Many business owners unfamiliar with the various forms of commercial financing misinterpret what exactly purchase order financing can do for a growing business. The biggest misconception is – “I am about to get a big purchase order and I need some working capital to get it started.†PO Financing will not pay you cash up front so you can start working on an order. It also will not provide capital upfront to purchase inventory to be sold at a later date (when a purchase order comes in.)
The most typical purchase order financing scenario is one that has a creditworthy customer who issues a bona fide P.O. – an obligation to purchase once the goods have been delivered. The client borrower who needs PO financing then negotiates with a supplier to fulfill the order. But the supplier is asking for cash up front or a guarantee of payment. The borrower has the order they are trying to fill but lacks the capital to guarantee payment to the supplier. When the supplier feels confident they will get paid, they produce the product and drop ship it to the end user who placed the initial order.
This is a very clean example of where the purchase order finance company steps in. First they need to actually see the P.O., is it real, has it been issued. Next they determine whether the purchaser or account debtor (customer) has qualified for credit on the sale. Then the supplier side of the equation is introduced and due diligence is prepared to know exactly where everything is going, how long it will take, breakdown of the costs etc. Ultimately the PO finance company is going to issue an Irrevocable Letter of Credit made out to the supplier, meaning when the supplier ships the goods, has the order inspected and the required documents sent to the bank, the supplier will be able to invoke the letter of credit made payable to their bank and thus be paid for the shipment.
Here are some things to consider about purchase order finance;
- PO Finance companies like situations where all the parts have worked previously, in other words – a new start up company with their very first purchase order is riskier than a company who has been selling the same product from the same supplier over and over, this time just happens to be a significantly larger order.
- The PO finance company must be paid in full when the customer accepts the shipment which means the borrower will also be using an invoice factoring company. The factoring company lets the PO finance company know the customer has credit, then when the shipment is accepted an invoice is produced and the advance from the factor goes directly to pay the outstanding amount to the PO finance company.
- The client borrower must have at least 30% profit margin on the transaction to qualify.
- Most PO finance companies require the goods to go directly to the end user, it is rare they will allow the client borrower time to accept the goods, work on the product (add things, put it together) and then re-ship the order.
An over looked aspect of purchase order financing is having a professional finance company oversee the issuance of the letter of credit and deal with inspections of the shipment. Banks can be tricky enough with letters of credit but then you add a foreign country where the supplier is located then all kinds of problems can arise. Having the experience of a good finance partner can make all the difference.