Summary: Purchase order (PO) financing companies often advise prospective clients to work jointly with a factoring company. Combining both products can reduce the total financing cost of a transaction and provide additional capital to the company. However, settling a transaction through a factoring line only benefits some transactions.
This article explains how a purchase order funding transaction is settled using both solutions and helps you evaluate the benefits of using each settlement option. The article assumes you are familiar with both products and how they work, though we have a summary of each. The article covers:
- What is purchase order financing?
- What is factoring?
- Transaction settlement
- Comparing settlement options – sample transactions
- Should you always use both products?
1. What is purchase order financing?
Purchase order financing is a solution that helps distributors pay for the supplier costs of a large order. The finance company handles the supplier cost and pays the supplier directly. Purchase order funding enables cash-strapped companies to fulfill a large order and book the revenue.
Financing rates vary by transaction. However, the average PO financing rate is 3% per 30 days. You can determine the cost of financing a transaction by applying the rate for a given time period to the utilized funds. To learn more, read “What is Purchase Order Financing? How Does it Work?”
2. What is factoring?
Factoring financing helps small companies that cannot wait 30 to 60 days to get paid by clients. The factoring company improves your cash flow by purchasing your invoices and paying you for them immediately. This type of financing provides cash flow to help pay company expenses and grow the business.
Factoring rates range from 1.15% to 3% per 30 days, though rates vary by financing volume. You can determine the factoring costs by applying the rate for a given time period to the gross invoice amount. To learn more, read “What is Invoice Factoring?”
3. Transaction settlement
The simplest way to settle a purchase order financing transaction is to use your existing line. You wait until your customer pays their invoice and let the purchase order financing company settle out.
Some transactions benefit from settling through a factoring line. This method can reduce your financing cost while also providing additional working capital. It works by factoring the invoice after you send it to the client.
You use the factoring advance to pay off the PO financing company and to improve your working capital position. From then on, the transaction proceeds like a regular factoring transaction that settles when your customer pays.
4. Comparing settlement options – sample transactions
The most effective way to understand how a purchase order financing transaction settles is to compare two examples. The first example shows a transaction that settles using the purchase order financing line. The second example shows the same transaction, but it is settled through a factoring line.
a) Transaction setup
Let’s examine a sample purchase order financing transaction. ABC Supplies sells $1,000,000 worth of electronics to a Super Store, a major retailer. ABC Supplies operates as a reseller; they buy the electronics from a supplier and resell them to clients at a profit.
Their leading supplier is ACME Corp, which is located overseas. ACME Corp will charge ABC Supplies $650,000 to fulfill this transaction. They can deliver the goods to Super Store sixty days after ABC Supplies places the order.
ABC Supplies can invoice Super Store at delivery and expect to be paid on net-30 terms. This transaction is financially attractive to ABC Supplies due to its profit margins. However, they don’t have $650,000 to pay the supplier. Consequently, they decide to use financing.
b) Example 1: PO financing alone
ABC Supplies engages a purchase order financing company to help with the transaction. The PO financing company agrees to pay the supplier costs and charges 3% per 30 days for the service. The costs accrue until the end customer pays the invoice. Once the invoice is paid off, the transaction settles.
This table shows a transaction summary along with the financing terms.
| Super Store Order | $1,000,000 |
| Acme Corp (Supplier) | $650,000 |
| Gross Margin | 35 % |
| PO Financing Rate (30 Day) | 3.00% |
| PO Financing Rate (Daily) | 0.10% |
ACME Corp takes 60 days to manufacture and ship the electronics. Additionally, Super Store takes 30 days to pay their invoice. Consequently, the transaction is open for 90 days.
After paying the invoice, the PO financing company subtracts the funds they paid ACME Corp and their fee. The remaining $291,500 is deposited in the ABC Supplies account.
The financing fee is calculated by multiplying the supplier cost by the accrued financing rate. In this case, multiply $650,000 by 0.10% (daily rate) by 90 days to get a financing fee of $58,500.
