Purchase Order Financing: The 8-Step Guide

Updated on June 4, 2020
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What Is Purchase Order Financing?

Purchase order financing is a funding solution for businesses that lack the cash flow to access the inventory to complete customer orders. The purchase order financing company will pay your supplier to manufacture and deliver the goods to the customer. The customer then pays the purchase order financing company directly, who then deducts their fees before sending the rest to you.

Small businesses without the cash flow to complete purchase orders can benefit from purchase order loans. For example, if you have a new business and get a bunch of orders at once, you might not have the money to purchase raw materials and fulfill the orders. Purchase order financing makes sure you don’t have to turn the customer away.

In this guide, we walk through how purchase order financing works, the pros and cons, the cost, and how purchase order financing compares to other types of business loans.

How Purchase Order Financing Works

Purchase order loans help you fill customer orders. If your business cannot afford the supplies or delivery means to fulfill a customer’s purchase order, purchase order financing (also called PO financing or PO lending) can offer you the funds you need in advance to complete the job.

The purchase order lender doesn’t send the funds to your bank account. Rather, the lender advances the money directly to your supplier. The supplier delivers the goods to the customer, and the customer then pays the supplier directly. The supplier then deducts their fees and pays you the remaining amount.

Purchase order financing companies make money by charging you a percentage of the amount that they advance to the supplier. In exchange for providing the cash up-front to your supplier, you have to pay this fee to the purchase order lender.

Purchase Order Financing: The Details

It is possible to finance up to 100% of the cost of filling the order, but most often, the loan will be issued for less than 100% of your supplier costs. That’s because the lender wants to see that you have some of your own money to bring to the table. Interest rates for purchase order financing range between 1.8% and 6% per month.

A purchase order financing loan typically takes about 1 to 2 weeks to fund. Because of the longer time frame, purchase order financing might not be the best option for your business if you need immediate access to cash.

To be clear, purchase order financing is funding you receive prior to delivering goods to your customers and prior to invoicing them. If you’ve already delivered your goods and invoiced your customer, you need invoice financing not purchase order financing.

Purchase Order Financing, Broken Down Step-by-Step

The process of purchase order financing is simpler than it might sound. Before we jump into the steps of the process, let’s define just a few terms:

  • Borrower/seller: This is you, the person seeking advance funding or financing to fulfill a purchase order.
  • Purchase order financing company/purchase order lender: This is the lender or the company that’s providing the financing.
  • Supplier: This is the company that manufactures or distributes the goods.
  • Customer: This is your customer, the party that’s trying to buy the goods and who has given you a written purchase order for the goods.

Step 1: You Receive a Purchase Order

Your customer submits a purchase order to you that specifies the type and volume of goods they’d like to purchase. This initiates the process of purchase order financing. And based on the preliminary information you’ve got from this purchase order, you’ll likely have an idea of whether or not you’ll need to access financing to fulfill it.

Step 2: Your Supplier Estimates Your Costs

You ask the supplier how much it will cost for the amount and type of goods requested by the customer. The supplier sends you an invoice for the costs. This is likely the point where you confirm you can’t afford to fulfill this order because you don’t have enough cash on hand to buy the supplies you need.

Step 3: You Apply for Purchase Order Financing

When you confirm you can’t afford to purchase the supplies necessary to fulfill your customer’s order, you can apply for purchase order financing. The lender will approve you for up to 100% of your supplier costs depending on your qualification requirements, your customer’s creditworthiness, and your supplier’s reputation. It’s more realistic to get approved for 80% or 90% financing.

Step 4: Your Supplier Gets Paid

The purchase order financing company pays your supplier. If you didn’t qualify for 100% purchase order financing, then you’ll have to make up any shortfall by paying the supplier the difference on your own. The supplier can now do the work necessary to fulfill your customer’s purchase order.

Step 5: Your Supplier Delivers the Goods to Your Customer

The supplier directly ships the goods to the customer. This is the least intuitive step of purchase order financing, mostly because it means you won’t be doing anything. Be sure to note that you won’t be the middleman here as you might typically be without purchase order financing in the mix.

Step 6: You Invoice Your Customer

Once the supplier delivers the goods to the customer, they’ll let you know. Now, it’s time for you to invoice the customer for the goods. If the customer plans to pay over time, the lender may purchase the invoice from you at a discount. This would be considered invoice factoring or factor lending. This typically has lower fees but helps you to access your money faster.

