Understanding Purchase Order Financing: How It Works for Your Business

As a business owner, you know that cash flow is critical to the success of your enterprise. But what do you do when you receive a large order that you don’t have the resources to fulfill? This is where purchase order financing comes in.

Purchase order financing, also known as PO financing, is a financing option that provides businesses with the necessary capital to fulfill customer orders. With PO financing, a third-party lender provides funds to the supplier to pay for the production and delivery of goods, allowing the business to fulfill the order without dipping into its own cash reserves.

In this blog post, we’ll explore the ins and outs of purchase order financing and how it can benefit your business. We’ll cover the basics of how PO financing works, including the application process, eligibility requirements, and repayment terms. We’ll also discuss the pros and cons of PO financing, so you can make an informed decision about whether it’s the right financing option for your business.

Whether you’re a small business owner looking to grow your operations or a large corporation in need of additional capital, purchase order financing can provide the financial boost you need to take your business to the next level. So let’s dive in and discover the world of PO financing.

How Purchase Order Financing Works

Purchase order financing involves a minimum of four parties at different points in the process:

• Borrower: This is a small business seeking financing.
• Purchase order financing company: This is the company providing financing. The PO financing company evaluates the purchase order and provides funding to the supplier.
• Supplier: The supplier is the company providing the goods that the borrower resells or distributes. The supplier receives payment for the goods directly from the purchase order financing company.
• Customer: This is the borrower’s customer and the ultimate recipient of the order. When purchase order financing is utilized, customers typically remit their payments directly to the purchase order financing company.

Since so many parties are involved, it can be more difficult to complete the financing process and keep costs down. For example, if your suppliers are slow to manufacture goods, then your costs will go up. The longer it takes for the PO financing company to get paid, the more expensive the funding as rates are charged on a monthly or even daily basis. Plus, you’ll have additional costs associated with any terms you’ve offered your customers.

Purchase Order Financing Process in 8 Steps

Purchase order financing can be understood more easily if broken down step by step. The eight steps to a purchase order financing transaction are:

1. You receive a purchase order: Your business receives a large purchase order from a customer.
2. You receive a written cost proposal: The supplier submits a written proposal detailing what it would cost to purchase the goods necessary to fulfill the order. At this point, you can determine with certainty if financing is necessary.
3. You apply and get approved for purchase order financing: Once you have determined that PO financing is necessary, you’ll need to find the right purchase order financing company, apply for the necessary funding, and be approved. To apply, you’ll need to provide both the customer’s purchase order and the supplier’s cost proposal.
4. Purchase order financing company pays the supplier: Once your application is approved, the purchase order financing company pays the supplier to manufacture and deliver the goods to fulfill the purchase order. Payment is usually in the form of a letter of credit.
5. The supplier delivers the goods to the customer: The supplier usually delivers the goods to the customer directly. However, you may instead choose to have the goods delivered to your business location. Once the customer receives the goods, the order is considered accepted.
6. You extend terms to the customer: You invoice the customer for the goods and extend terms to your customer. The longer it takes to receive payment from the customer, the more expensive the purchase order financing becomes.
7. Customer pays the purchase order financing company: The customer pays the PO financing company directly for the full price on the invoice.
8. Purchase order financing company pays your business after deducting fees: The PO financing company deducts its fees from the funds and then pays the remaining balance to your business.

Who Purchase Order Financing Is Right For

Most businesses that rely on outside suppliers for the products that they resell can benefit from purchase order financing. This is because you’ll be able to grow the business and onboard new customers without tying up your cash in pending orders. Some examples include:

• Distributors: Distributors can reduce their upfront costs while meeting buyer demand for high-margin products, especially during peak seasons. PO financing helps distributors maintain more inventory and offload some of the transportation costs that often reduce the working capital available for investment.
• Wholesalers: Wholesalers can take advantage of increasing customer demand without depleting their capital or having unsold inventory. By financing the purchase and delivery of those products when they already have a customer, wholesalers can reduce some of the risk associated with keeping products in stock.
• Resellers: Resellers can reduce the amount of inventory they carry, especially when they first open, to spend their working capital to cover business expenses like rent and payroll. Purchase order funding can free up additional cash flow and allow the reseller to take on more customers rather than investing funds in inventory.
• Importers or exporters of finished goods: Importers and exporters are faced with high transportation costs for their products. By financing a purchase order, they can avoid locking up their money while they wait for goods to arrive.
• Outsourced manufacturers: Outsourced manufacturers can use purchase order financing to continue to grow if they are short on capital but demand for their products is high. Rather than tying up funds in the manufacturing process, your business can reinvest in the company and finance the supply and delivery of goods.

When Purchase Order Financing Is Right

Purchase order financing is one of the best ways to finance growth for your business, especially in these types of situations:

• When your business has a spike in demand: If your business signed a new distributor and demand for your product spiked, purchase order financing makes a lot of sense.
• Consistently tight cash flow: Many small businesses have consistent cash flow problems at specific points of the month. Using purchase order financing can help smooth out the tight cash flow and provide business owners with the funds to invest in their businesses.
• Startups seeking to fuel growth: Taking advantage of purchase order financing can be a lower-cost way to fuel growth while meeting customer demand.
• Companies wanting to reduce capital in shipping: Businesses using overseas suppliers often pay for goods long before they can invoice a customer. By financing your purchase orders, you can use your capital to invest in other parts of your business instead of having it tied up in an order.

If purchase order financing sounds like a viable option, SMB Compass is a purchase order financing company that works with small businesses, funding purchase orders as small as $25,000 to as large as $10 million. Approval and funding can happen as soon as two weeks.

