What is Purchase Order Financing?
Purchase order financing is a business funding method for companies to get a cash advance to cover the costs associated with fulfilling a purchase order. Businesses use purchase order (PO) financing to get the funds to pay their suppliers for the goods or materials necessary to meet the needs of their customers.
The process seeks to solve a problem some companies, such as manufacturers or wholesalers, face when they don’t have the money on hand to cover purchase order costs. Instead of turning away business, PO financing allows them to buy the necessary materials or inventory.
How does Purchase Order Financing work?
PO financing involves four companies: your business, your customer, your supplier, and the purchase order financing company. Your company enters into a funding agreement with the financing company, which allows you to send PO funding requests when needed.
Most financing companies charge a factor rate for purchase order advances on a 30-day cycle. The monthly factoring rate varies, usually between 1%-6%.
The process goes as follows:
- Your company receives a purchase order from your customer.
- You then get an invoice from your supplier for the costs of fulfilling the order.
- You send the supplier’s invoice to the financing company for approval.
- Once approved, the financing company pays the invoice amount to the supplier.
- The supplier then delivers the materials to your warehouse or directly to your customer.
- You send an invoice to your customer when you fulfill the PO.
- Your customer pays the invoice to the purchase order financing company.
- The financing company sends the money to you minus the advance and its fees.
Purchase Order Financing Example
ABC Wholesalers receives a purchase order from its client XYZ Retailer for $125,000 worth of inventory. The cost of the materials from ABC’s supplier is $90,000, meaning the company could make $35,000 in profit (minus internal expenses) from the transaction. However, ABC does not have the liquid funds to cover the costs, so it gets an invoice from the supplier.
ABC sends the supplier’s invoice to the purchase order financing company. After reviewing XYZ’s credit, the financing company approves the invoice and sends the entire $90,000 to the supplier to deliver the materials. ABC Wholesaler provides the goods to XYZ and issues an invoice for $125,000.
The agreement with the PO financing company states that ABC is charged a 2% factoring fee every 30 days. XYZ pays the $125k invoice directly to the PO financing company after 45 days.
The costs to ABC are as follows:
- 2% of $125k for the first 30 days = $2,5000.
- 2% of $125k for going past 30 days = $2,500.
The purchase order financing company recoups its initial $90,000 for the supplier invoice plus another $5,000 for its fees and sends ABC a total of $30,000.
Who is Purchase Order Financing best for?
Businesses that struggle to meet customer orders because they lack the funds to pay suppliers could benefit from PO financing. The industries that are most likely to use purchase order financing include:
- Seasonal businesses.
What are the best Purchase Order Financing companies?
Finding the right PO financing company depends on your unique needs. We cover tips on how to identify a good fit later. Here are our top options for PO financing companies:
- SMB Compass.
- King Trade Capital.
- Liquid Capital.
- Star Funding, Inc.
How do I get Purchase Order Financing?
The first step is ensuring you qualify for purchase order funding. Online financing companies set different qualifications, but generally speaking, most companies require the following conditions:
- Your business doesn’t make the products it sells.
- The sales price should be at least $50,000.
- Your customers must be creditworthy (will pay their invoices).
- Your supplier should have a proven track record of delivering goods on time.
- The margin on the transaction should be at least 20%.
- The transaction must be non-cancelable.
Most financing companies offer online applications, or you can call them to apply. You should prepare the following documents ahead of time:
- The customer’s purchase order.
- The supplier’s proforma invoice.
- Your invoice to your customer.
- Information about your business.
- Financial statements.
- Business tax returns.
What are the advantages of PO Financing?
PO financing offers several benefits to companies that are short on funds to pay their suppliers. The primary advantage is that PO financing allows your company to receive and fulfill more customer orders.
Once you’ve established a relationship with your purchase order financing company, the funding process becomes quick and easy. Your business can also save time on collections since your customers pay their invoices directly to the financing company.
Unlike other forms of small business financing, you won’t have installment payments that could interrupt your cash flow. The debt you incur only lasts as long as it takes for your customers to pay their invoices.
Since purchase order financing companies receive payment from your customers, they care more about their creditworthiness than yours. If your customers and suppliers are reputable and reliable, you should be able to qualify for purchase order financing when you can’t qualify for other business loans.
What are the disadvantages of PO Financing?
While there are benefits to PO financing, you should know the drawbacks before applying. The biggest drawback is the purchase order financing cost. While the fees may seem low at first glance, they can be comparable to APRs anywhere from 20%-60%.
