Purchase order (PO) financing has become a popular option for growing resellers and distributors. It helps cover supplier expenses associated with large purchase orders.
However, PO financing can be challenging to understand at first. It follows a different structure and has different requirements than typical financial products.
This article helps small business owners navigate the decision to use purchase order financing. You will learn how it works and whether it’s a good fit for your company. We cover the following:
- What is purchase order financing?
- Can it help your small business?
- Benefits and disadvantages
- How does it work?
- How much does it cost?
- How to choose the right company?
- Alternatives to PO financing
1. What is purchase order financing?
Purchase order financing helps small and midsized distributors that have a large order but need funds to pay their suppliers. It covers the supplier expenses associated with the order, enabling you to fulfill it.
This solution is designed to help companies that re-sell products and have high gross margins. It has simple qualification criteria, is available to small companies, and can be set up quickly.
2. Can it help your small business?
PO financing can be a great option to finance a growing small business, provided the business meets the following criteria.
a) Do you re-sell a product?
Your company must be a product reseller or distributor. It must buy the finished product from a supplier and sell it without modifications. Manufacturers and companies that assemble products should consider supplier financing instead (see #7).
b) Is your order big enough?
Purchase order finance companies often have minimums. This means that they are only able to finance orders that are above a specific value. Minimums vary by company, and most set it at $100,000.
c) Have you sold this product before?
Your company must have sold this or similar products before. Having prior product sales shows the finance company that you have ironed out the logistics of the sale. Note that exceptions can be made on a case-by-case basis.
d) Are your gross margins over 20%?
Purchase order financing works best for transactions whose gross margins exceed 20%. A higher margin provides a safety cushion and adds flexibility to the transaction.
e) Is your client credit-worthy?
The customer paying the invoice must have good commercial credit. Alternatively, it must be a government agency.
f) Does your supplier accept Letters of Credit?
Finance companies pre-pay all suppliers using a Letter of Credit or similar instrument. A Letter of Credit protects both sides of the transaction. It guarantees payment to your supplier as long as they fulfill your order correctly. Note that the purchase order financing companies cannot pre-pay foreign supplies with a wire transfer.
3. Pros and Cons
Purchase order financing has several benefits but also a few drawbacks. Small businesses must evaluate these to determine if the solution is right for them.
a) Benefits
In our experience, the following benefits are the most important for small business owners.
i. Allows you to take on very large orders
The most important benefit of purchase order financing is that it enables companies to takelarge orders. Consequently, it is no longer constrained by its current capital.
ii. Covers most/all supplier expenses
Finance companies can typically cover 100% of your supplier expense as long as your gross margins are at least 30%. The client usually covers the difference in transactions with lower margins.
iii. Available to new and small companies
The type of funding is available to startups and small companies. Note that startups should have completed one sale from beginning to end to be considered.
iv. Simple qualification criteria
The qualification criteria for funding are comparatively simple. Consequently, the due diligence process can be completed fairly quickly.
v. Scale the line quickly
The line is designed to scale quickly as your company grows. The principal requirements to qualify for line increases are a valid purchase order, a high-grade customer, and the ability to fulfill it.
b) Disadvantages
However, this solution has three disadvantages that you must consider.
i. Serves a narrow need
The most important disadvantage of purchase order financing is that it only works in strict re sale transactions. The solution is designed to avoid manufacturing risk. This challenge limits its usefulness for many companies.
ii. More expensive than other options
Purchase order financing handles transactions considered ‘high risk’ by conventional finance companies. This level of risk is reflected in its high price. Consequently, this solution works only for transactions with high margins.
iii. Introduces transaction complexity
This solution introduces complexity to your transaction because it adds the finance party. Some clients or suppliers may object to this.
4. How does purchase order financing work?
The initial step in every transaction is to evaluate if it qualifies for this type of funding. Transactions that qualify go through the following general steps.
a) Supplier payment
Suppliers typically require a payment or guarantee to begin working on your order. This payment is typically handled using a Letter of Credit from the finance company’s bank.
b) Product manufacture and inspection
The supplier manufactures the product and/or assembles the order. Upon completion, the order is inspected by a 3rd party company (e.g., SGS) to ensure it complies with your order.
c) Product shipping and delivery
The product is shipped to the location where the client will receive it. This location varies by transaction. Some clients can take delivery at their facility. Others may take delivery once the goods are loaded onto a vessel (e.g., FOB).
d) Transaction settlement
Transactions can be settled in two different ways. The simplest method is to wait until the customer pays their invoice, typically on Net-30 terms. Alternatively, you can settle through a factoring company. This type of settlement can increase your cash flow but is somewhat more complex.
Read “How does purchase order financing work?” to learn more.
5. How much does it cost?
The financing cost of a transaction averages between 2.5% – 3.5% per month. It varies and is determined by your transaction’s size and risk profile.
Most finance companies charge the fee using ten-day increments for the first month and then move to daily pricing. However, this model can be adjusted based on specific situations. Read “Purchase order financing costs explained” to learn more.
6. How to chose the right finance company?
Working with the right finance company is essential to the success of your transaction. The following four questions will help you evaluate finance companies.
a) Do they focus solely on PO funding?
You will usually get better service and terms if you work with a company that focuses solely on PO financing. Some factoring companies offer purchase order financing as an ‘accommodation’ to certain clients. These accommodations can be limited and typically work only with simple or smaller transactions.
b) How long have they been in business?
A company with a long track record of operations is preferable to a newer company. Their longevity shows they can manage transactions in different economic environments.
c) Are they familiar with your industry?
Working with a finance company familiar with your industry helps transactions go smoothly. The finance company will know your suppliers, products, and logistics.
d) Do their transaction limits meet your requirements?
Most finance companies have minimum transaction sizes or work only with certain industries. Ask about these beforehand to ensure that the finance company is a good fit for your business.
7. Alternatives to PO financing
The main alternative to purchase order financing is supplier financing. While supplier financing is more flexible and can be used by manufacturing companies, it has stricter qualification criteria.
In general, your company will need:
- Yearly revenues over $2,000,000
- Three-year track record of profitability
- Credit-insurable clients
Get more information
We are a leading purchase order financing company and we work with small businesses. For more information, get an instant quote or call us toll-free at (877) 300 3258.