The following chart illustrates the transaction settlement figures.
| Super Store Payment | $1,000,000 |
| Less: Amount Paid to Acme | ($650,000) |
| Less: Financing Fee | ($58,500) |
| Due to ABC Supplier | $291,500 |
The PO financing fee is calculated as follows:
| Supplier Cost | $650,000 |
| Daily Cost | 0.10% |
| Number of Days | 90 |
| PO Financing Cost | $58,500 |
c) Example 2: PO financing combined with factoring
Let’s consider the same transaction but settle it through a factoring line. ABC Supplies gets the same PO financing terms. They work with a factoring company that offers an 85% advance at a rate of 1.75% per 30 days. The following chart shows the transaction setup.
Here is a summary of the transaction:
| Super Store Order | $1,000,000 |
| Acme Corp (Supplier) | $650,000 |
| Gross Margin | 35 % |
It has the following financing terms:
| PO Financing Rate (30-Day) | 3.00 % |
| PO Financing Rate (Daily) | 0.10 % |
| Factoring Advance | 85% |
| Factoring Rate (30-Day) | 1.75% |
Like the previous example, ACME Corp manufactures and ships electronic products in 60 days. Once the goods are received, ABC Supplies issues an invoice to Super Store. However, they factor the invoice and use the proceeds to pay off the PO financing line and to improve their working capital.
The following chart shows the funds needed to settle the transaction with the purchase order financing company.
| Amount Paid to ACME Corp. | ($650,000) |
| Days Open | 60 |
| PO Financing Cost | ($39,000) |
| Due to PO Financing Company | ($689,000) |
This table shows how the funds are distributed once the invoice is factored:
| Super Store Invoice | $1,000,000 |
| 85% Factoring Advance | $850,000 |
| Paid to PO Financing Company | ($689,000) |
| Advance Due to ABC Supplies | $161,000 |
ABC Supplies factors the $1,000,000 and gets an 85% advance of $850,000. The funds to pay off the PO financing company are subtracted from the advance.
The $689,000 needed to pay off the PO financing company is calculated by adding the $650,000 paid to ACME Corp to the $39,000 financing fee. The financing fee is determined by multiplying $650,000 x 60 (days) x 0.010% (daily rate).
The remaining $161,000 is deposited into the ABC Supplies account. ABC Supplies can use this working capital injection to pay other business expenses.
The transaction now proceeds as a regular invoice factoring transaction. After 30 days, Super Store pays off the $1,000,000 invoice. The factoring company settles the transaction as shown in this chart.
Super Store pays the invoice, as shown in this table:
| Invoice Payment | $1,000,000 |
| Days | 30 |
| Factoring Cost | $17,500 |
The factoring company settles the transaction as follows:
| Super Store Payment | $1,000,000 |
| Less: 85% Advance | ($850,000) |
| Less: Factoring Fee | ($17,500) |
| Settlement Due to ABC Supplies | $132,500 |
The factoring company subtracts the $850,000 advance and their $17,500 fee. The fee is calculated by multiplying $1,000,000 by the 1.75% cost for 30 days. The remaining $291,500 is remitted to ABC Supplies, which closes the transaction.
d) Comparing both options
As shown in the following chart, the fees for settling through a PO financing line alone were $58,500. Combining PO financing factoring decreased the cost to $56,500, providing a $2,000 savings.
| PO Financing Only | ($58,500) |
| PO Financing and Factoring | ($56,500) |
| Savings | $2,000 |
While the savings are not substantial, they can add up if your company finances several transactions. You can realize further savings by forgoing the working capital injections and factoring a partial invoice. This approach provides enough funds just to close off the PO financing line.
Keep in mind that savings are not guaranteed, and some transactions could end with higher costs. For this reason, you must determine whether to use factoring on a case-by-case basis.
In our opinion, the important benefit of using factoring to settle a PO financing line comes from the working capital injection. These funds can help you with company expenses and new transactions.
5. Should you always use both products?
In many cases, combining both solutions provides more advantages than using PO financing alone. These advantages can come from lower costs, additional working capital, or both.
Every transaction differs, and several variables affect the cost and working capital availability. These include:
- Final invoice size
- Supplier cost
- Delivery time for the supplier
- Shipping time
- Length of time for end-customer to pay their invoice
- PO financing rate
- Factoring rate
- Factoring advance
Changes in these variables affect whether combining both solutions or using PO financing alone is better. No single answer applies to every transaction. Instead, every transaction must be carefully reviewed to determine the most cost-effective financing option.
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Legal disclaimer: This transaction and article are for illustration purposes only and all numbers are hypothetical. You should not rely on it to make legal or financial decisions.