Purchase order financing is commonly used by small companies that have won a large purchase order but don’t have the financial means to fulfill it. This article discusses the average costs of PO financing and how transactions are structured. This information will help you determine if PO financing is the right solution for you. The article covers:
- What is purchase order financing?
- How much does PO financing cost?
- How is a transaction structured?
- Minimum volumes
- Is PO funding right for your transaction?
- Choosing a PO financing company
1. What is purchase order financing?
Getting a large order can be a great opportunity for a small business. However, large opportunities can also put a financial burden on the company. The small business must have the funds to pay the supplier for the large order. Additionally, they must often wait up to 90 days for their client to receive the goods and pay for them. This situation often puts small companies at a financial disadvantage.
Companies that don’t have the funds to handle a large order should consider purchase order financing. This solution provides the funds to pay the supplier costs associated with the order. It enables the company to fulfill the order and book the revenue. Here is more information about how purchase order financing works.
2. How much does PO financing cost?
Purchase order financing rates average 3% per 30 days on utilized funds. Rates can vary higher or lower based on the transaction’s specific details and risk profile. Rates are influenced by:
- Size of supplier payment
- Length of times funds are outstanding
- Supplier reputation
- Client issues
a) Rate structure
Each purchase order financing company structures its proposals differently; however, the following models are common. For example, assume a “3% per 30 days” rate. Common structures could include:
- 3% for the first 30 days; 1% per 10 days thereafter
- 3% for the first 30 days; 0.1% per day thereafter
- 2% per 20 days; 1% per 10 days thereafter
b) Cost examples
Let’s consider two examples in which a supplier must be paid $100,000. The difference between the transactions is only in the timing of the payments. Note that the examples have been simplified for clarity.
Transaction #1 – Single Payment
In the first example, the transaction has the following terms:
- Supplier paid by Letter of Credit (L/C) at start of the transaction
- Transaction concludes/settles in 60 days
- Finance company charges 3% per 30 days
The financing cost is calculated as follows: 3% x $100,000 = $3,000 per 30 days. Since the transaction lasts 60 days, the total cost is $3,000 x 2 = $6,000.
Transaction #2 – Multiple Payments
The second example has slightly different terms:
- Supplier requires 30% down payment (via Letter of Credit)
- Supplier is paid remaining 70% at shipment
- Supplier ships goods 30 days after receiving deposit (L/C)
- Customer receives goods and pays for them 30 days later
This transaction consists of two parts. The 30% down payment is open for 60 days from the start of the transaction until its conclusion. However, the remaining 70% is open only after shipment (day 30) and closes 30 days later.
The cost for each component is calculated as follows:
- 30% x $100,000 x 3% = $900 per 30 days or $1,800 for 60 days
- 70% x $100,000 x 3% = $2,100 for 30 days
The cost of the 30% down payment that was open for 60 days is $1800. The cost of the 70% payment due at shipping that was open for 30 days is $2,100. Consequently, the financing cost of this transaction is $1,800 + $2,100 = $3,900.
3. How are transactions structured?
Many transactions are financed with a combination of purchase order financing and factoring. This structure often results in a total lower cost. Transactions work as follows:
- The transaction begins with a purchase order
- The purchase order financing company pays the supplier
- The supplier manufactures the goods
- The supplier ships the goods. This concludes their involvement
- The goods are delivered to your client
- You issue an invoice to your client, due in 30 to 60 days
At this point, the transaction has evolved from a purchase order to an actual sale. The product has been delivered, and the client is expected to pay in net-30- to net-60-day terms. This change from order to sale lowers the risk of the transaction and allows you to factor the invoice. The transaction proceeds as a conventional factoring transaction, which costs less. It works as follows:
- Your company factors the invoice
- Part of the advance is used to pay off the PO financing line
- The PO financing line is settled
- The transaction proceeds as a factoring transaction
- Your client pays the invoice
- The factor settles the transaction
Whether factoring lowers the total cost of a transaction varies based on a number of details. These include transaction length, profit margins, PO financing rate, and factoring rate. Each transaction should be reviewed beforehand to ensure that using both solutions produces the optimal cost structure.
4. Minimum volumes
Purchase order financing transactions have many moving parts and are labor-intensive for the lender. Consequently, many finance companies have minimum volume requirements. These minimums vary by company and are negotiable. Most finance companies work with transactions with a minimum supplier payment of $100,000. They also prefer to work with companies that submit a minimum volume of transactions per year.
5. Is PO financing right for your transaction?
While purchase order funding has several benefits, business owners need to determine if it’s the right option for their transaction. It may be the right solution if the following are true:
- Minimum supplier payment of $100,000
- Minimum gross margin of 30%
- Lasts less than 90 days
- Product has an existing market
- It’s not the company’s first sale
- Is for a client with good commercial credit
Learn about the qualification requirements for PO financing.
6. Choosing the right PO funding company
Many companies make the mistake of selecting their finance company based on the rate alone. While cost is critical, it’s not the only variable. To choose the best purchase order financing company for your business, focus on:
- Industry experience
- Transaction flexibility
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