Step 7: Your Customer Pays the Purchase Order Financing Company

When your customer pays their invoice, they will submit their money to the purchase order financing company, not to you. Yet again, you’ll be on the sidelines for this step of purchase order financing. Also remember that the faster your customer pays the lender back, the faster you’ll get your cut of the profits.

Step 8: The Purchase Order Financing Company Forwards Your Money

Once the purchase order finance company receives payment from your customer, they deduct their purchase order financing fees and forward you the remaining sum of the proceeds from the purchase order. Practically speaking, the purchase order financing fees will act like the interest on your financing.

The Advantages and Disadvantages of Purchase Order Financing

The Advantages of Purchase Order Financing

If you’re struggling to buy the supplies you need to fulfill an order or are facing a cash flow problem, you should look into purchase order financing. Generally speaking, the main upside of purchase order financing is that it prevents you from having to turn down client orders. That said, there are a few other advantages of accessing purchase order finance to consider, too:

    Easy to Qualify

    Purchase order financing is a good choice for business owners who are having a hard time getting approved for a loan or have a low credit score. Purchase order loans have fewer, less restrictive requirements for approval than do traditional bank loans. The purchase order sort of acts as collateral to back your loan.

    In fact, purchase order lenders care more about your customer’s payment history and credit than they do about your’s. Since your customer directly pays the lender after the goods are delivered, the lender wants to make sure your customer has a history of paying bills on time.

    No Personal Guarantee

    When you take on a regular business loan, you typically have to sign a personal guarantee. This means that if the business can’t pay back the loan, the lender can seize your personal assets to get their money back.

    PO financing is typically non-recourse. This means if your customer is unable to pay for the goods, the lender absorbs the risk. You won’t be responsible in most cases. Whether the customer refuses the shipment of goods, is dissatisfied with the product, goes broke after the shipment, or for any other reason doesn’t pay, the lender loses their money.

    Of course, you should check with the lender about their policies in the event the customer doesn’t pay.

    Great for Startups

    Startup owners often find themselves in a catch 22. They have a hard time getting funding because they don’t have a track record, but they are in rapid growth mode. If a startup turns down even one customer’s order, that can seriously hamper the company’s growth prospects. Purchase order financing helps you keep all your customers satisfied while shoring up your cash flow.

    Flexible Funding

    Purchase order financing technically isn’t a loan, even though you are borrowing money. When your cash flow dips, you can trade in outstanding purchase orders for funding. Plus, you can finance up to 100% of your costs in one lump sum, without having to worry about paying back the money in installments.

    PO financing is much more transaction-focused and flexible than, say, a bank loan or SBA loan that you make a long-term commitment to paying back over several years in small installments.

The Disadvantages of Purchase Order Financing

Just like any other form of business funding, purchase order financing isn’t necessarily for everyone. Be sure to consider the downsides that come with purchase order finance:

    Fees Can Be High

    Purchase order financing is certainly not the most expensive type of business funding. It’s more affordable than, for instance, short-term loans and merchant cash advances. But the fees of PO lending can add up over time. Providers charge around 1.8% to 6% every month. When converted to an annual percentage rate (APR), PO financing can run in the range of 20% APR to 75% APR. This is much more expensive than a bank loan or SBA loan.

    100% Financing Isn't Guaranteed

    With purchase order financing, you can get up to 100% financing for your supplier costs, but more realistically, you’ll get only 80% to 90% up front. Since there’s a chance that your customer might not pay the bill, the PO lender usually lends you only some of the costs. You’ll get the rest (minus the lender’s fees) when your customer pays for the goods.

    Not Available for Service Businesses

    To qualify for purchase order financing, you need to have physical goods that the supplier can manufacture and deliver to your customer. PO financing is not available for businesses that sell services. If you offer services and invoice your customers for them, then invoice financing might be the better option for you.

    Short-Term Funding Only

    Keep in mind that purchase order financing is designed for businesses that need fast, short-term access to cash. In most cases, customers pay for the goods within 1 to 2 months, and the financing tides you over during that time period. But if you have larger business costs that you’d like to finance, such as launching a new product or opening a new location, then you’ll want to look into getting a traditional term loan.

    Customers Work With the Lender

    The other downside to purchase order financing is that the customer pays the lender directly after the goods are delivered. This means your customers will know that you are using some sort of financing, coloring their impression of your business.

Purchase Order Financing: Should You Apply?

