This post was reviewed and updated on July 22, 2020
When clients pay late or you have a large expense to cover, it compromises your business’ ability to pay other things, like payroll and utilities.
Sound familiar? You’re far from alone. Cash flow challenges are a common issue that many businesses have to overcome. These challenges are what cause many businesses to explore financing options.
While there are many different funding solutions available, we’ll cover a funding method known as purchase order financing. Depending upon your business and its specific borrowing needs, a purchase order loan 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
- How Purchase Order Financing Is Different from Factoring
- Alternative Borrowing Methods
- Where to Find the Best Purchase Order Finance Companies for Your Business
- The Value of Building Good Credit
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 transactions and orders coming in than they have the inventory or cash to fulfill.
If you don’t have the resources (either in inventory or working capital) to fulfill 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 lender 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 or not 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 presold goods.
- Your customer pays its invoice (usually to the PO financing company directly).
- The PO financing lender takes out its fees from the funds paid by your customer.
- You receive the remaining balance.
Let’s use an example here. You sell dog collars, and just received an order for 100,000 of them. You don’t have the cash to place that order until you get the payment, so you take out purchase order financing.
You send the purchase order to your lender, along with the estimate from your supplier for the 100,000 collars. Your application is approved, and your lender sends payment directly to the supplier who then ships you the dog collars.
You send the collars to your customer, along with an invoice. The customer, happy with the 100,000 dog collars, pays the invoice directly to the purchase order financing company, who then takes out its fees and sends you the 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.
|Advantages of PO Financing||Disadvantages of PO Financing|
|You don’t have to turn down business and risk damaging your reputation because of working capital constraints.||If your client (who placed the order) has poor credit, you may have a hard time qualifying for funding.|
|You may be able to qualify for PO financing even with poor business or personal credit.||PO lenders may take as long as two weeks to fund.|
|New or small companies may have access to PO financing even if they might not yet be able to qualify for a loan from a traditional financial institution.||Financing costs tend to be on the high side when compared with other funding options.|
|PO financing isn’t a loan, so you don’t have to add monthly payments into your budget.||The cost of financing will take an additional bite out of your profit margin.|
|You can secure financing without selling equity in your company and sometimes without depleting your available cash.||Your customer will typically have to pay the PO financing company directly—possibly alerting them to your cash flow issues.|
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 long, reputable histories of delivering products as agreed
- Businesses with large purchase orders (often $50,000+, though this can vary)
- 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’ 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 lender will charge you fees for the money 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, they 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, 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:
- 6% for the first 30 days (charged on day 1)
- 3.5% for every 30 days after (charged on day 31, day 61, day 91, etc.)
This type of fee structure works in the financing provider’s favor 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 Financing vs. Factoring
Though similar, purchase order financing isn’t the same as invoice factoring. One of the biggest differences between purchase order financing and factoring has to do with when funding is received.
With PO financing, your business (or rather your business’ supplier) may receive funds at the front end of the sales cycle, once the purchase order is signed. Factoring, on the other hand, typically occurs a little later in the sales cycle. Invoice factoring lenders usually require you to submit an invoice to your customer (for products already delivered) before you become eligible for a cash advance on unpaid invoices.
Keep in mind, some businesses use PO financing upfront and switch over to invoice factoring later. The additional financing requires extra legwork, but for some businesses, it’s worth the added effort. Using a factoring company to pay off your purchase order financing agreement early might save your business money if the borrowed amount is large enough and the factoring company charges lower fees.
Alternative Financing Options
Depending upon your business, its credit rating, why you need to borrow, and a variety of other factors, purchase order financing might not be the best way to go when you have a large order and not enough capital to fulfill it.
Here are several alternatives to PO financing you might want to review:
Is a Purchase Order Financing Company Right for You?
As with most types of financing, you’ll be hard-pressed to find the “perfect” purchase order financing program. Business financing (or even personal financing) isn’t that simple. What works best for one business might not work best for the next.
Purchase order financing, like closely related accounts receivable factoring and financing options, usually isn’t the most affordable way for a business to borrow money. Nonetheless, it may still be a viable option if you can’t qualify for cheaper funding in the time frame you need to fulfill an order.
Unfortunately, there aren’t many lenders known for PO financing, and many lenders may have a high dollar requirement that may not fit your business needs. In that case, consider the alternative financing options above.
If you believe that purchase order funding is a good funding solution for your business, schedule a call with a Lending Specialist to talk through your best options and to find out if there’s a better financing product category for your needs.
Questions to Ask
Before you make your final selection, here are a few questions you should ask any potential purchase order financing lender you’re considering:
- How long have you been in business?
- Have you handled transactions in my industry? How many?
- What are the typical fees and costs you charge?
- Do you send funds to my supplier directly?
- What are your qualification requirements—for my business, my customers, and my suppliers?
- Will you contact my customers?
- How do you receive payment directly from my customers?
- Do you have a dedicated team that handles these payments?
- What happens if my customers fail to pay as agreed?
The answers to the questions above will help you to narrow down your choices and understand what to expect before you sign a new financing agreement.
The Value of Building Good Credit
Regardless of the financing solution you ultimately choose for your business, there’s no question that good credit can be a strong asset when you borrow. It’s true that your personal credit (and your business’ credit) usually matters less with purchase order financing than it does with other funding alternatives. But even though it matters less, the condition of your credit could still be a factor considered when you apply for PO financing.
Good credit can also make it easier to qualify for a broader range of funding options. A solid credit rating can help you to secure lower rates and better terms—potentially saving you money every time you apply for new financing for your business.
If you’re ready to start building a better business credit profile today, check out the free Nav account where you can also track both your business and personal credit and finances.
Of course, you can’t establish good business credit overnight. It will take hard work, consistent follow-through, and a bit of patience thrown in for good measure. But the sooner you get started, the sooner you can reach your goal and start enjoying all the great benefits that a solid credit profile can bring to both you and your business.
Nav’s Verdict: Purchase Order Financing
Whether you’re looking for cash to fulfill a government contract or large retail order, having access to capital is key. PO finance can get you the money you need to not only fulfill that order but also take your business to the next level.
This article was originally written on July 17, 2019 and updated on December 29, 2021.