Purchase Order Financing is an alternate method for businesses to obtain operating capital. Purchase order finance provides corporates with flexible financing options. Small and mid-sized enterprises can get financing to pay suppliers before billing buyers. Cash flow challenges are severe for small business owners.
For example, assume a lending company receives a large order from a buyer. The lending company does not have the cash to pay the supplier in full. As a result, the borrowing company employs the PO to obtain liquidity by seeking funding from a financial institution.
As a sole trader, you may want to know more about purchase order financing or explore various possibilities to secure additional capital for your small business.
This guide will discuss everything you need to know about purchase order financing. Continue reading to find out:
What is Purchase Order Financing?
Purchase order financing is a type of commercial finance that offers funds to pay suppliers in advance for confirmed purchase orders. Businesses avoid emptying their financial reserves or refusing orders due to cash flow constraints. It enables companies to accept large orders and easily change the loan basis up or down to match demand. If order volume declines, there is no long-term commitment so that they can discontinue use at any moment.
Purchase order financing can assist small firms and startups facing difficulty fulfilling large orders. They are used by businesses to track consumer orders. Purchase orders form a contract between a corporation and its customer. It indicates that the consumer agrees to pay after the goods have been delivered. Because this agreement results in a contract, the purchase order becomes crucial to corporations, known as factors. A factor can fund a company’s purchase order per their need to produce and complete orders.
Purchase Order Financing Explained
Purchase order loans may fund the entire order in some situations but only a portion in others. The purchase order finance organization takes money directly from the customer when the supplier is ready to ship the order. After deducting their commissions, the firm sends the remaining invoice amount to your firm.
Vendors would most certainly prefer not to have to fret about financing significant purchase orders. The best part is that by employing PO loans to finance purchase orders, suppliers may meet customer needs while comfortably expanding operations.
Purchase order finance businesses are happy to finance vendors with less-than-perfect credit. These creditors are more concerned with the credibility of consumers who submit purchase orders. Furthermore, whereas obtaining a loan from a typical financial institution can take a long time, PO loans are far easier to get. Such options benefit newer businesses that cannot handle a surge in purchase orders due to a lack of funds.
How Purchase Order Financing Works
Standard small-business loans comprise only two parties, i.e., you and the lender providing the financing. However, when you get into a purchase order finance agreement, you will usually work with the company throughout the process:
You Receive a Purchase Order
Your customer sends you a purchase order detailing the kind and quantity of goods they want. Depending on the data, you ought to be able to assess whether you’ll need to obtain financing to complete the order. If you do, the procedure of purchase order financing begins.
Your Supplier Estimates Your Costs
You should contact the provider to determine how much it will cost to execute the order. One can confirm whether you’ll need to apply for finance to fulfill the order based on the financial assessment provided by the supplier.
You Apply for Purchase Order Financing
Once you’ve determined that you require PO funding, you’ll have to select the most appropriate purchase order financing firm, fill out an application, and gain approval. Include the purchase order and the supplier’s estimated cost as part of your application. Based on your organization’s credentials, the supplier’s track history and credibility, and the customer’s trustworthiness, the financial institution may sanction up to 100 percent of the supplier’s expenditures.
Your Supplier Gets Paid
Following the approval, the purchase order finance firm will pay the supplier to create and ship the product required to fulfill the customer’s purchase order. Many finance businesses may pay suppliers with a letter of credit. A letter of credit is an official bank assurance that payment will be paid after specific requirements are met, in this case, once the items are shipped, and a shipment confirmation is produced.
Your Supplier Delivers the Goods to Your Customer
The goods are delivered straight to the consumers by the supplier. The order is complete once the customer has received the items.
You Invoice Your Customer
The supplier will notify you once the goods are delivered to the customer. It’s now time to bill the consumer for the goods. If the consumer intends to pay in installments, the creditor may purchase the invoice at a discounted price from you. This method is called installment payments or factor lending. This method often offers lesser fees but allows you to access your money quickly.
Your Customer Pays the Purchase Order Financing Company
When the customer makes the payment, they will pay the purchase order financing directly to the firm instead of you. You’ll be on the side once more for this stage of purchase order financing. Also, remember that the sooner your customer repays the lender, the faster you’ll receive your earnings cut.
The Purchase Order Financing Company Forwards Your Money
When the purchase order finance firm gets cash from the customer, they reduce their costs and send you the balance of the purchase order funds. In fact, the purchase order finance fees function similarly to that of an interest applied to a loan.
Who is Purchase Order Financing Best for
Purchase order funding is for growing enterprises that need to fill massive orders. They have limited liquid assets or a negative cash flow.
A typical company that qualifies to get a purchase order funding includes:
Purchase order financing is comparable to short-term loans in many ways, as it pays to manufacture the products indicated on the purchase order. Purchase order loan and purchase order funding applicants are not permitted to use the funds for any other purpose.
This financing method ensures that the buyer’s orders remain fulfilled while keeping the track record of other business loans clean.
When to Use Purchase Order Financing
One of the primary factors to decide if your company qualifies for buy order financing is whether you sell finished goods. Your company will not be eligible for purchase order financing if you offer services or goods.
Purchase order financing will assist organizations who find themselves in the following situations:
- Growing quicker than cash inflow
- Seasonal sales increases
- Cyclical cash flow constraint
If your firm has been experiencing any of these cash flow issues, purchase order finance may be able to help you.
Advantages and Disadvantages of Purchase Order Financing
Benefits of Purchase Order Financing
- Permits you to accept customer orders that you would not be able to satisfy
Purchase order financing might be a suitable alternative for seasonal firms or those rapidly expanding and wanting more liquidity to fulfill significant customer orders. Similarly, this form of financing might benefit organizations with a cash flow problem and help them make a profit from a large order.
- It may be easier to qualify other kinds of business finance
When analyzing your business’s funding application, many purchase order financing businesses prioritize the creditworthiness of your customers and the reputation of your suppliers. Although these organizations may still evaluate typical business loan requirements, such as your company’s financials and credit history, startups and businesses with negative credit may find it easier to qualify compared to other sources of business finance.
- It is not necessary to budget for weekly or monthly loan installments
Since you are borrowing money, buy order financing is not technically a loan. Therefore, you are not required to repay funds in monthly or weekly installments, as you would with a business term loan.
- Excellent for new businesses
E-commerce startup founders often face difficult situations. They have difficulty obtaining finance because they do not have a track record but aim to expand operations. If a startup refuses even one customer’s order, the company’s growth prospects will suffer greatly. Purchase order financing allows you to keep all of your clients happy while also improving your cash flow.
Disadvantages of Purchase Order Finance
- It can be costly
Purchase order financing fees may appear affordable at first look, generally ranging from 1% to 6% of total monthly supplier costs. However, rates can be significantly higher when these fees are factored into an APR. According to anecdotal evidence, they range from 20% to 50%.
- Customer loyalty
Since the amount you spend in fees is determined by the time your customers take to pay their invoice, estimating the entire cost of purchase order financing upfront is challenging. Furthermore, in order to qualify for PO financing, you must rely on your customer’s creditworthiness.
- Failure of control
The company you partner with oversees a substantial portion of the process with buy order financing, including paying your supplier and receiving money from your consumer. Your supplier also distributes things straight to your consumer, so you’re not involved in that process either. Although this may save your company time, it may also mean that operations are not handled as you desire, potentially jeopardizing relationships with suppliers or customers.
- Service businesses are not eligible
You must have tangible goods the supplier can create and deliver to your customer to qualify for purchase order financing. Purchase order financing is not available for service-based firms. Invoice financing may be better if you provide services and bill your consumers for them.