Purchase order financing is a funding solution that helps businesses fulfill large customer orders without upfront capital. This financing option is particularly useful for businesses experiencing rapid growth or dealing with large, one-time orders.
Purchase order financing comes at a relatively high cost, however. Here’s what you need to know about this type of funding, how it works, its pros and cons, plus alternatives you might consider.
Key Points
• Purchase order financing provides businesses with upfront capital to pay suppliers, enabling them to fulfill large customer orders without depleting cash reserves.
• It is an advance based on a specific order, repaid once the customer pays, unlike traditional loans.
• PO financing is ideal for companies experiencing rapid growth or handling large orders they couldn’t otherwise afford.
• Fees and interest can be higher than traditional loans, but it helps prevent missed opportunities due to limited cash flow.
Purchase Order Financing Definition
Purchase order financing, also known as PO financing, is essentially a cash advance that a company can use to fulfill its purchase orders. With this type of financing, a lender will pay a third-party supplier up to 100% off the cost involved in producing and delivering goods to your customers.
While you often need strong credit to get a traditional small business loan, that’s not necessarily the case with PO financing. Purchase order financing companies are typically willing to work with small businesses and startups with bad credit. These lenders tend to be more concerned about the creditworthiness of your customers, since they will be repaying much of the loan.
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How Purchase Order Financing Works
To understand how purchase order financing works, here’s an example. Let’s say you receive a large order from a customer but discover that you don’t have enough inventory on hand to fill it. After reaching out to your supplier, you determine that you don’t have enough available cash to purchase the goods needed to fulfill the order, either.
Rather than turn your customer away, you reach out to a PO financing company. As part of your application for funding, you send the lender your purchase order as well as your supplier’s estimate. If the lender approves you for PO financing, they will then pay your supplier all or a large portion of the invoiced amount. If, for example, the lender approves you for just 90% of the supplier’s costs, you would need to cover the remaining 10% on your own.
The supplier then fills the order and sends the product to your customer. Next, you invoice your customer, who sends payment directly to the lender. The lender then deducts their fees and sends you the balance.
Who Uses Purchase Order Financing?
You might consider PO financing if your business needs to purchase goods or supplies from a third party, but you don’t have enough cash reserves to make those purchases.
Types of companies that may use PO financing include:
• Startups
• Business owners with low credit scores
• Wholesalers
• Distributors
• Resellers
• Importers/exporters of finished goods
• Outsourcers
• Government contractors who are fulfilling government orders
• Companies with seasonal sales
Pros and Cons of Purchase Order Financing
There are advantages and disadvantages to small business purchase order financing. Here’s a look at how the pros and cons stack up.
Pros
• Enables you to take customer orders you otherwise could not fulfill. Purchase order financing allows you to serve customers despite seasonal dips in cash flow and/or take on an unusually large order from a customer.
• Can be easier to get than other types of business loans. While PO financing companies will look at your business’s financials and credit history, they are typically more interested in the creditworthiness of your customers and the reputation of your supplier. As a result, it can be easier for startups and businesses with less-than-stellar credit to qualify for PO financing compared with other types of business funding.
• You don’t need to make regular loan payments. Since PO financing is more of a cash advance than a loan, you won’t need to pay the money back in regular installments like you would with a regular term business loan.
Cons
• Can be costly. PO financing fees may seem relatively low at first glance, often ranging between 1% and 6% of the total supplier’s costs per month. But when that rate is converted into an annual percentage rate (APR), purchase order financing rates are actually fairly high, potentially 20% or significantly more.
• Cost depends on your customer. Since fees are charged per month, how much you will end up owing the PO financing company will depend on how long it takes your customer to pay their invoice. This can make it difficult to estimate the total cost upfront.
• You’re cut out of the process. With this type of financing, the lender and supplier often take over most of what you normally do. In many cases, the lender will pay the supplier, the supplier will ship the product to the customer, and the customer will pay the lender. As a result, you won’t have the usual amount of quality control.
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Applying for Purchase Order Financing
Purchase order financing is primarily offered by online financing companies. Some banks offer PO financing, but typically only to large companies or existing clients.
To qualify for PO financing, you usually need to:
• Have a purchase order of $50,000 or more
• Sell finished goods (not parts or raw materials) that you don’t make yourself
• Sell to business-to-business (B2B) or business-to-government (B2G) customers
• Have profit margins of at least 20%
• Have creditworthy customers (some lenders will conduct a detailed credit check on your customers)
• Have reputable and trustworthy suppliers
If you meet the basic criteria for PO financing and want to apply, you’ll typically need to have the following documents:
• The customer’s PO
• Your supplier’s invoice
• Your invoice to your customer
• Your purchase order to your supplier
• Information about your business
• Financial statements (such as your balance sheet, income statement, and cash flow statement)
• Tax returns
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Alternatives to Purchase Order Financing
If PO financing doesn’t sound like the right financing solution for your business, you’re not necessarily out of luck. There are a number of other small business financing options that can help smooth out dips in cash flow and help you grow your business. Here are some to consider.
Invoice Factoring
Invoice factoring is a type of invoice financing that involves “selling” some or all of your company’s outstanding invoices to a third party, called an invoice factoring company. The factoring company will typically pay you 80% to 90% of the invoice amounts, then collect payment directly from your customers. Once the factoring company gets paid by your customers, the company will pay you the remaining invoice amount — minus any fees.
Small Business Loans
With a traditional term business loan, you receive a lump sum of capital upfront and then pay it back (plus interest) in regular installments over a set term. While banks typically have strict criteria for business loans, online business lenders tend to have more flexible qualification requirements and are faster to fund. A short-term business loan from an online lender can help solve a short-term cash crisis, but rates and terms are generally higher than bank loans.
Merchant Cash Advances
A merchant cash advance (MCA) might be an option if you do business using credit card transactions. With an MCA, you get a cash advance in exchange for a fixed percentage of future credit card receipts. Typically, the MCA provider automatically deducts a daily (or weekly) percentage of your debit and credit card sales until the advance, plus fees, is repaid in full. While an MCA can be a quick source of cash, this is one of the most expensive ways to finance a small business.
Business Lines of Credit
You can also use a business line of credit for short-term financing. Similar to how a credit card works, a line of credit allows you to draw up to a certain limit and only pay interest on the money you borrow. You then repay the funds and can continue to draw on the line. A business line of credit can be used for a variety of immediate needs, such as managing cash flow, buying inventory, or paying employees.
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The Takeaway
Purchase order financing provides funds to buy needed items to fulfill business needs. If it isn’t right for you, you may want to shop around and compare other small business financing options.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
Is PO financing a loan?
Purchase order financing is not a traditional loan. Since it doesn’t provide you with a lump sum of capital you then pay back in installments, it’s considered a cash advance.
What documents are required for purchase order financing?
To apply for purchase order financing, you’ll need to provide a number of documents, which may include the customer’s purchase order, your supplier’s invoice, information about your business, financial statements (such as your balance sheet, income statement, and cash flow statement), and personal and business tax returns.
Can purchase orders be used as collateral?
Yes, purchase orders can be used as collateral in purchase order financing. Lenders consider the purchase order as a guarantee of future payment from a customer, advancing funds to cover supplier costs. The order itself serves as security, ensuring repayment once the customer fulfills their payment obligations.
What is the difference between purchasing order financing and invoice financing?
Purchase order financing funds suppliers upfront to fulfill customer orders, covering the cost of goods before they’re sold. Invoice financing, on the other hand, provides cash advances based on unpaid customer invoices, helping businesses access cash after a sale is made but before the customer pays the invoice.
Photo credit: iStock/Kerkez
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