Last Updated on July 2, 2020 by Grey Idol
What can a small business do when it needs more cash to expand inventory? One option is purchase order financing, but it may not be the best choice for every company. It’s important to understand how the solution works before jumping into a deal.
What is Purchase Order Financing?
When a small business lacks the capital to purchase enough inventory to fulfill customer orders, it can be problematic and hinder the company’s growth. Purchase order financing companies provide funding to cover inventory and manufacturing needs so that a small business can satisfy its customers.
How Purchase Order Financing Works
Purchase order financing is a short-term solution that functions a lot like a loan. In this case, the PO financing company acts as the lender.
Company A receives a large order from a customer. Unfortunately, they don’t have enough product to fill the order, but they don’t want to turn down the customer and lose out on the business. Company A reaches out to a purchase order financing company for assistance.
The financing company agrees to lend Company A enough money to cover the cost of production. Usually, the lender only covers the cost of supplies or production, and they pay the manufacturer directly. As part of the deal, the manufacturer distributes the finished product to Company A’s customers.
Once the customer receives their products, they pay the lender. The purchase order financing company takes a percentage of the profits to cover their fees then delivers the rest of the profits to Company A.
Like every aspect of the business world, there are pros and cons to utilizing purchase order financing for your company. It’s not a complicated concept, and it can solve issues with shortages. However, any time you include extra people or steps in a process, it can be problematic.
The Benefits of Purchase Order Financing
It’s easy to see the most significant benefit to purchase order financing. You can accept orders you otherwise couldn’t fulfill. If your business has the opportunity to fill a massive order, but you lack the cash to make it happen, PO financing could save the deal.
Saving potential sales isn’t the only benefit of PO financing. It opens a lot of doors for businesses when they need it most.
It’s Easy to Secure PO Financing
There’s a good chance that you can qualify for purchase order financing, even if you have a low credit score, or haven’t been able to get a traditional loan. PO financing has fewer requirements, and the actual order is your collateral.
You Don’t Have to Put Yourself on the Line
When you default on traditional loans, the lender can seize your personal assets to repay the amount you owe. For the most part, purchase order financers can’t go after your personal property if a customer doesn’t pay. You should check with each lender about their policies, though.
The Funding is Flexible
While PO financing sounds a lot like a loan, it doesn’t technically qualify as one. Consequently, you have a lot more options with your lender, including the ability to pay everything back in one lump sum. You don’t have to worry about early payment penalties or measured installments.
The Downside of Purchase Order Financing
Every upside has a downside, and when it comes to purchase order financing, there are some serious drawbacks. It’s not that they aren’t a viable option, but you need to prepare for everything before taking on PO financing for your business.
Mind the Fees
The PO financers make their money off of fees for their services, so you must know what the lender charges. A lender may list a low fee to make it sound appealing, but if it’s charged on a monthly basis, you need to convert that to an annual percentage rate (APR).
Some purchase order financing options charge significantly higher APRs than traditional loans. You may find some lenders that charge upwards of 50% APR!
They Don’t Guarantee 100% Financing
With purchase order financing, the lender takes on the bulk of the risk, so they don’t always finance 100% of the manufacturing costs to protect themselves. You may not receive the full 100% until after your customer settles up with the lender.
Short-term Funding Means Quick Payback
PO financing gets your business cash fast, but it’s not a long-term investment. Lenders usually expect repayment within a month or two.
Your Customer Knows
Since your customer works with your lender during most of the process, they know you’re borrowing money. While that’s not an issue for some businesses, it can impact how your customer views your company. They may assume you have regular problems with cash flow.
Should You Apply for Purchase Order Financing?
Weighing the pros and cons may not be enough to help you decide whether or not to apply for PO financing. Let’s dig a little deeper into the best uses and qualifications for this type of financing.
Who Benefits from PO Financing
Purchase order financing is a wonderful option for certain types of businesses that just need a little boost. This type of financing can bolster a business that struggles with tight cash flow and support growth.
- Startups can secure funding to accommodate rapid growth.
- Business owners with questionable credit can still get the money they need.
- Wholesalers, distributors, and resellers can expand their client base with a little extra capital.
- Government contractors who need help filling orders for the government can salvage their agreements.
- Companies that need to address seasonal sales, like costume shops.
Who Qualifies for Purchase Order Financing?
It doesn’t take much to qualify for purchase order financing, but there are some requirements. You’ll find that while the benchmarks are easy to meet, purchase order financing is not an option for all companies.
- You must sell a finished product. To qualify for this type of lending, you cannot sell raw materials, product parts, or services.
- Transactions must be business to business (B2B) or business to government (B2G) customers.
- Meet the established order size and profit margin minimums. Each lender sets their own minimums, but profit margins usually need to be around 20% to qualify.
- Your customers must be reliable with a good payment history.
- Suppliers must be equally reliable with the ability to manufacture and deliver the finished product to your customer.
- In many cases, lenders insist that the customer cannot cancel the contract.
Questions to Ask Yourself Before Applying
If you’re still not sure, take a step back and evaluate your situation. Ask the big questions to see if your business needs fit with purchase order financing.
- Calculate your current finances. How much do you need to borrow to make things work?
- What do you plan to use the money to purchase? Does it fit with the requirements for PO financing?
- What are the interest rates? Can you afford to pay them?
- Are there any additional fees involved?
- How soon do you need to repay the money? Can you make that happen?
Alternatives to Purchase Order Financing
Purchase order financing may not be the right choice for your company, but that doesn’t mean you’re out of luck. If you need cash to cover aspects of your business so you can keep growing, there are other opportunities.
This financing option relies on invoices already sent to customers and covers your business until you receive payment. In this case, you receive money directly from the lender. While this option can keep you afloat until your customer pays up, it often comes with high fees attached.
Similar to invoice financing, this method involves selling your unpaid invoices to a third party for cash. It eases your cash flow issues, but it can be expensive and alerts your customer to your problems.
Short-term loans look and feel like purchase order financing except for a few key aspects. When you take out a short-term loan, you agree to repay the money in installments spread over several months. You can also utilize these loans in many ways, not just to cover the cost of a product.
Business Credit Cards
Credit cards work in personal and professional capacities. You can use a business credit card to cover short-term deficits, and they tend to be affordable. While you still have to contend with fees in terms of APR, the rates on credit cards remain lower than most PO financing options.
Business Line of Credit
Lenders offer a set amount of money that a business can draw from to cover expenses. There are some benefits to using a line of credit because you only pay back what you borrow. The lender only applies fees to the portion you borrow as well.
The Bottom Line
Purchase order financing provides small businesses with an opportunity to grow by covering cash deficits to secure customer orders. As long as you understand what you’re signing up for, it could be the band-aid you need to stay afloat and fulfill a lucrative deal.
Grey is the Director of Marketing for altLINE by The Southern Bank. With 10 years’ experience in digital marketing, content creation and small business operations, he helps businesses find the information they need to make informed decisions about invoice factoring and A/R financing.