What is Purchase Order Financing?
Small businesses and start-ups often face liquidity crunch and cash flow challenges, which can at times prevent them from accepting new and large customer orders.
Purchase Order Financing is a type of financing option that helps these small businesses meet their short-term capital requirements for fulfilling specific customer orders.
Essentially, it is a cash advance of up to 100% offered by a third party to the seller’s supplier against the customer’s purchase order. The supplier can utilize these funds for the timely production and delivery of goods to the customer. Upon receiving the goods, the customer pays directly to the purchase order financing company, who then deducts its fee and passes on the balance amount to the business.
A purchase order is a legally binding contract between the buyer and seller, which works as a collateral under this arrangement. The financing company reviews the customer’s creditworthiness and the seller’s relationship with the customer and supplier, before extending the required funds. In most cases, funds are offered on a non-recourse basis, ie, in case of payment default by the customer, the purchase order financing company has to bear the risk.
Purchase Order Financing is applicable for both, export and import financing, where funds are usually extended for shorter durations of 30-90 days, with the average being 45 days.
Why Do Businesses Use Purchase Order Financing?
Businesses typically use purchase order financing for several reasons:
Expand customer base – For small businesses, acquiring new customers is critical to being profitable. Purchase Order Financing allows these businesses to acquire multiple new orders and customers, even from beyond the borders, thus enabling them to expand their footprint and horizons.
Tight cash flow – As per a report, 61% of small businesses worry about cash flow problems every month. Purchase Order Financing is an ideal way to fund these businesses, who can now focus on strengthening their growth prospects without worrying about funds.
Seasonal demand spike – If a business witnesses a sudden spike in demand during a particular time of the year, arranging for funds to fulfil the cost of the order might seem difficult. Purchase Order Financing can come to the rescue of the business, by giving them easy access to funds in a short period of time.
How Does Purchase Order Financing Work?
The various steps of the Purchase Order Financing process are explained below -
- Customer/buyer places an order with the seller and sends a purchase order, specifying details such as type of goods, quantity, timeline, etc.
- Seller connects with the supplier to get an estimate on the materials and costs required to fulfil the order. Supplier shares an invoice for the same with the seller.
- Seller applies for Purchase Order Financing.
- Purchase Order Financing company evaluates the order and checks the creditworthiness of the seller and the customer’s supplier to decide the amount of funding to be offered. Usually, lenders finance around 80-90% of the order, although it can go up to 100% also, especially with collateral-backed POs
- Purchase Order Financing company extends funds to the supplier (and not the seller) to manufacture and deliver goods to the customer. In case the seller doesn’t qualify for 100% funding, the balance supplier payment would have to be made by the seller.
- Supplier ships the products directly to the customer.
- Seller issues the invoice to the customer requesting for payment.
- Customer sends the due amount directly to the financing company.
- Upon receiving the payment from the customer, the Purchase Order Financing company deducts its financing fee and pays the remaining invoice balance to the selling business.
Example of Purchase Order Financing
Let’s say, Company A secures a purchase order from Company B to supply 10,000 electric bulbs within 30 days. The total cost of the order is $1,000. Now, Company A works with the supplier, Company C, who agrees to manufacture the bulbs at a cost of $700, and thus sends an invoice to Company A. Company A applies for Purchase Order Financing from Financier D, who evaluates the order and conducts a credit check on the customer and its supplier. Upon being satisfied, Company D agrees to fund 100% of the supplier’s cost and extends $700 to Company C at a monthly fee of 2%.
Company C successfully executes the order and sends the shipment of 10,000 bulbs to Company B on the completion of 30 days. Once the shipment is delivered, Company A then sends the invoice to Company B. Company B then pays the sum of $1,000 to the purchase order financing firm, Company D. Company D deducts its fee of 2%, i.e., $14 (calculated on the supplier’s cost). It then deducts the amount paid to the supplier, i.e., $700. The balance amount, i.e., $286, is then passed on to Company A. This amount is the profit earned by Company A.
Who Uses Purchase Order Financing?
Purchase Order Financing is usually opted by cash-strapped businesses that need to purchase inventory or supplies to complete their customer’s order. Typically, these businesses could include -
Small business owners and start-ups engaged in buying and selling of goods, but have limited working capital to fulfil the large influx of orders.
Businesses selling finished products, and not semi-finished goods or raw materials.
Manufacturers, distributors, wholesalers, resellers, importers, exporter, government contractors fulfilling government orders, etc. Government contractors use government purchase order financing.
