The Pros and Cons of Purchase Order Financing for SMBs

If you are a recently established business still struggling to get your footing, purchase order financing may prove invaluable to your ability to build your business and establish yourself as a reliable supplier. Though not everybody is familiar with this business tool, it can help mitigate cash flow concerns.

Purchase order financing is a loan that is provided in connection with specific sales orders. Rather than taking out a loan that flows from the lender to the borrower, purchase order financing flows from the lender to the company’s supplier and is paid back as the company’s customer submits payment for the product. This solves the all-too common problem of coming up with the cash to fulfill orders, which can lead to cash flow issues that end up cutting into profits and impacting the company’s ability to fulfill all of their other financial obligations.

Purchase order financing companies secure the loans that they make with the orders that the borrower is trying to fill. When a company applies for a purchase order loan they sometimes get full financing, but more frequently take out a loan of about 90% of the total order and then pay for the remaining 10% themselves. They can expect to pay a rate of between 1.6% and 6% per month until the customer pays for the products that they receive. The process of applying for and receiving purchase order financing is generally quick, taking no more than one or two weeks.

Though purchase order financing can be accomplished by opening a line of credit between the lender and the supplier in cases where multiple orders need funding, in most cases the financing company remits payment for the goods to be delivered to the manufacturer or supplier, and then after they are delivered to the customer the lending company receives the payment that would normally go to the borrowing client. Once the lender has received the amount of their loan and their lending fee amounts from the customer, the remaining payments are sent to the borrower.

Though many of the borrowers who take advantage of purchase order financing are relatively new and don’t have well-established credit, the lending company gauges their lending decision on the customer’s credit rating, as they are the ones that will be sending them payments. As a result, these loans are much easier for new businesses to be approved for. 

The Purchase Order Financing Process

• A distributor receives an order for goods that they cannot afford to purchase. Instead of turning the order away or delaying delivery until they have enough cash on hand, they apply for purchase order financing.
  
  
• The order is placed with the supplier, and when the invoice is received it is sent to the purchase order financing company. The company will determine whether to extend full financing or to only fund 90% or less of the order amount, and will pay the supplier the amount that they decide is appropriate. If it is less than 100% of the order value, then then distributor pays the balance.
  
  
• The supplier sends the product ordered directly to the customer and their invoice is fully satisfied.
  
  
• An invoice is sent by the distributor to the customer that received the materials or products. In cases where distributors allow payments to be made over time, cash flow concerns may lead to a need to incorporate invoice factoring.
  
  
• The invoice sent to the customer directs that payments be sent directly to the purchase order financing company, which will keep the amount that they are owed for the loan amount as well their fees, and send any additional monies received to the distributor as their profits.

The Advantages of Purchase Order Financing 

Purchase order financing solves the problem of cash flow that is so frequently an issue for new businesses. It is a simple loan to apply for and receive approval for because it relies more on the customer’s credit rating than on the new company’s credit rating. No collateral is required from the borrower, as it is their client that owes the money, and the amount that the borrower pays in fees is dependent on the speed with which their client pays for the goods received.

The Disadvantages of Purchase Order Financing

Though purchase order financing is extremely convenient and offers the advantages of low fees because customers pay in a short period of time, if you calculate the costs out over a year they would amount to as much as 75% when expressed as an Annual Percentage Rate. Therefore, it should only be used for short term needs, and can only be used for goods rather than for services. You also cannot use the funds to expand your business or for any of the other purposes for which businesses take out loans.

Should You Take Out a Purchase Order Loan?

Deciding whether to take advantage of purchase order financing is a relatively uncomplicated issue: if you are facing a cash flow problem based on orders from customers with good credit ratings, it offers an excellent way to meet your client’s needs and build your business. Just make sur that you are fully aware of the fees you will be charged, and take the time to weigh whether the loan might hurt your credibility. Your customers will by necessity know that you’ve taken out a purchase order loan since their payments will be sent to the lending company, but most businesses decide that it is worth that risk – especially as most customers were once new businesses themselves, and understand the need for help in the face of demand.

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All Articles by Sonu Shukla, CPA, CFP