Purchase order financing: what is it, and how does it work?
When customers order from your business, they’re counting on you to deliver the goods on time. To do that, you may need liquid capital to purchase raw materials and other products from your suppliers.
As a small business owner, the last thing you want is to have to turn away a large purchase order because you don’t have enough cash on hand.
Purchase order financing is one way to close temporary gaps in cash flow, keep operations running smoothly, and ultimately grow your business.
What is purchase order financing?
Purchase order financing allows businesses to fulfill orders before they’ve invoiced and received payment for those orders. Essentially, it’s an advance against the money you expect to receive once customer invoices are paid. That being said, if you’ve already issued these invoices to your customers, invoice factoring may be a more appropriate funding option for fulfilling orders.
In a nutshell, the purchase order finance company provides funding to your suppliers to complete the order. Once the goods are delivered, the financing company collects the customer’s payment and passes that amount on to you, after deducting fees.
Depending on the lender, you may be able to finance up to 100% of your costs with purchase order funding.
How does purchase order financing work?
There are four key players in a purchase order loan arrangement:
- The borrower (that’s you)
- The financing company paying the money to fill a purchase order
- Your supplier, who delivers the products to your customers
- Your customer, who places the order
Here’s how they all work together in the purchase order financing process:
1. You receive a purchase order from your customer. This order tells you what the customer wants to buy and the quantity.
2. You forward the purchase order to your supplier. Your supplier gives you an estimate of the cost to fill the purchase order.
3. Based on the supplier’s estimate, you decide to apply for purchase order financing. The financing company reviews your application and approves you for purchase order funding.
4. The financing company pays your supplier through a letter of credit or with cash. If you’re approved for less than 100% of the cost of the purchase order, you may have to make up the difference out of pocket.
5. The supplier fills and delivers the order to your customer. Products are shipped directly, and once they’re delivered, you send an invoice to your customer.
6. Your customer pays the invoice to the purchase order financing company. Once the invoice is paid, the financing company deducts their fees and sends you the remainder of the money.
7. The remaining funds are passed on to you. Keep in mind that purchase order funding can take one to two weeks to fund. Repayment terms are typically 60 days or less.
Purchase order financing: the pros and cons
As with any type of financing, it’s helpful to consider the advantages and disadvantages of purchase order loans.
Pro #1: Easier to qualify
With certain types of business financing, you may need a stellar credit score or high annual revenues to be approved. Purchase order funding removes some of the barriers to financing for newer businesses or business owners with less-than-perfect credit. In fact, purchase order financing companies tend to focus more on the creditworthiness of the customer who places the purchase order, as they’re the ones responsible for repaying the invoice.
Pro #2: No collateral required
Having to offer collateral for a business loan can sometimes be challenging if your business doesn’t have extensive assets. With purchase order financing, the purchase order itself is usually the only security you need for the loan. Some purchase order financing companies may ask for a personal guarantee, but it’s less common, compared to other financing options. If the lender doesn’t require a personal guarantee, you won’t assume liability if your customer fails to make good on the invoice.
Pro #3: No long-term repayment commitment
Business loans and lines of credit can be useful in meeting working capital needs or funding longer-term growth investments. But a loan or line of credit can stretch out repayment over a period of months or even years. Purchase order loans have a much shorter window for repayment, and again, the burden is shifted to the customer. It allows you to satisfy orders on time, without taking on a recurring debt payment that could drag down your cash flow.
There are, however, some potential drawbacks.
Con #1: A purchase order loan is not as fast as other funding options
Speed can be vital to your business’ success, especially when it comes to satisfying customer orders. That’s one area where purchase order financing tends to fall short, as it can take up to two weeks for the financing company to pay your supplier.
Con #2: You may not qualify for enough purchase order funding
While PO financing companies can offer up to 100% of the financing you need, there’s no guarantee that you’ll be able to borrow that amount. Once you’re approved, you may find that you’re only eligible to borrow 80 to 90% of the purchase order. If this happens, you’ll have to find a way to make up the difference.
Con #3: It can be more expensive than other types of financing
Cost is always a concern with business loans, and purchase ordering financing is on the higher end of the scale. The monthly fees can range from 1.8% to 6%, which converts to an annual percentage rate (APR) ranging from 20% to 75% — and interest starts accruing once your supplier receives the funding. The longer it takes your supplier to fill the purchase order and the longer it takes your customer to pay the invoice, the more you’ll end up paying in fees to the financing company. Some purchase order financing companies may also charge a one-time origination fee, which increases your cost.
Con #4: Your customers aren’t paying you directly
In a purchase order loan arrangement, payments from your customers are made directly to the financing company. That could add a wrinkle if you’d rather your customers not know that you’re using financing to cover cash flow or capital needs.
