Cash flow challenges are a common issue that many different businesses must overcome. In fact, it was found that the top two reasons a business borrows money are to either to expand or to solve immediate cash flow problems.
Of course, there are many ways to borrow money for your business. In this guide, we’ll cover a funding method known as purchase order financing. Depending on your business and its specific borrowing needs, purchase order financing might be an effective way to raise the working capital you need quickly.
Keep reading below to learn:
- What Purchase Order Financing Is and How It Works
- The Pros and Cons of This Funding Method
- The Cost of Purchase Order Financing
What Is Purchase Order Financing?
Purchase order financing, also called PO financing or purchase order funding, is a financing method that business owners have used to grow their companies and solve cash flow challenges for many years. PO financing can be a good fit for certain types of businesses that have more sales and orders coming in than they have the inventory or cash to fulfil.
If you don’t have the resources (either in inventory or working capital) to fulfil customer orders, purchase order financing may offer you a potential solution. How? This funding option can cover your upfront costs with your suppliers so that you aren’t forced to turn down lucrative sales and other opportunities due to business cash flow restrictions. It can help you to avoid burning bridges and losing customers in the future because you couldn’t afford to fill their orders now.
How Does Purchase Order Financing Work?
While purchase order financing can help you get the supplies you need to complete your customers’ orders, it doesn’t work the same way as the traditional loans with which you’re probably more familiar. Instead of giving you the funds you need to pay a supplier, the purchase order funding company will pay your supplier directly.
Here’s a 10-step overview of how the purchase order financing process typically works:
- A customer (usually another business) sends over a purchase order agreeing to buy a specific quantity of a product that your company sells.
- Once both parties (you and your customer) agree to the terms of the purchase order, it becomes a legal contract.
- You send a copy of the purchase order, plus the cost estimate from your supplier, to the financing provider to apply for funding.
- The PO financing provider reviews the purchase order, the supplier’s estimate, and other factors to determine whether to approve your application for financing.
- If approved, the PO financing lender pays not you, but rather your supplier directly.
- You receive materials from your supplier, finish the goods, and ship them to your customer. (Note: If your business is a reseller, the supplier would likely ship the finished goods directly to your customer.)
- You send an invoice to your customer for the order your company fulfilled.
- Your customer pays its invoice (usually to the PO financing company directly).
- The PO financing lender deducts its fees (see below for more info) from the funds paid by your customer.
- You receive the remaining balance.
Purchase Order Financing Advantages and Disadvantages
Are you considering a purchase order financing arrangement for your business?
Here are a few pros and cons to review during your search for funding:
Businesses that are usually the best candidates for purchase order financing include:
- Companies with business-to-business (B2B) or business-to-government (B2G) models
- Businesses whose suppliers have good financial track records and a long, reputable history of delivering products as agreed
- Businesses with large purchase orders
- Companies that lack the assets or credit rating needed to qualify for traditional financing options
- Businesses who have well-respected customers with solid credit ratings
- Businesses that don’t include guaranteed sale terms (i.e. your customer can return unsold products to you)
Even if your business seems like a good candidate, it’s important to make sure that a purchase order financing arrangement makes sense from a financial standpoint as well. This is something that your financing providers will also want to confirm before approving your funding application, but it’s smart to do your own homework here too.
Here’s what to look for:
A purchase order needs to be profitable enough to make money for all three parties involved. That will include you, your purchase order financing company, and your supplier. If your business’s profit margin on a deal is less than 15% to 20%, you may not qualify for this type of funding.
What Is the Cost of Purchase Order Financing?
First, it’s important to understand that purchase order funding isn’t a loan. So, this type of financing doesn’t actually come with an interest rate. Instead, a PO financing company will charge you fees for the funding you receive.
The fee you pay is usually a percentage of the money the financing provider advances to your supplier. Fees can vary considerably from one PO financing company to the next. However, the fees are commonly in the range of 2% to 6% per month.
That 2% to 6% per month might not seem very high, but when you use a business loan calculator to convert those fees over to APR (Annual Percentage Rate) the true cost can be surprising. Purchase order funding can frequently cost between 20% to 70% APR — a costly borrowing option when compared with many other business loans and funding choices.
It’s also worth noting that fees for purchase order financing aren’t generally prorated. So, you may be charged on the first day of each new billing period. For example, the fee structure of your agreement might look something like this:
- 6% for the first 30 days (charged on day 1)
- 5% for every 30 days after (charged on day 31, day 61, day 91, etc.)
This type of fee structure works in the financing providers favour and not yours. Whether the financing provider is paid back on day 61 or day 89, you would pay the same amount in fees.
Purchase Order Funding can though make sense for your business and is worth considering if you wish to boost your cash flow.
Flex Capital offers a Purchase Order Funding solution that injects cash flow into your business.
We also offer Structured Finance and Invoice Discounting options.
The source of this article can be found here.