asset based financing line, which is better suited for larger and more established companies.
Combining PO Financing with Asset Based Financing
The only reason to use another product with PO financing is that it usually reduces the total transaction cost. Purchase order financing is expensive when compared to other solutions. Therefore, the objective is to use PO financing for as short a period as possible. Once you reach a point where the transaction can be refinanced, you do so with a lower-cost alternative.
Here is a way to think about it. PO financing funds a transaction based on the strength of a purchase order. A purchase order is basically a promise from a company to buy your products. Unfortunately, this promise is risky because purchase orders, even strong ones or so-called “non-cancellable orders,” can fall through. This transaction risk is reflected in the higher price.
On the other hand, an asset based loan finances the invoice that was generated from the transaction. Since the goods have been delivered, the invoice is a promise from your customer to pay you. The strength of this promise can easily be determined through a commercial credit report and is much stronger than a simple promise to buy. This strength is reflected in lower prices and is why you are better off using both solutions together.
Using an inter-creditor agreement
To use an asset based loan along with purchase order financing, both lenders need to sign an inter-creditor agreement. Most asset based lenders and PO financing companies work together regularly, so executing this agreement is usually easy. However, getting the inter-creditor agreement in place ultimately depends on the complexity and risk of the individual transaction.
The agreement gives the PO financing company priority over the future receivable created from financing the transaction. Once the goods are delivered and an invoice is created, the invoice can be financed with the asset based loan. At that time, the purchase order financing company is paid back and priority over the receivable reverts to the asset based financing company.
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