Purchase Order Financing
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What is Purchase Order Financing?
Essentially, PO funding capitalizes on the active purchase orders that a business uses as collateral to secure funding for a loan to fill their purchase orders.
By using this source to boost working capital, a small business can borrow up to 100% of the money or cost needed to fulfill an order the customer places. This offers business owners flexibility when it becomes a challenge to fill active orders which in turn keeps your cash flow stable.
Who Can Use Purchase Order Financing?
A purchase order (PO) is a contract that buyers send which indicates the quantities, prices, and types of products or services they are looking to purchase. These buyers usually order in bulk. However, without the right amount of cash, the suppliers cannot fulfill this order. For that reason, they usually apply for purchase order financing.
This type of funding resource is most commonly used by companies that are rapidly growing and, or not able to fulfill the quantity or size of orders they have committed to. Companies that can take advantage of this financing plan include:
Businesses with poor credit rating
Import and export companies
PO Funding Advantages
Compared to other types of traditional lending options, PO funding is also typically easier to qualify for. This is what makes this option attractive to most business owners. The main advantages associated with it are speed, liquidity, ease of credit (qualifications) requirements, and the funding’s flexibility.
The Speed of Application Approvals
This solution is different from other lending options for the simple reason the purchase order itself serves as collateral that secures the funds. This often speeds up the application and qualification process because the lender often does not have to take as much time with documentation and underwriting.
Once the value of a PO is established, the lender in most cases makes their qualification decision quickly. Once an approval decision is made, funds arrive much quicker than with traditional bank loan products.
On the other hand, PO funding for small businesses ensures that capital is available whenever they receive new purchase orders. This allows them to fulfill all of their orders, regardless of the size and date.
In addition to the business’ ability to fill all orders, taking advantage of PO financing will also keep other credit lines and other sources of capital available for future expenses. Instead of using operational cash flow to fill purchase orders, purchase order financing allows you to free up funds to be utilized elsewhere.
You need to demonstrate that your clients have a strong history of paying their invoices in a timely manner. The more you can prove that they can fulfill their end of the agreement, the higher your chances for approval.
PO Financing Disadvantages
Fees Tend to be Higher
It Doesn’t Guarantee a 100% Financing
The Financing Company Pays the Suppliers Directly
It’s Not Suitable for Long-Term Needs
How does Purchase Order Financing work?
First, there is the seller that received the purchase order, followed by the one seeking financial assistance to help fulfill the order. The second party is the customer that placed the order with the first party. The third party is the supplier that the first party purchases goods or services from which enables them to fulfill their customers’ orders. The fourth party is the lender that is providing the working capital used to pay suppliers.
Small businesses of all sizes use purchase orders to balance and maintain their operating cash flow. Without it, they would be unable to support new and existing orders. Filling purchase orders is critical for a business to stay functioning, and PO funding is one way to accomplish this. By taking advantage of this source as well as other lines of credit, a small business can easily fulfill orders.
The process itself consists of seven key steps. A purchase order is received from a customer which contains a breakdown of costs from the supplier. PO is submitted to the lender and the lender pays the supplier. The supplier in turn provides the goods to the customer who then pays the lender, and the lender pays the final balance to the borrower.
Here’s a breakdown of the steps involved in Purchase Order (PO) Financing:
Step 1: Receiving a Purchase Order from the Customer
Step 2: Supplier Provides Cost Breakdown for Order
This information is essential when applying for PO financing because this is what determines the number of funds necessary to fill the order.
Step 3: Submit Purchase Order to Lender
Step 4: Lender Pays the Supplier
Step 5: Supplier Delivers the Goods to the Customer
The lender makes the payment to the supplier enabling the customer to receive their order, giving the borrower the ability to transfer the cost of filling an order to a lender.
Step 6: Customer Pays the Lender
Step 7: Lender Pays Balance
It is important to note that the rates are applied to the cost of the order, not the cost of the purchase order. Once the lender receives the invoice payment from the customer, the lender receives their payment via the feed rate and returns the outstanding balance to the borrowing business.
What type of collateral is used for Purchase Order Financing?
PO’s typically outline the terms of the sale, which include the price of the goods or service, the quantity ordered the terms of payment, the shipping date, and delivery details, along with other incidental details associated with the order. Once the purchase order is accepted by the seller, the purchase order itself can be used as collateral when the seller applies for financing.
The LTV (or loan to value ratio) for PO financing agreements is typically between 30% to 40%, but once the goods are delivered or the services are rendered, the purchase order becomes an invoice and the remaining 40-50% of the invoice can be advanced from the lender to the borrowing business.
Accounts Receivable (A/R)
For most purchase order lenders, the accounts receivable directly associated with the purchase order funded will allow the lender to collect payment after the supplier delivers the goods.
Typically, the LTV ratio for accounts receivable is up to 90% of the face value of the invoices associated with the purchase orders. These rates can vary from lender to lender and will be determined based on different characteristics of the borrowing business and purchase order agreements.
Lenders will typically consider the credit strength and quality of the customers, the payment terms that are offered in the purchase order agreements, as well as the diversification of the client base associated with the borrowing business.
Purchase Order Financing vs. Invoice Factoring
The first step is an order placed by the buyer from the seller. Once the order is received, the seller fills the order via their suppliers. With the details in hand, the order is shipped and delivered to the buyer.
The buyer receives their order along with an invoice. That invoice is owed to the seller unless a purchase order funder provided the funding for the order.
PO funding solves the liquidity need for the borrowing business at the time an order is received and filled. On the other hand, if an order is shipped and the invoice is created, the invoice can be used for invoice factoring if there are no purchase order financings generated.
The difference between PO funding and invoice financing is the time in which the goods are shipped and a borrowing business receives payment. With purchase order funding, the goods are yet to be shipped, which makes the transaction a higher financial risk for the lender.
With invoice factoring, the goods or services have already been delivered and accepted, which reduces the risk for the lender and ultimately will provide lower rates and fees for the borrower.
PO Financing Rates and Fees
Purchase order funding rates and fees are based on a variety of different factors that the lender considers. Because of the nature of the financial risk associated with this type of financing, the rates and fees are often more expensive than with other traditional bank financing sources.
Often, rates and fees range from 1.5% to 3.5% per 30-day period. It is important to highlight that the rates and fees are applied also to the cost of filling the order, not only the purchase order value.
For example, if a borrower receives a 100% gross margin for a purchase order, and the purchase order has a total value of $100,000, the cost of filling the order would be $50,000. The rates and fees paid by the borrowing business after the customer is invoiced will be applied to the $50,000 cost of filling the order, as opposed to the $100,000 that is invoiced to the customer.
Different lenders take into account several different factors when evaluating applications. The lender will analyze the credit risk of the purchase order by assessing features of the borrowing business along with their client base when determining the rates, fees, and qualification status.
What are the Qualifications for PO Financing?
Sell finished, assembled products
Accept purchase orders in large amounts
Sell to other businesses or government customers
Have reputable suppliers that offer high-quality products
Profit margins should reach at least 30%
Customers must have a good credit background
FAQ About Purchase Order Financing
What is purchase order financing?
When a business doesn’t have the capital to fulfill orders, they can capitalize on the value of the purchase order itself in order to ensure the orders promised to clients are filled.
How do you qualify for PO financing?
With PO funding, the lender is primarily concerned that the borrower’s customers who are being invoiced are financially healthy, and able to make the invoice payments.
How long does the application process take for purchase order financing?
How do you use PO financing?
Is collateral required for purchase order financing?
Instead of using inventory, equipment, or real estate as collateral, you are able to capitalize on your existing purchase orders and obtain the funds you need in order to fill requisitions.