What Is Purchase Order Financing?

What is purchase order financing? 

A purchase order (PO) is an agreement to pay for goods or services. Companies of all sizes, from multi-billion-dollar manufacturers to small bakeries, use purchase orders to protect themselves and their customers. 

However, there are times when a purchase order is too large or too expensive to fulfill. When this occurs, the organization needs to seek out financing options to pay suppliers, so they can hold up their end of the purchase agreement. A common solution to this problem is purchase order financing. 

Going back to your high school economics class, think about this in terms of a lemonade stand. It’s fine to fulfill one lemonade cup order for a dollar, but what happens when someone orders 1,000 cups of lemonade and promises to pay you upon delivery? You don’t have the money yet for enough lemons and sugar to fulfill the order.

With PO financing, a lender can help to ensure the order gets fulfilled—protecting your customer, your supplier, and everyone else involved in the process.

Purchase order funding is not working capital.

Before diving deeper into PO financing, it’s important to consider what this form of funding isn’t. Purchase order financing is not a working capital loan. You can’t bring a purchase order to a lender and receive cash to fulfill a major order. One of the biggest misconceptions about PO financing is that business owners simply receive the loan like they would with any other source of funding. However, it’s more complicated than that. Let’s review what purchase order funding is so you can understand what it’s not.

How purchase order financing works.

Purchase order financing works when you bring in a lender to mediate between you, your supplier, and your customer. Here are a few steps that explain how this process works:

1. You’ll provide a clear purchase order to your lender to review. 
2. If the lender approves the loan, they’ll reach out to your supplier to discuss the materials and manufacturing. 
3. Your lender will pay your supplier for the work.
4. Your supplier fulfills the order and presents it directly to your customer (not to you, the business owner). Their role in the process is over. 
5. You’ll send an invoice to your customer to pay for the order.
6. The customer pays the financing company, not you. Your lender will take their side of the fees and send you the balance.

Throughout each of these steps, the lender is involved with the purchase process. They need to make sure the order is fulfilled and the customer is happy—or the invoice won’t get paid and they’re not getting their money. 

If you want to return to the lemonade stand example again, it’s like your mom going to the store and making the lemonade for you, but letting you have the profits only after she delivers the order to the customer.    

Understanding the costs of purchase order financing.

When considering PO financing, it’s essential to understand the costs associated with this form of funding. Unlike traditional loans, the costs of PO financing aren’t defined by interest rates alone. They’re typically calculated as a percentage of the purchase order value.

Here’s a simple breakdown of how it works:

1. Financing fee – This is usually the primary cost. It’s a percentage of the total value of the purchase order and typically ranges from 1.8% to 6% per month. The exact percentage depends on factors such as the complexity of the transaction, the perceived risk, and the lender’s criteria.
2. Due diligence fee – This fee covers the lender’s cost to vet the deal. It includes verifying the legitimacy of the PO, the creditworthiness of your customer, and the capability of your suppliers. It typically ranges from $400 to $600.
3. Other potential fees – Depending on your lender, there might be additional costs such as origination fees, administration fees, or wire fees. It’s crucial to ask your lender about all possible fees upfront to avoid unexpected surprises.

Remember, the total cost of PO financing isn’t simply the sum of these individual charges. The true cost should also consider the opportunity cost of potentially losing a large order if you can’t fulfill it without financing.

How do I qualify for PO financing?

If you are considering PO financing, there are a few things you need to know. Having the right information beforehand can make the loan process easier and bring you closer to approval. 

• Verifiable purchase orders – Oftentimes, business owners mistakenly request funding when a PO is about to come through or when they’re responding to a proposal. A lender won’t fund your order unless the customer has already submitted the order. 
• Time in business – Criteria here will vary by lender. Some have no minimum while others will look for a minimum of one year in business.
• Profit margin – Many purchase order financing companies require at least a 20% to 30% profit margin on any project they agree to fund. This ensures that the lender can get paid and the company still makes money in the process. 
• Down payment – This will vary by lender. Some have no down payment requirements, while others will require a down payment that varies based on the terms of the agreement.
• Collateral – Some purchase order financing companies will take a blanket lien on the company’s assets.
• Type of product – Most funders will only provide PO financing for tangible products—not services. They may also have restrictions based on whether you’re ordering completed products versus raw goods.
• Customer – Your customer must either be a commercial business or a government entity.

If you plan to work with a PO business to get funding, make sure you read their requirements carefully. A good lender will explain clearly what they need before you start the application process. 

Pros and cons of purchase order financing.

Like any financial decision, PO financing comes with its own set of advantages and disadvantages. Understanding both sides can help you make a more informed decision about whether it’s the right choice for your business.

Pros

1. No need for perfect credit or business history – Unlike traditional loans, PO financing isn’t necessarily based on your company’s credit history. Instead, lenders focus on the creditworthiness of your customers and the validity of the purchase order.
2. Helps manage cash flow – PO financing can bridge the gap between receiving an order and getting paid, helping you maintain a healthy cash flow.
3. Fulfill larger orders – With PO financing, you’re able to accept and fulfill larger orders that might otherwise be out of reach due to financial constraints.
4. Quick turnaround – You’ll generally have access to funds within two to 10 days.

Cons

1. Cost – PO financing can be more expensive than traditional financing options. Lenders take on a considerable amount of risk and charge accordingly.
2. Loss of control – Since the lender is directly involved in the process, you may feel like you’re surrendering some control over your operations.
3. Limited to physical goods – PO financing is typically only applicable to businesses dealing with physical goods. Service-based companies may not qualify.

Remember, it’s crucial to consider your specific business needs, circumstances, and financial health before opting for PO financing. Consulting with a financial adviser could provide valuable insights tailored to your situation.

How to choose the right purchase order financing company.

Choosing the right purchase order financing company is crucial for the success of your business. There’s no one-size-fits-all solution—what suits one business may not necessarily meet your unique needs. Here are a few tips to guide you:

1. Experience and reputation – Consider the company’s experience in the industry and its reputation among other businesses. A lender with a long track record of success is generally more reliable and adept at handling different types of financial issues. Be sure to check out their reviews or ask for references.
2. Understand the terms – It’s crucial to understand the terms and conditions of the financing agreement. This includes interest rates, fees, repayment terms, and any potential hidden charges. If something seems unclear, don’t hesitate to ask for clarification.
3. Customer service – Opt for a lender that is responsive and has a good customer service record. You want someone who is readily available to answer your questions, offer advice, and resolve any issues that may arise during the process.
4. Flexibility – Look for a company that offers flexibility. Every business has unique needs and challenges. A lender that can adjust its terms or provide a customized financial solution can be invaluable.
5. Industry knowledge – A PO financing company with knowledge of your industry can better understand your business needs and challenges. This can lead to a smoother working relationship and more effective financial solutions.

Remember, it’s not about finding the cheapest financing company, but rather finding the one that understands your business and offers the most value. So, take your time, do your research, and make an informed decision.

Alternatives to purchase order financing.

While PO financing can be an effective solution for certain businesses, it might not be the best fit for everyone. Luckily, there are various other financing options available that you might want to consider.

Invoice factoring

Invoice factoring is a similar concept to PO financing, but it focuses on invoices instead of purchase orders. If you’re dealing with customers who take a long time to pay, this can be a great option. You essentially sell your outstanding invoices to a factoring company, which gives you an immediate cash advance. When your customers pay their invoices, the money goes straight to the factoring company.

Business lines of credit

A business line of credit provides flexibility that a regular business loan doesn’t. It’s a revolving fund that you can tap into whenever you need it. You only pay interest on the funds you use, and once you pay back the funds, your line of credit refills to its original amount.