With purchase order financing, you surrender control over many of the processes to the financing company as it pays your suppliers and collects payments from your customers. Suppliers and customers might think your company has cash flow problems, which can strain the relationship. You also don’t have control over when your customers pay, which can increase your costs since the fees usually apply every 30 days an invoice goes unpaid.
Purchase order financing only covers the costs of the physical items involved in the transaction. It does not pay for any overhead, and you cannot use the funds for other purposes.
While an ideal purchase order financing agreement would cover 100% of the supplier costs, some only cover a portion, such as 80%-90%. That means you’d still have to supply the remaining amount.
Purchase order financing pros & cons
Here is a quick summary of the benefits and drawbacks of purchase order financing.
- Allows you to accept & fulfill more customer orders.
- Quick & easy funding process once you’ve established a relationship.
- No installment plans or frequent payments to strain cash flow.
- Usually near-term debt, which is paid off when your customers pay.
- Easier to qualify for than other small business loans.
- The costs can be high compared to other business financing options.
- Your company surrenders some control over the fulfillment process.
- Relies on customers paying their invoices on time.
- Potential to strain relationships with suppliers and customers.
- Limited use of funds – only covers costs of physical items needed for the PO.
- Might not get 100% of supplier costs covered.
Frequently Asked Questions
Here are the most common questions about PO financing for small businesses.
Can I get Purchase Order Financing with bad credit?
Getting approved for PO financing might be possible if you have a low credit score. Purchase order financing companies base credit approval more on your customers’ and suppliers’ creditworthiness than yours.
Some financing companies may have a low credit score requirement, while others might not have any requirement. You can also consider bad credit business loans if you need financing help beyond fulfilling purchase orders.
How do I choose a Purchase Order Financing company?
Here are some important considerations when evaluating purchase order financing companies:
- Costs. The most important thing to understand is how much PO financing will cost your business. Paying some fees to avoid turning down a customer makes good business sense, but if the costs involved make the transaction not profitable, the ends do not justify the means.
- Available amounts. Most financing companies publish a max funding range. If the total amount a company is willing to finance is lower than your needs, you must find another option.
- Qualifications. You must be able to qualify for the PO financing company. Check their minimum credit score, time in business, and annual revenue requirements. Look for any other requirements that might disqualify you as well.
- Funding time. You’re applying for PO financing to fulfill a customer order and must know if you’ll get the money in time to achieve that goal.
- Terms. This one is also related to costs – you must know how much you’ll be charged when your customers pay late. Most financing companies offer 30-day terms, but some might offer 90 days. Others will charge a daily or weekly factor rate. Calculate the payment terms compared to your customers’ average payment cycles to determine your likely costs.
- Industry experience. Working with a financing company that has experience in your industry is a plus. You want a company that understands and has dealt with the unique challenges of your sector.
What are the alternatives to Purchase Order Financing?
Purchase order financing meets a specific business financing need but is limited in the industries it serves and how you can use the funds. Other small business loans provide similar funding amounts but with a broader range of uses.
You can still use most of these forms of financing to pay suppliers and fulfill purchase orders, but you have more flexibility in meeting other business needs. The top purchase order alternatives to consider are:
Invoice factoring: In this financing method, you essentially sell, or “factor,” unpaid invoices for a cash advance. The factoring company sends cash based on the advance rate, usually 75%-95% of the invoice’s value. Once your customer pays the invoice, the factoring company releases the remaining amount minus its fees. Invoice factoring is probably the most comparable to PO financing.
Merchant Cash Advance: an advance of funds based on previous debit and credit card sales. Repayment for the advance comes from a percentage of daily card sales.
Business line of credit: Similar to a credit card, a business line of credit provides an available credit limit from which you can draw funds as needed. You only pay back what you draw, plus interest and fees.
Business term loans: The most common form of business financing, term loans are traditional loan structures where you receive a large sum upfront, which you repay plus interest and fees in fixed payments. You can use business term loan proceeds for various purposes, including paying suppliers.
SBA loans: The gold standard of small business financing. The US Small Business Administration partially guarantees SBA loans, giving lenders the security to offer large loan amounts at competitive interest rates and long repayment terms. However, SBA loans typically require good to excellent credit.
Purchase Order Financing – Final Thoughts
Purchase order financing is a viable solution for small businesses that need cash to pay their suppliers and fulfill a PO. The costs are higher compared to traditional business loans, but it’s easier to qualify in most cases.
When choosing a purchase order financing company, look at their rates, funding times, and qualifications. You should also look for industry experience or special perks that separate it from a traditional financial institution.
Many small business loan options exist if PO financing doesn’t work for your business. Most can provide funds to cover supplier costs.
Contact us if you have more questions or want to apply for a small business loan. Our loan executives can help you find the right financing package for your business needs.