Should You Use Factoring With Purchase Order Financing?

Purchase order (PO) financing companies often advise prospective clients to also work with a factoring company. For many transactions (though not for all), combining both products reduces the total cost. This is because the cost per dollar for factoring is usually lower than the cost per dollar of PO financing.

When combining these products, the transaction starts as a purchase order financing transaction that is refinanced as an invoice factoring transaction once an invoice is generated.

A sample PO financing and factoring transaction

The following hypothetical transaction illustrates the benefit of combining both products. Assume that company “ABC Inc.” is a purchase order finance client with a transaction that they wish to finance. ABC Inc. buys widgets from a supplier and sells them to ACME Corporation, a large conglomerate.

ABC Inc. needs to pay the supplier upfront to begin production. The supplier drop ships the widgets after production and the widgets are received by ACME on day 30. At that point, ABC Inc. sends an invoice to ACME for the product. The invoice is paid 30 days after that.

Assume the following details:

  • ACME’s PO to ABC Inc. is for $100
  • The widget supplier charges $70 to produce and ship the widgets
  • The PO financing rate is 3% for 30 days on $70 paid to the supplier
  • The factoring cost is 2% for 30 days on a $100 invoice. The factoring advance is 80% of the invoice (or $80)

The transaction timeline would look like this:

1. Day 1: The PO financing company pays the widget supplier $70 by letter of credit (LC)

2. Days 2-28: The widget supplier manufactures and ships the widgets and cashes the LC

3. Day 30:

  • ACME receives and accepts the widgets
  • ABC Inc. sends an invoice to ACME for $100, payable in 30 days

4. Day 31:

  • ABC Inc. sends an invoice to the factoring company
  • The factor advances 80% of $100 (or $80). It sends $72.10 to the PO finance company, closing the PO financing transaction. It also sends the remaining  $7.90 to ABC Inc. (the advance is $80; PO financing cost is 3% of $70 = 2.10 + original $70 = $72.10)

5. Day 60: ACME pays the $100 invoice in full. The factoring fee is $2. The remaining $18 ($100 – $80 invoice – $2 fee) is rebated to ABC Inc. The transaction is closed.

Comparing financing costs

The total cost of this transaction is $2.10 for purchase order financing and $2 for invoice factoring, bringing the total cost to $4.10. For comparison purposes, assume that the transaction was left open as a PO transaction for the entire 60 days and that no factoring was used. The cost for this transaction would be the 60-day PO financing fee of 6% x $70 = $4.20. In this simple example, using PO financing alone is $0.10 more expensive than the cost of combining both products.

Is all this hassle worth saving 10 cents? No, not for 10 cents. But this difference adds up as your revenues grow. It won’t take long before that 10-cent savings (for every $100 transaction) starts adding up to real money. A small company doing $5,000,000 a year in transactions would save $5,000 by combining both solutions.

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Legal disclaimer: This transaction and article is for illustration purposes only and all numbers are hypothetical. You should not rely on it to make legal or financial decisions.