Are purchase order loans right for your business?
Purchase order financing isn’t necessarily the best fit for every business. In terms of structure, it’s often best suited for:
- Import and export businesses
- Outsourced manufacturers
Broadly speaking, PO financing can also be helpful for newer businesses and startups, as well as companies with a poor credit history. If you have a service-based business with no products, purchase order loans are obviously a no-go.
Purchase order financing can be a good choice for certain use-cases. For example, you may want to consider it if:
- Your business experiences seasonal upticks in purchase order requests but you want to preserve your working capital.
- Your business is on a strong growth trajectory and you want to be able to meet purchase order needs without taking on debt.
- Certain times of the month or year present recurring temporary cash flow issues that a longer-term financing option wouldn’t be right for.
How to qualify and apply for purchase order funding
Every PO financing company has different qualifications, but generally, you must:
- Sell a finished, tangible product or good
- Be a business-to-business (B2B) or business-to-government (B2G) entity
- Work with creditworthy suppliers and customers
- Meet minimum profit margin requirements (typically 15 to 25%)
- Meet minimum order requirements set by the lender
Again, you’ll see that your business and personal credit scores aren’t on the list. While a purchase order financing company may check your credit, that’s likely to carry less weight in the final approval decision than the other factors listed.
As far as where you can find purchase order funding, there are two main options: banks and alternative lenders.
PO financing from a bank is less common and may only be available if your business has a longstanding relationship with a specific financial institution. The better bet is to look for purchase order financing from an online lender or financing company.
Of course, there are a few key things to consider as you compare financing companies. When shopping around for purchase order loans, use these questions to vet your options:
- What’s the maximum amount of financing available?
- How quickly are loans funded?
- What’s the monthly interest rate and the repayment term?
- How is payment received from customers?
- What criteria must I meet to qualify?
- When will my business be paid once the invoice is satisfied by the customer?
- What happens if a customer doesn’t pay?
- How are supplier and customer backgrounds checked and verified?
Also, consider the company’s reputation and history. For instance, are they a newer lender or an older, more established company? What’s their total transaction volume for loans financed? Are there any complaints filed against them with the Better Business Bureau or Consumer Financial Protection Bureau? All these questions are important for finding a reputable financing company to work with.
Alternatives to purchase order financing
Before you commit to PO funding take some time to explore other options. For example, you may prefer:
- Invoice financing: Invoice financing uses your outstanding accounts receivables as collateral for a loan. The financing company gives you an advance on your unpaid invoices so you can continue on with business as usual, using the money as needed. That’s different from purchase order financing, where the money is paid to the supplier. Cost-wise, you’ll pay a factor fee for invoice financing, but it may prove less expensive than purchase order financing.
- Term loans: Terms loans are installment loans, meaning you receive a lump sum of funding which is repaid over time according to a set repayment schedule. Compared to purchase order financing, term loans offer greater flexibility, in that you can use them for virtually any capital need. Plus, term loans can also be a more cost-effective way to borrow if you have good credit. If you lock in a fixed rate on a term loan, you can estimate the total cost of borrowing, which can be more difficult with purchase order loans.
Term loans from Funding Circle
Funding Circle offers term loans with fixed, affordable interest rates and predictable repayment terms. Loans range from $25,000 to $500,000, with terms ranging from six months to five years. Interest rates start at 4.99% for qualified borrowers. You can get a decision in as little as 24 hours after document submission with money in your bank account in as few as 10 days.
Why should I get financing from Funding Circle as opposed to a bank or other lender?
The underwriting process at traditional banks can be lengthy, confusing, and opaque. At Funding Circle, we’ve taken the best parts of an SBA business term loan — like fixed and affordable once-monthly payments and no prepayment penalties — and created something faster and more flexible. Unlike traditional lenders, we also deliver a best-in-class and transparent experience. You’ll work with a dedicated loan specialist who will guide you through the entire application process and remain focused on meeting your unique financing needs. We strive to deliver a decision quickly — often in as little as 24 hours after you submit your documents.
How long does it take to apply for working capital through Funding Circle?
Funding Circle’s application process is quick, easy, and transparent. You can apply for a loan and get your free quote in just 10 minutes, and have the money in your bank account in as few as 10 days.
What documentation is required with my Funding Circle application?
- 2 most recent years of business tax returns
- 1 most recent year of personal tax return
- 6 most recent months of business bank statements
- Business debt information
- Signed guarantor form for any owner with 20%+ ownership of the business
Does Funding Circle offer purchase order financing?
While Funding Circle does not offer purchase order financing, we provide businesses with the capital they need to fulfill large orders that exceed their current financial capabilities.