In this article, we review how a purchase order transaction is structured and settled. This review should give you a good understanding of how this solution works and help you determine if it’s the right way to finance your company.
What is purchase order financing?
Purchase order (PO) financing – a financial solution that can be used by companies to finance large purchase orders – provides resellers and distributors with the financial resources they need to pay supplier expenses associated with the order. This solution allows them to fulfill the order and book the revenue. It works well for small companies that are growing quickly and provides a number of benefits. The best way to explain how PO financing works is to show a sample transaction.
Please keep in mind that this is a hypothetical transaction. Let’s assume that Johnson Electronics Inc., a distributor of digital picture frames, has been working with an Asian supplier to develop a digital picture frame that is attractive to consumers and reasonably priced. After months of work, CEO Peter Johnson secures a purchase order from Super Stores Inc, a large electronics retailer. Super Stores Inc. plans to buy $500,000 CAD of digital picture frames and needs them in 30 days. The net 30 terms of the agreement mean that Super Stores Inc. will pay for the goods within 30 days.
Johnson Electronics’s supplier can deliver these picture frames on time for a cost of $300,000 CAD. However, like many Asian suppliers, they require a letter of credit (L/C) to secure payment. They will begin processing the order as soon as the L/C is presented. Unfortunately, Johnson Electronics does not have the cash collateral to open the letter of credit with their bank. As a result, they decide to use purchase order financing.
Johnson Electronics secures an agreement to finance the purchase order. They plan to use purchase order financing to finance the supplier’s costs of the transaction. After the goods are delivered, they will use factoring financing to close the PO financing transaction. This strategy is common because factoring usually lowers the total transaction costs.
Johnson Electronics gets the following terms:
- PO Financing: 3% for 30 days on the $300,000 supplier costs
- Factoring: 1.75% per 30 days on the $500,000 receivable. The advance is set at 80%
Day 1: Johnson Electronics buys $300,000 of digital picture frames from their Asian supplier. The PO financing company makes the payment by letter of credit.
Day 24 – 29: The goods are inspected and approved prior to shipment.
Day 30: The supplier ships and delivers the goods to Super Stores Inc.
Day 31: Johnson Electronics sends an invoice for $500,000 to Super Stores Inc. They also factor the invoice, so they send a copy of the invoice to their factoring company for financing. The factor advances 80% ($400,000) of the receivable. $309,000 is remitted to the PO financing company to close the line ($300,000 + 3% fee). The reminder – $91,000 – is remitted to the client.
Day 60: Super Stores Inc. pays the invoice for $500,000 CAD. The factor settles the transaction, charges a 1.75% fee for the service, and remits the difference ($91,250) to the client. This is calculated as follows: $500,000 – $400,000 advance – $8,750 fee = $91,250).
Disclaimer: Please note that this is a hypothetical transaction intended to illustrate how this product works. It does not represent any individual transaction.