The Lowdown on Purchase Order Financing

Financial crises and ensuing credit crunches make it harder than ever for small businesses to borrow money. But that doesn’t mean companies in need of capital should give up.

Some creative financing options beyond traditional bank loans or venture capital can help many manufacturing firms secure the funds they need to grow. One of these is purchase order financing, a form of inventory financing that may be appropriate for businesses that purchase inventory to fulfill orders. Here’s how it works.

Suppose you receive an order for 10,000 widgets, but you don’t have enough capital to manufacture and deliver them. One option is to sell the purchase order from your client to a finance company that specializes in purchase order financing. This company would send a letter of credit to your supplier guaranteeing payment for the widgets. It would then pay your supplier and collect from your customer after the order has been fulfilled, remitting payment to you less its fee, typically around 5 percent.

This is actually a fairly common scenario for manufacturing companies, especially startups whose suppliers expect payment upfront. However, the manufacturer may not get paid until 60 days or even longer after delivery of finished goods, creating a cash-flow lag that can stretch out 90 days or longer. More than a lack of sales or profits, it’s this cash flow gap that causes most manufacturing firm failures.

In general, the purchase order financing industry is not typically as impacted by a credit crunch as traditional lenders because PO financing is a totally different type of lending. It’s based not on the creditworthiness of a company or the value of its accounts receivable or inventory but on actual orders the manufacturer has received. Therefore these types of lenders face different types of risk than banks or venture capitalists, for example, the risk that the purchase order will be canceled or that there will be disputes due to late shipments or other errors.

Many manufacturing firms like purchase order financing because it frees up cash for other purposes, such as meeting everyday working capital needs. Also, it is not classified as debt on the balance sheet, which helps make the company more attractive should it decide to apply for financing in the future. Purchase order financing is also relatively easy to apply for and obtain, and the arrangement can usually be set up quickly so you don’t miss out on opportunities for growth.

In addition to manufacturers, PO financing may also be appropriate for wholesalers, distributors, and resellers selling third-party products. However, it would not be used by a business to buy and store inventory in anticipation of orders to come in the future.

Purchase order financing is a niche within the broader commercial financing industry. To find a finance company to work with, start by asking your banker for a recommendation. When talking to potential finance companies, ask these questions:

• What are the minimum and maximum funding requirements? Make sure there is not a minimum loan amount that’s more than what you need to borrow and that the company will be able to meet your total funding need.
• What are the underwriting guidelines? Asking this question upfront will help you avoid wasting time with finance companies that likely won’t be a good fit for your company.
• What is the timeline for product delivery and billing? If you are importing raw materials or goods, this will be especially critical.
• What are the terms, fees, and rates? Make sure you’re comfortable with these before entering into a formal agreement with any finance company. 

Don Sadler is a freelance writer and editor specializing in business and finance.