How Purchase Order Financing Can Help a Small Business

Your purchase orders can become cash sooner than you think.

Two young clothing designers go over some info on a laptop screen.

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Most business owners are familiar with the ins and outs of cash flow, and the problems caused by lack of funding at critical times. If you find yourself with a temporary lack of cash flow, what can you do?

One option is purchase order financing (also known as PO financing). This is essentially a loan based on your orders. For a fee a purchase order financing company provides funding. 

This type of financing is a good solution under certain circumstances. Small businesses often struggle to find the funding to deliver on their orders. Purchase order financing allows small businesses caught in a cash crunch to satisfy customers, while eating into the profits that could alleviate the cash flow issue. Here’s what you need to know.

What Is Purchase Order Financing?

The purchase order financing company is a lender who loans businesses money using orders as collateral. While some may finance 100%, most will not assume financing for the total order. They expect you to contribute something. Interest rates on the money vary, and usually range between 1.6% and 6% per month. It typically takes a week or two to set a PO financing in motion. 

There are two ways to approach purchase order financing. 

In the first, usually the financing company pays the manufacturer or supplier, who then delivers the goods to your customer. The customer pays the financing company directly, and the financing company deducts their fees and forwards the remaining balance back to you.

The second option is an established line of credit between the lender and the supplier. This is an ongoing relationship where businesses get funding they need for multiple orders, even if their own credit is less than perfect.

Because loan approval depends on the creditworthiness of the customer and not the distributor, purchase order loans are easier to secure than traditional business loans. For new companies and companies with credit issues, this can be a good way to generate operating cash. 

How Purchase Order Financing Works

  1. You receive an order from a customer and don’t have the funds to purchase the goods necessary to fill the order. Without established credit, your options are limited. You can delay or refuse the order, which jeopardizes your relationship with your customer, or you can find funding to pay for the order.
  2. You give the order details to your supplier, receive an invoice, and assess your ability to pay for the order. If you can’t cover all or part of the costs, you apply for purchase order funding. If your credit is excellent and you have a history, the lender may be willing to fund 100% of your order, but it is more common to get approval for 90% or less.
  3. The lending company pays the supplier. If you did not qualify for full funding, you put up the additional funding. 
  4. The supplier fulfills the order and delivers the goods to the customer. 
  5. You invoice the customer for the goods. If the contract allows the customer to pay in installments, you may want to consider invoice factoring to cover the costs—and the dip in your cash flow.
  6. Your customer pays the invoice directly to the purchase order finance company. When the amount of the loan plus fees is paid, you receive the remaining profit from the sale.

The Pros and Cons of Purchase Order Financing

When you’re starting a business, finding funding can be a challenge. If a big order comes your way, it is exhilarating … until you realize you lack the funding to deliver.

Pros of PO Funding

  • PO financing is easier to get than a traditional loan, and less restrictive. Lenders are more interested in the customer’s credit history than in yours, because it is your customer who pays the bill. For a small business owner who is deeply in debt and/or yet to establish credit, it’s a good solution.
  • You don’t have to guarantee the loan in most cases. If the customer doesn’t pay, you are not responsible for paying back the loan. The lender assumes the risk. Your only risk is whatever money you provided for the deal.
  • PO financing is more flexible than a business loan. It is not repaid on a fixed schedule, and fees are based on how quickly it is paid. Since interest accrues, the faster the customer pays, the more profit you realize. 

Cons of PO Funding

While there are a lot of good reasons to consider this kind of financial solution, there are a few cautions to consider.

  • This should be considered a short-term solution. Most customers will pay invoices in 30-60 days, keeping your fees reasonably low. The fees are by no means the most expensive type of business funding available, but if the fees were converted to Annual Percentage Rate (APR), fees could come in at up to 75% APR.
  • You cannot use purchase order financing to fund services or as a loan for general business purposes, such as expansion or a new product launch. 

The Bottom Line

If you’re in a cash crunch and orders are pouring in from reputable customers, purchase order financing is a good way to fill orders without taking on a great deal of debt or risk. Your customers will know you’re working with a lender, and this may have a negative impact on your business reputation. 

Alternative financing offers startups and small businesses a great way to meet unexpected demand without compromising their brand and reputation. Before you decide to apply for any kind of business funding, make sure you understand the fees, risks, and implications.