Purchase Order Financing Rates, Terms & Qualifications

PO financing funds up to 100% of the cost of goods sold, two weeks after you apply to fulfill a purchase order. Your B2B or B2G business needs to sell at least $15,000 worth of tangible goods with at least a 15% profit margin to qualify. The cost of this financing ranges from 1.15% to 6% per month with the financing company expecting repayment in 90 days or less.

Terms, Costs, & Qualifications at a Glance

The typical costs, terms, and qualification requirements you can expect from a purchase order financing company are:

Purchase Order Financing Terms

With purchase order financing, you can fund up to 100% of the total cost of goods needed to fulfill a written customer order. The PO financing company will typically issue payment to your suppliers in two to four weeks via a letter of credit, although payment may be issued in cash on a case-by-case basis. Most purchase order funding companies will want to be repaid within no more than 90 days.

When you apply, you’ll need to provide the financing company with a copy of the purchase order submitted by your customer and documentation from your supplier of the cost to fulfill the order. It’s important to consider how much time it will take your supplier to manufacture or provide the goods after they’ve received payment as the longer it takes, the more expensive the funding costs.

Purchase Order Financing Costs

Purchase order financing fees vary based on the volume and risk of the transaction to the financing company. Most of the best purchase order financing companies charge a percentage of the financed amount for the first 30 days in repayment. The costs vary industry-wide from 1.25% to 6% per month.

The costs after the first month are not made as clear by individual PO financing companies, but the industry average for these additional costs is about 1.00% per 10 days. The quicker your customer pays your invoice, the less expensive purchase order financing becomes.

According to the purchase order financing company Commercial Capital, the following cost examples are common if you’re approved for a 3% financing rate:

• Model 1: 3% for the first 30 days; 1% per every 10 days thereafter
• Model 2: 3% for the first 30 days; 0.1% per day thereafter
• Model 3: 2% for the first 20 days; 1% for every 10 days thereafter

The table below shows an example of what purchase order financing could cost you. We assume the loan in the table is paid by your customer in exactly 50 days and you qualify for a 3% interest rate using the first model.

Purchase Order Financing Cost Example

The loan term begins when your supplier is given the funds. If your supplier is slow to manufacture or deliver goods, or if you’ve promised your customer payment terms longer than 30 days, then PO financing can become rather expensive.

Purchase Order Financing Qualifications

Qualifying for purchase order financing is relatively easy, provided you deal with established and reputable customers and suppliers. Even newer businesses can qualify if their owners have verifiable industry experience. The typical qualification requirements when applying for purchase order financing are:

• Type of business: B2B or B2G
• Type of products: Tangible finished goods intended for direct resale
• Minimum order size: Varies by loan provider from $15,000 to $100,000
• Minimum profit margin: Varies by loan provider from 15% to 30%
• Customer and supplier: Must be creditworthy, which typically means a good credit history as reported by Dun & Bradstreet (D&B)

The exact meaning of “creditworthy” varies and depends on the loan provider you choose. Many loan providers will complete a commercial credit check of your customers through a company such as Dun & Bradstreet. At a minimum, your customers and suppliers should have a history of timely payments, no recent bankruptcies, and no history of serious litigation.

Where to Get Purchase Order Financing

There are generally two types of financing institutions that offer purchase order financing. Traditional lenders such as banks don’t commonly advertise purchase order financing but may offer it as an add-on for long-standing customers. If you have an existing banking relationship, check with your bank first, as it may offer better rates than other providers. Also, there are online financing institutions that focus on accounts receivable financing or other lending solutions that will offer PO financing.

What to Look for in a Purchase Order Financing Company

If you’re looking for the right PO financing partner, then you’re going to want to know some specific details about the lender’s history in PO financing and what its typical costs look like. Asking questions about a provider’s experience and determining the extent of its communication with your customers can help you select a lender.

Some of the questions you can ask potential purchase order funding providers are:

• How many transactions have they handled in your industry?
• How long have they been in business?
• What loan products do they offer? If PO financing is one of many products, do they have a team of specialists that exclusively work on purchase order lending?
• How do they pay suppliers and when? Is it through a letter of credit or cash? Do they pay upfront or after the customer pays?
• What are their typical costs, and what is the breakdown of those costs?
• What kind of background or credit check do they perform on your customers or suppliers?
• How do they receive payment from your customers?
• Do they communicate directly with your customers?

The answers to these questions will give you a better idea of whether the product offered by any potential purchase order financing company will work with your business’s needs.

Alternatives to Purchase Order Financing

Purchase order financing is an expensive funding option for small businesses. There are many alternatives available that may be better suited to your situation. Some good alternatives to purchasing order financing are short-term business loans, invoice factoring, and business credit cards.

Short-term Business Loans

Short-term business loans can be a great financing option for one-time expenditures like purchasing inventory or machinery. The best short-term loans have an online application and can get you funded for up to $500,000 in one business day.

Invoice Factoring

With outstanding B2B or B2G invoices, businesses can take advantage of invoice factoring. The best invoice factoring companies advance more than 90% and will sometimes collect invoices directly from your customers.

Business Credit Cards

Business credit cards are a great funding tool, regardless of your other financing options. The best business credit cards offer small businesses rewards, perks, and low introductory rates on purchases.

Bottom Line

Purchase order financing is a good choice if your sales growth is outpacing cash flow, but it can be expensive and may not be the best business financing option if you have good credit. For the best rates, we suggest you have profit margins above 20% with a long customer and supplier history. If you decide purchase order financing is necessary, consider SMB Compass as they can fund purchase orders ranging from $25,000 to $10 million with industry-competitive rates.