Purchase order (PO) financing would appear to be an ideal solution to finance commodity sale transactions. Most commodity brokers are intermediary companies buying products such as sugar, metal ore, coffee, and such, and reselling them for profit by getting a commission on the transaction — usually the difference between the purchase and sale price.
Many of these transactions are for large amounts of money – such as a one million dollars-per-month sale for 12 months – representing a substantial opportunity. These transactions would seem to meet the qualification requirement for PO financing. However, the most important requirement is usually missed.
It’s all about gross margins
The problem is that most commodity product sales have very low gross margins – often under 7%. PO financing works only with transactions having high gross margins – above 20%. The low margins of most commodity transactions make purchase order financing an unsuitable solution (with some exceptions).
Why are high margins required?
In general, vendor financing transactions like PO financing have a higher risk of failure compared to other transactions. Working with high-margin transactions enables finance companies to reduce the risk of losing part, or all, of their investment. Limiting this type of financing to high-margin transaction also reduces the chances of the client incurring a loss of profit.
Risk #1 – Transaction delay
Transaction delays are probably the biggest risk when dealing with low-margin transactions. Most PO financing lines accrue their fees based on time. The average PO financing rate is 3% per 30 days. Imagine a transaction in which the commodities cost $95 and are sold for $100. This transaction has a gross margin of 5%. Let’s also assume that the transaction takes 30 days from beginning to end.
If the transaction completes in 30 days, the cost is $2.85 (3% of $95) and the client makes a profit of $2.15. If, because of delays, the transaction completes in 60 days, the transaction fee now becomes $5.70 (6% x $95) – exceeding the gross margin. Consequently, the client incurs a loss and the transaction fails.
Risk #2 – Product returns
The second risk deals with products returns. Let’s assume that 20% of the order in the above example is returned because it does not meet the client acceptance criteria. While this scenario is unusual because all goods are always inspected and insured prior to shipping, it can happen. Furthermore, assume that the supplier has been paid and refuses to reimburse for the return.
This situation leaves your company with an order for which the finance company has paid $95. However, the order generates revenue of only $80 and has negative transaction equity. Again, the client incurs a serious loss.
Are all commodity transactions disqualified?
While not every commodity transaction is disqualified, most do not meet the requirements for purchase order financing. However, PO financing can be used on select transactions in which these criteria are met:
- The transaction must have minimum margins of 15%
- The commodities broker must have experience in selling commodities
- The commodities broker must have some capital to contribute to the transaction