Purchase order financing guide

When your business receives a large order from a customer, the last thing you want to do is reject the order due to insufficient cash reserves needed for fulfillment. This is when purchase order financing comes in. With purchase order financing, your business can borrow the cash it needs to keep operations running smoothly so you can fulfill costly orders and grow your business.

What is purchase order financing?

Purchase order financing (PO financing) is a financial arrangement where a third-party lender provides funds to a business to cover the cost of fulfilling a specific purchase order.

Typically, the lender advances a percentage of the purchase order value directly to the supplier, allowing your business to receive the inventory or materials needed to fulfill the order request. Once the goods are delivered and the customer pays for the order, the lender is repaid, with additional fees or interest included.

Purchase order financing involves four parties: your business, your customer, the company financing your purchase order, and the supplier.

How does purchase order financing work?

While the process varies from company to company, here’s a step-by-step process of how this type of funding generally works:

1. Your business receives a purchase order from a customer. You get a large order from a customer, and you don’t have the inventory or cash on hand to fulfill it.
2. Apply for purchase order financing. Compare purchase order financing companies and apply. You’ll typically need to submit documents such as the purchase order and the supplier’s cost estimate.
3. Get financing approval. Once approved, the financing company weighs several factors to determine how much funding you’re eligible for. If you aren’t approved for 100% of the cost, you’ll need to cover the remaining balance of the order.
4. The purchase order financing company pays the supplier to manufacture and deliver the order. Once you’re approved, the purchase order financing company takes over. It pays your supplier to manufacture and deliver the goods required to fulfill the customer’s order. Typically, this payment is facilitated through a letter of credit, ensuring payment upon shipment and proof of delivery.
5. The supplier delivers the goods to the customer. The supplier delivers the products directly to the customer.
6. The customer pays the invoice to the purchase order financing company. Once the order is fulfilled, you send an invoice to your customer, which is paid to the financing company.
7. The financing company deducts its fee and transfers funds to the company. Once your customer pays the invoice to the financing company, any applicable fees are deducted, and the remaining profit is forwarded to your business.

Purchase order financing costs

Purchase order financing fees typically range from 1.8% to 6% of the total purchase order value per month. These fees are influenced by factors like creditworthiness, transaction risk, invoice volume and agreement terms. Fees are usually billed every 30 days. If your customer delays payment or you have prolonged supplier fulfillment, fees may rise accordingly.

For example, let’s say you have a purchase order financing agreement where the supplier is paid $50,000. The financing company charges a fee of 3% per 30 days. If it takes your customer 30 days to pay their invoice, your total fees are 3% of $50,000, or $1,500. If it takes your customer 60 days to pay their invoice, on the other hand, your total fees equal 6% of $50,000, or $3,000.

While these fees may seem low compared to traditional business loan interest rates, you’ll want to calculate them into annual percentage rates (APRs) to understand how the cost compares to traditional business loans. APRs on purchase order financing often exceed 20%.

Where to get purchase order financing

Several reputable companies offer purchase order financing, such as SouthStar Capital and SMB Compass. While some banks may offer PO financing, it’s more common for online lenders to provide this service, especially for small businesses. Compare fees, repayment terms and customer reviews to be sure you’re getting the best deal.

How to qualify for purchase order financing

While requirements vary by company, most evaluate the following to determine eligibility:

• Verified purchase order. PO companies want to see a legally binding and verifiable purchase order from reputable businesses or government entities.
• The creditworthiness of supplier and customer. Financing companies evaluate the financial stability of both your supplier and customer to be sure they’ll be paid back.
• Invoice to the customer. You’ll likely need to provide the customer with an official invoice outlining the terms of the sale.
• Gross margin. Lenders often examine your gross margin to gauge transaction profitability. Healthy profit margins signal sound business management.
• Financial statements. Most PO companies require you to submit recent profit and loss statements or balance sheets. This information offers insights into your company’s financial health and helps the lender assess your overall risk.
• Nature of products or services. Some lenders consider the type of products or services involved, favoring those with clear deliverables.
• Business operations duration. A history of successful operations may mean less risk for the lender. However, some lenders cater to newer businesses.

Purchase order financing pros and cons

Pros of purchase order financing:

• Access for new businesses. Unlike traditional lenders that often demand a lengthy operational history, purchase order financing may offer funding to startups and newer businesses.
• Easier to qualify for than bank financing. Purchase order financing focuses more on the creditworthiness of the purchasing customer rather than the borrower’s credit score, which means a lower credit score may not rule you out of this type of funding.
• Quick funding. Purchase order financing offers fast cash to cover customer orders, whereas a traditional business loan can mean a lengthy application and approval process.

Cons of purchase order financing:

• Limited usage scope. Purchase order financing can only be used for one thing: to cover supplier expenses.
• Partial coverage. Approval for less than 100% financing means your business will have to bridge the gap with additional funds.
• Potential strain on relationships. As customers are aware of payments to a lender rather than the business itself, there’s a risk of damaging your business’s reputation or creating tension in customer relationships, which could impact long-term growth prospects.

Alternatives to purchase order financing

If purchase order financing doesn’t fit your business requirements, you still have options:

• SBA loans. Small Business Administration (SBA) loans are known for competitive interest rates and government backing. SBA loans offer comprehensive funding solutions with favorable terms.
• Invoice financing. With invoice financing, you can leverage outstanding invoices to access immediate cash flow without giving up equity. Unlike PO financing, this type of financing relies on existing invoices rather than orders.
• Merchant cash advance. This option provides fast access to capital based on future credit and debit card sales. While convenient, it’s essential to know the higher costs associated with merchant cash advances compared to PO financing.
• Business lines of credit. If approved, you can borrow up to a predetermined limit with interest payments only on what you use. Business lines of credit offer versatility in managing cash flow gaps without the restrictions of PO financing.

Bottom line

Purchase order financing can be a helpful tool if you need to cover a large customer order without putting your cash flow in a bind. However, if you need more financing flexibility or don’t meet requirements, explore other business loan options.

Frequently asked questions

What is government purchase order financing?

Government purchase order financing ensures that businesses can meet demand from government agencies without facing cash flow constraints. Both traditional financial institutions and alternative lenders offer this financing option.

Can I use purchase order financing for my service-based business?

Purchase order financing is only available for tangible goods.