Is Purchase Order Financing the Right Choice for Your Business?

In the fast-paced world of business, small businesses and startups often find themselves facing cash flow challenges, especially when large customer orders come knocking. This is where  Purchase Order Financing  (PO Financing) comes into play. It provides a lifeline to businesses that need capital to fulfill customer orders, especially when they don’t have enough working capital to cover the costs. This financing option offers businesses a solution to meet short-term funding requirements, allowing them to grow and expand without financial constraints.

What is Purchase Order Financing?

Purchase Order Financing is a type of short-term funding designed to help small businesses fulfill large orders when they lack the liquidity to do so. It provides a cash advance (sometimes up to 100%) for purchasing inventory or materials to fulfill a customer’s order. This financing option is typically extended by a third-party financier who pays the supplier directly on behalf of the business. Once the customer receives the goods and makes the payment, the financier collects the payment, deducts their fee, and transfers the remaining funds back to the business.

In essence, it acts as a bridge for businesses to meet customer demand while ensuring suppliers are paid promptly.

How Does Purchase Order Financing Work?

The process of obtaining Purchase Order Financing involves several steps. Let’s walk through each of them to understand how it works:

1. Customer Places an Order: The journey begins when a customer (buyer) places an order for goods, specifying the quantity, price, and delivery timeline.

2. Seller Connects with Supplier: The seller, who may not have enough funds to fulfill the order, contacts the supplier to get the materials required for production. The supplier sends an invoice for these goods.

3. Seller Applies for Financing: The seller then applies for purchase order financing to cover the cost of the goods or materials needed to fulfill the customer’s order.

4. Financing Company Evaluates: The financing company evaluates the order based on various factors, including the seller’s relationship with the customer and the creditworthiness of both the supplier and the customer. If the financier is satisfied, they offer to fund up to 100% of the order’s supplier cost (though 80-90% is more common).

5. Supplier Receives Payment: The financing company sends the funds directly to the supplier to manufacture and deliver the products to the customer.

6. Goods Delivered: The supplier ships the goods to the customer.

7. Seller Issues Invoice: After delivery, the seller sends an invoice to the customer, requesting payment.

8. Payment Received: The customer pays the financier, who deducts a fee for the financing and then sends the remaining amount to the seller.

Example of Purchase Order Financing

Let’s consider a practical example to better understand the process:

• Company A receives a purchase order from Company B to supply 10,000 electric bulbs. The total value of the order is $1,000.
• Company A contacts Supplier C, who agrees to manufacture the bulbs for $700. The invoice for this cost is sent to Company A.
• Company A then applies for purchase order financing from   Financier D  , who agrees to fund 100% of the supplier’s cost, which is $700.
• Supplier C manufactures and ships the bulbs to Company B.
• Once the shipment is delivered, Company A sends an invoice to Company B for $1,000.
• Company B pays Financier D, who deducts a 2% fee on the supplier’s cost ($14), and sends the remaining amount ($286) to Company A.

In this case, Company A earns a profit of $286 after fulfilling the order.

Why Do Businesses Use Purchase Order Financing?

1. To Expand Customer Base

For small businesses, acquiring new customers is crucial for growth. With PO Financing, businesses can fulfill large orders and tap into new markets, both locally and internationally.

2. Address Cash Flow Issues

Many small businesses worry about cash flow problems. According to reports, 61% of small businesses face cash flow issues every month. PO Financing can help them bridge these gaps and secure the necessary funds for growth without the stress of immediate payments.

3. Manage Seasonal Demand

Businesses often face a surge in demand during certain seasons or events. PO Financing helps them get the funds they need to meet this increased demand without jeopardizing their finances.

Who Uses Purchase Order Financing?

PO Financing is commonly used by businesses in industries where large orders require significant capital to purchase inventory or supplies. The businesses that typically use PO Financing include:

– Small Business Owners and Startups: These businesses may not have the working capital to fulfill large orders but want to grow by securing big clients. 

– Manufacturers and Distributors: Companies that manufacture or distribute finished goods often use PO Financing to ensure they can meet customer demands.

– Wholesalers and Resellers: Businesses in the wholesale or reselling sector often rely on external suppliers to fulfill customer orders. PO Financing allows them to access the capital needed to place bulk orders.

– Exporters and Importers: Companies that deal with international orders often use PO Financing to cover the costs of production or importation.

Key Documents for Purchase Order Financing

To apply for PO Financing, businesses need to provide the following documents:

• Purchase Order: The official order from the customer that details the products or services requested.
• Supplier Invoice: The invoice from the supplier showing the cost of the materials needed to fulfill the order.
• Seller’s Invoice to Customer: The invoice issued to the customer for the finished goods.
• Financial Statements: The seller’s financial records, including the balance sheet, profit and loss statement, and cash flow statement.
• Tax Filings: The business’s tax records may also be requested to assess financial stability.

Requirements to Qualify for Purchase Order Financing

To qualify for PO Financing, businesses typically need to meet the following criteria:

1. Sell Finished Goods: Businesses must deal in tangible, finished products rather than raw materials or semi-finished goods.

2. Profitable Margins: The business should have a profit margin of at least 15-20% on the order.

3. Creditworthy Customers and Suppliers: The business should have reputable and reliable customers and suppliers with good credit histories.

4. B2B or Government Sales: PO Financing is generally only available for businesses selling to other businesses (B2B) or to government entities. B2C businesses are usually not eligible.

Cost of Purchase Order Financing

The cost of PO Financing varies depending on factors such as the size of the order, the duration of financing, and the creditworthiness of the parties involved. Typically, businesses can expect to pay an interest rate between 1.8% and 6% per month. The interest rate may increase if the repayment period extends beyond 30 days.

In some cases, businesses may find that the interest rate is initially lower but increases after a certain period. For example, the rate may start at 2% per month, increasing by 0.5% every 15 days if the customer takes longer to make the payment.

Advantages and Disadvantages of Purchase Order Financing

Advantages:

1. Quick Access to Funds: PO Financing offers a fast, simple way to secure funding, typically within two weeks after approval.

2. No Collateral Required: Unlike traditional loans, PO Financing doesn’t require collateral or personal guarantees.

3. Flexibility: Businesses can use PO Financing on an as-needed basis, making it adaptable to fluctuating order volumes.

4. Risk Mitigation: Since the financing company is responsible for collecting payment from the customer, the business doesn’t have to deal with the risk of non-payment.

Disadvantages:

1. High Fees: The fees associated with PO Financing can be high, which may reduce a business’s profit margins.

2. Short-Term Funding: PO Financing is only available for short-term periods (usually 30-90 days), making it unsuitable for long-term projects.

3. Not Available for Service-Based Businesses: This financing option is only available to businesses that sell tangible products, not services.

4. Partial Financing: In most cases, PO Financing covers only 80-90% of the supplier’s cost, meaning the business may have to cover the remaining amount.

Conclusion

Purchase Order Financing is a valuable tool for businesses looking to fulfill large customer orders without the burden of upfront costs. It offers small businesses the flexibility and funding they need to grow and expand while addressing cash flow challenges. While it comes with its own set of costs and limitations, PO Financing can be an essential resource for businesses seeking to take on bigger opportunities and scale their operations.

Also Read:The PO Financing Process: Step-by-Step