Both purchase order (PO) financing and inventory financing can be used to finance certain types inventory. However, both solutions work very differently and serve very different business objectives.
From this article you will learn:
- What purchase order financing is
- What inventory financing is
- The main differences between these solutions
- How to determine which solution is right for you
What is purchase order financing?
Purchase order financing allows you to finance the supplier costs associated with a specific customer purchase order. It’s used to pay for the inventory costs associated with fulfilling a specific purchase order.
This type of financing can be used only by companies that buy finished goods directly from vendors and re-sell them without modifications. It’s available only to wholesalers and re-sellers. To learn more, read this.
What is inventory financing?
Inventory financing is a solution that allows you to finance and leverage existing inventory, whether or not it is associated with a specific purchase order. The transaction can provide additional working capital to purchase inventory (if needed) or to pay for regular business expenses.
This type of financing can be used by re-sellers, wholesalers, and manufacturing companies. Unlike purchase order financing, inventory financing can be used to leverage raw materials and work-in-progress for manufacturing companies. To learn more, read this.
Although the solutions can serve a similar purpose, they are used under different circumstances and have a number of important differences. The main differences between them include:
1) Due diligence
An important difference between these solutions is the amount of due diligence required to set up an account. The due diligence for purchase order financing is relatively straightforward and can be done in a few days. The lender needs to review your current financial statements and make sure that the purchase order can be financed.
Inventory financing lines, on the other hand, require extensive due diligence. Initially, financial statements are reviewed. Once the initial review concludes, a field exam must be conducted at the client’s plant and the inventory must be evaluated by an appraiser. This process can take a couple of weeks.
2) Funding advance
Purchase order financing lines can provide up to 75% of what your end customer will pay you for the goods. The funds have to be used specifically to pay for supplier expenses associated with your customer’s purchase order. This last point sometimes confuses clients, so we’d like to provide an example.
Let’s assume that you have a purchase order from a customer to buy your product for $100. Let’s assume that your supplier cost for this order is $75. In this example, PO financing could cover $75 ($100 x 75% advance) to be used for supplier payments. Thus, the line can cover the majority of costs for transactions that have a gross margin of 25% or higher.
Inventory financing lines can provide up to 70% of either the forced liquidation value (FLV) or net orderly liquidation value (NOLV) of your inventory. This valuation can create problems in some cases because some products have FLVs or NOLVs that are much lower than the current market price. This difference can lead to the potential for low advances relative to what you actually paid for the inventory.
The actual finance cost for both solutions is similar. However, the cost of the due diligence for inventory financing is substantially higher. The client has to pay for the cost of the field examination and the inventory appraisal. Furthermore, the lender may require that you go through a field examination on a regular basis.
The initial due diligence can average $15,000, though this cost varies based on the complexity of the deal.
4) Flexibility of use
In a purchase order financing transaction, the funds can be used only to pay the specific supplier costs directly associated with the purchase order. Unfortunately, this solution has a narrow use. Purchase order financing lines are not good for building inventory. Furthermore, PO financing can be used only by re-sellers and cannot be used by manufacturing companies.
Inventory financing lines are more flexible and can be used to pay for any business expense. Often, the lines can be used to build inventory, which can be useful for companies that have reached their credit limits with key vendors.
Purchase order financing lines require little maintenance to keep the line active. Inventory financing lines require regular visits to perform field examinations and inventory assessments. Also, inventory financing lines are offered only to companies that use perpetual inventory and have an inventory tracking system in place. The soundness of the inventory system has to be verified regularly.
6) Qualification requirements
Lastly, qualifying for purchase order financing is easier and cheaper than qualifying for inventory financing. PO financing can be provided to startups and small, growing businesses. Inventory financing, on the other hand, is provided only to established businesses that have reasonable financials.
Which one works better?
There is no better solution, per se. Rather, you need to determine which solution helps you accomplish your business objectives most effectively. Companies that have a firm purchase order from a qualified commercial buyer are probably better served by purchase order financing. On the other hand, companies that want to build inventory or who manufacture goods may be better served by inventory financing.
(Note: Before considering inventory financing, look at supplier financing. It’s an alternative solution that enables you to build inventory and is ideal for manufacturers and product re-sellers).
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