Businesses rely on external suppliers for the products that they resell.
What Documents are required for Purchase Order Financing?
The following documents need to be submitted by a business in order to apply for Purchase Order Financing -
- Purchase order sent by the customer
- Invoice raised by the supplier
- Invoice raised by the seller to the customer
- Financial statements of the selling business, including balance sheet, cash flow statement, profit and loss statements, etc.
- Tax filings
- Financiers may typically request for different documents on a case-to-case basis
How to Apply and Qualify for Purchase Order Financing?
Below listed are a few requirements for a business to qualify for purchase order financing –
- A business must sell finished goods, and not raw materials or semi-finished products.
- Profit margins in the order should be at least 15% to 20%, varies from financier to financier.
- Business must be working with creditworthy and reputable customers and suppliers.
- Business must only be selling the goods to business or government customers. B2C is not eligible for this type of financing.
How Much Does Purchase Order Financing Cost?
The cost of financing purchase orders varies from transaction to transaction.
Typically, the interest rates lie in the range of 1.8% to 6% per month, and depend upon various factors such as size of the order, repayment time, creditworthiness of supplier and customer, supplier amount, etc.
While some companies charge a consistent interest rate, many even increase their rates after 30 days.
For example, a company might charge an interest rate of 2% for the first month, and then increase it by 0.5% every 15 days. Also, in case the customer takes longer to clear the invoice, the fee/ interest rate increases significantly.
Alternatives to Purchase Order Financing
Purchase order financing has a few alternatives which are listed below. Along with revenue based financing, there are other financing methods that can be employed. The key differences between purchase order financing and other alternatives are explained in the table below -
Advantages of Purchase Order Financing
Purchase Order Financing can benefit a business in the following ways –
Facilitate expansion of small businesses - Purchase Order Financing gives small businesses and start-ups the required funds to secure big clients, and thus fast-track their expansion and growth. They can also secure required capital to purchase the raw materials they need to manufacture the goods on their purchase order through another short-term finance option called inventory financing.
Easy to qualify – It is fairly simple to qualify for purchase order financing, as the approval requirements are relatively few and less stringent. Also, since the creditworthiness of only the supplier and customer is evaluated, a business need not worry about its financial or credit history to get the financing approved.
Quick Funding – Simple, quick procedures ensure access to funds mostly within two weeks after approval. This allows businesses to execute the orders in a timely manner.
No collateral required – Purchase Order Financing does not require any collateral or personal guarantee. The purchase order, in this case, acts a collateral.
Flexible – The financing option offers a lot of flexibility, as businesses can stop using it as per their requirements, ie, as and when their order volume fluctuates. Thus, there is no long-term commitment of the business in purchase order financing.
Less Risky – As the responsibility of collecting the due invoice from the customer lies with the lender (purchase order finance company), the business does not have to deal with the risk of non-payment.
Disadvantages of Purchase Order Financing
Although purchase order financing is a great funding option for small businesses, there are some limitations attached with this mode of finance -
High Fees - The cost associated with purchase order financing is relatively high, as lenders charge a fee between 1.8% to 6% per month. When converted to an annual percentage rate (APR), Purchase Order financing falls in the range of 20% to 75%. This high fee means reduced profit margins for the seller.
Cannot be availed by service-oriented businesses – This funding option is only available for businesses dealing with tangible, finished goods. Service-oriented businesses cannot apply for Purchase Order Financing.
Short-term funding only – Under purchase order financing, funds can be availed only for a shorter duration of 30-90 days. For projects which require long-term funding, other financing options must be considered.
100% financing is not guaranteed – In most cases, the funding offered to businesses is 80-90% of the supplier’s invoice amount. This means that the seller, on its own, might have to arrange for remaining funds that need to be paid to the supplier.
In conclusion, purchase order financing can be a valuable tool for businesses looking to grow and expand. By providing the necessary cash flow to fulfill orders, purchase order financing can help businesses improve their credit, reduce their risk, and increase their cash flow. If your business is struggling to fulfill large orders, consider exploring purchase order financing as a possible solution.
Purchase Order Financing By Drip Capital
Drip Capital also offers a service similar to a PO financing solution in order to resolve cash flow gaps that growing businesses in the United States face regularly.
Our supply chain financing platform allows your suppliers to get paid immediately by leveraging your credit profile. This ensures a healthy trade-relationship that allows importers to grow quickly simply based on their purchase orders.