Purchase Order Financing
Businesses that lack sufficient cash flow to purchase materials, use purchase order financing to fund procurement. This ensures that the order is fulfilled and they can keep their commitment – even if they do not make a profit.
Purchase order financing allows the benefit of obtaining timely supplies to fulfil orders and sustain reliable relationships with clients.
What Is Purchase Order Financing?
Purchase order financing is an agreement that you enter into with a finance company whereby the company lends you money for procurement. Once your order is fulfilled, the company will also receive payment on your behalf.
How Does Purchase Order Financing Work?
Purchase order loans aid procurement. If you lack the funds to purchase raw materials or fulfil an order, you may approach a finance company for funds. The company will pay your supplier on your behalf. Once your order is fulfilled, the company will also receive the payment on your behalf. Finance companies charge a small fee for their services. Once this fee is deducted, the balance is transferred to you.
How Much Loan Can You Get?
Theoretically, it is possible to get 100% finance to fund your procurement. In practice, however, lenders require business owners to fund part of the procurement. The actual contribution by the financier and the borrower varies from one company to another, as do interest rates and the fees.
The process can take up to two weeks, depending on the product you deal with and the time needed for production and fulfilment.
A Step-By-Step Guide to Purchase Order Financing
Unlike invoice financing where you sell or mortgage your invoices, purchase order financing is a more complex process. Here is how it works-
- There are three parties involved in a purchase order financing contract – the borrower (you), your supplier and the financing company. Your customer is involved to the extent that he/she pays for goods purchased.
- Your customer sends you a purchase order specifying the requirements.
- You assess your inventory to determine your procurement need.
- You ask your supplier for a quotation.
- Based on your supplier’s quotation, you decide whether you will need finance to fulfil the order.
- Assuming you need a loan, you approach a financing company and make an application for a loan.
- The financing company will assess your application and make an offer to fund your purchase. This may be as low as 50% or as high as 100% depending on your creditworthiness.
- The finance company pays your supplier the agreed amount. If the loan sanctioned is less than 100%, you fulfils the shortfall.
- Your supplier delivers the material or goods either to you or to your customer.[A1]
- Once the order is fulfilled, your customer makes payment to the finance company. If your customer demands a credit line, the finance company may insist on invoice factoring.
- Once the payment is complete, the finance company will pay you for the order after deducting their fee and interest.
Who Is Eligible For Purchase Order Finance?
Any business in need of funds for procurement may apply for purchase order finance. Typically, new startups, businesses with low credit rating and businesses dealing in finished goods – such as wholesalers and retailers – may opt for this source of finance.
Manufacturing and assembly units may also use purchase order funding to procure raw material or components for assembly. The risk to the lender is higher in case of businesses involved in manufacturing or assembly because of the involvement of three parties as against two – the supplier and the customer – in the case of finished goods.
The finance company will check the creditworthiness of the company seeking finance, the supplier, as well as the customer whose order is to be fulfilled. This is because the purchase order financier must be assured that the order will be fulfilled and payment will be forthcoming.
To this end, you and your supplier may have to submit historical financial statements, bank statements and projected financial statements. You may also have to submit proof of credit rating, business continuity, and other documents as required by the lender.
Most financing companies insist on minimum order value as well as minimum turnover as eligibility for finance.
Businesses may opt for purchase order loans in three situations:
- When the growth is extremely fast
- When they have heavy seasonal sales
- When the cash flow is cyclical and unable to fund supplies
Benefits of Purchase Order Finance
Easy Eligibility – Since payment will ultimately be received from your customer, finance companies are more concerned with your customer’s credit rating than your own. As such, it is easy to become eligible for purchase order loans.
No Guarantee Required – Institutional loans frequently require collateral or guarantee. With purchase order financing, your purchase order acts as collateral, and most lenders do not insist on a guarantee or collateral.
Ideal For Startups – Purchase order financing is ideal for new businesses, startups, and other small businesses that lack the funds to fulfil orders. New businesses strive to attract new customers and turning down even a single order can be bad for their business reputation.
Flexibility – Purchase order loans are flexible in the sense that funds become available when you need them. In fact, purchase order financing is technically a loan. The payment is made to your supplier, and the finance company takes over your invoice.
Promotes Business Growth – With purchase order financing, you never need to turn down an order for lack of cash or material. This means that your market standing improves – which is conducive to business growth and development.
Enables Sustenance – Small units strive to sustain and struggle with cash flow. In such cases, purchase order finance can help fund supplies, thus aiding the units to fulfil orders and maintain the business.
The Flip Side
While purchase order financing may seem like the ideal solution to your cash flow problems, there is a flip side that you should be aware of:
- Purchase order financing costs more than traditional loans.
- There is no guarantee that 100% of your procurement cost will be funded.
- It is short-term finance limited to a single order.
- The customer becomes aware of third-party involvement.
Purchase Order Finance vs. Other Forms of Finance
Purchase order finance funds your order and enables fulfilment. It is costlier as compared to other forms of finance. Here is how they compare:
Purchase Order Finance vs. Invoice Factoring – Purchase order financing helps to fund procurement, while invoice factoring liquidates your invoices. The former begins when you receive the order while the latter starts after fulfilling the order.
Purchase Order Finance vs. Institutional Loans – Purchase order is for a specific purpose, while institutional loans may be used for any purpose. In the former, you can close the account within two or three weeks – as soon as your order is fulfilled – while in the latter, the loan term may be longer.
Purchase order financing is ideal for new start-ups and businesses that wish to expand and grow. By adopting purchase order financing, these businesses will be able to channel their cash to other areas such as marketing and logistics.