Most purchase order (PO) finance companies usually ask that the client use factoring financing to settle a transaction. The transaction starts by using purchase order funding; however, once the goods are delivered and an invoice is generated, the finance company will ask that you factor the invoice and close the PO funding line.
This request can often confuse clients because it adds complexity to the transaction. Frankly, to many business owners, this step seems unnecessary. This article helps you understand the benefits of combining these financial products.
How does factoring work in this transaction?
Let’s start by reviewing how the transactions work together. In a conventional purchase order finance transaction, the finance company pays the product supplier on your behalf. This payment allows the supplier to manufacture and deliver the product to the customer (the buyer). Now that the customer has received the product, you can send them an invoice for the product.
At this point, you have two options: wait until the customer pays and settle the transaction with the finance company, or you can factor the invoice. Factoring can give you sufficient funds to close the PO financing line and often provides additional working capital. To learn more about factoring, please read “How does factoring work?”
The benefit: lower total transaction costs
Usually, factoring an invoice to settle a PO financing transaction offers two benefits. First, it can lower the total transaction cost, which improves your profits. Second, it can provide additional working capital which can be put into the business. Using factoring lowers total transaction costs for a simple reason: factoring tends to cost less than PO financing.
One thing to note is that using factoring doesn’t always lower the transaction costs. It depends on the transaction parameters. Therefore, review each transaction individually to determine transaction costs.
A sample transaction
This hypothetical transaction demonstrates how both products can work as part of the same solution and lead to lower costs. Let’s assume that RESELLER Inc. has a purchase order that they would like to fund. They buy products from a supplier that are then re-sold to LARGECO Inc. The supplier is able to ship the goods 30 days after the order is placed. Once the goods are shipped, RESELLER inc. will invoice LARGECO Inc. for the full amount. The invoice has net-30 terms and will be paid within a month. To keep the transaction simple, let’s assume these details:
- LARGECO’s PO to RESELLER is for $100 CAD.
- The supplier charges $70 CAD to manufacture and ship the computers.
- PO funding costs are for 3% of the $70 CAD paid to the supplier.
- The cost to finance the invoice is 2% per 30 days, using an 80% advance (or $80 CAD).
1. Day 1: The PO financing company pays the product supplier $70 CAD through a letter of credit (LC).
2. Days 2-28: The supplier manufactures and ships the product. They collect the LC upon shipment.
3. Day 30:
- LARGECO receives and accepts the goods.
- RESELLER Inc. sends an invoice to LARGECO for $100 CAD. The invoice is due in 30 days.
4. Day 31:
- RESELLER Inc. sends an invoice to the factor.
- The factor advances 80% of $100 CAD (or $80 CAD). It sends $72.10 CAD to the PO financing company. This step closes the purchase order finance component of the transaction. The remaining $7.90 is sent to RESELLER Inc. (the advance is $80; PO financing cost is 3% of $70 = 2.10 + original $70 = $72.10).
5. Day 60: LARGECO pays the $100 CAD invoice in full. The fee to finance the invoice is $2 CAD. The remaining $18 CAD ($100 – $80 invoice – $2 fee) is rebated to RESELLER Inc. The transaction concludes.
The total cost for this transaction is $4.10 CAD, which is split between PO financing costs of $2.10 CAD and factoring costs of $2 CAD. On the other hand, if this transaction had been done solely with purchase order financing, the cost would have been $4.20 CAD. We arrive at this figure by multiplying the 60-day fee by the advance: 6% x $70 = $4.20. As you can see, combining factoring and PO financing saved $0.10 CAD in this transaction.
This may seem like a lot of work just to save $0.10 CAD. The benefits of these savings come with scale and growth. A company that finances $10,000,000 CAD per year could realize about $10,000 CAD in savings. Further savings are also possible because factoring fees usually decrease as volume increases.
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