Purchase Order Financing: Who It Works For

Any business that needs to buy supplies to fill a customer order but can’t afford those supplies might benefit from purchase order financing. Companies that use purchase order financing include:

One of the keys to know if your business qualifies for purchase order financing or not is whether or not you sell a completed product. If you sell services or materials, your business won’t qualify for purchase order financing.

Purchase order financing will help businesses who find themselves in these types of situations:

  • Growing faster than cash is coming in
  • Seasonal sales spikes
  • Cyclical tight cash flow

If your business has experienced any of these cash flow problems, purchase order financing might be able to help smooth the flow of your business.

How to Qualify for Purchase Order Financing

Purchase order financing is fortunately pretty simple to qualify for.

Here are the typical qualification requirements for purchase order financing:

  • Sell finished goods, not raw materials or product parts
  • Sell to B2B or B2G customers
  • An order of at least $20,000
  • Profit margins of at least 15% to 20% (calculated per transaction by comparing your supplier’s costs to the amount you charge your customer)
  • Sell to creditworthy customers
  • Have reputable suppliers who can manufacture and deliver the goods to your customer on time

One of the key things to remember with purchase order financing is that the lender isn’t as interested in your credit history as they are in your customer’s credit history and supplier’s reputation.

Let’s say that you are a Walmart distributor and a distributor for a new, local retail shop. Who’s more likely to have the funds to pay the PO lender back on time? Walmart, of course. Purchase order lenders prefer to work with companies who have reliable, creditworthy customers. Your supplier’s reputation is important too because your supplier must be able to manufacture and deliver the goods on time.

See Your Loan Options

Finding a Purchase Order Financing Company

There are several types of companies that you can work with if you’re in need of purchase order financing. Microlenders and online companies both offer purchase order finance. But it can be hard to know which are the reputable companies.

Here are some questions you might ask when interviewing a potential purchase order financing company:

  • How many transactions have you handled in my industry?
  • How long have you been in the purchase order financing business?
  • What other types of loan products do you offer?
  • Do you have a team of specialists who work only on purchase order financing?
  • How do you advance funds?
  • Do you pay my suppliers directly? When?
  • What will be my costs of purchase order financing?
  • What’s the APR on this financing?
  • What kind of background or credit check do you run on my business, my customers, and my suppliers?
  • How do I or you receive payment from my customers?
  • What happens if my customers don’t pay on time or refuse delivery of the goods?
  • Do you communicate at all with my customers?

Once you know the answers to all of these questions, you’ll know better whether or not this is the purchase order financing company you want to work with.

Purchase Order Financing Alternatives

If you’re in search of business financing, there are plenty of options at your disposal. You’re probably wondering why you should look into this financing option instead of a traditional loan from a bank or other types of business loans.

Purchase order financing is unique in a few ways. This type of financing is easy to qualify for as long as you have reputable suppliers and customers. Plus, there’s no risk to you in most cases if your customer refuses the goods or fails to pay. The lender assumes those risks when they agree to work with you.

That said, even if you think purchase order financing is perfect for you, it’s good to know all of your options before making a decision.

Here’s purchase order financing compared to other types of business financing.

Purchase Order Financing vs. Invoice Financing

A common misconception is that purchase order financing and invoice financing/invoice factoring are the same thing. But, there are key differences.

The major difference between these two is that factoring is a loan based on invoices you’ve already sent to your customers. You already paid for the goods to be prepared and delivered to your customers. Now, you’ve sent an invoice to your customer and are waiting for the customer to pay. Purchase order financing is based on an order that you haven’t yet delivered or invoiced the customer for.

The other difference is when you see the money. If you use invoice factoring, you will receive the funds from the lender. But with purchase order financing, the lender sends the funds directly to your supplier.

The final difference between factoring and purchase order financing you should be aware of is the cost. The risk taken on by the lender is higher in purchase order financing (because your customer might refuse the goods or go broke after receiving the goods), so they charge higher interest rates. If you’re looking to save money, invoice factoring typically costs less money than purchase order financing.

Purchase Order Financing vs. Short-Term Loans

Short-term loans and purchase order finance have a lot of similarities. They both can cover temporary gaps in cash flow. The cost is similar. And both types of financing are relatively easy to qualify for. However, short-term loans and PO financing are structured very differently.

With purchase order financing, you have to trade in your purchase orders for funding, and the lender will pay your supplier. Then, your customer pays the lender, before the lender deducts their fees and sends the net balance to you. The only way this money can be used it to pay the supplier to manufacture and deliver goods.

In contrast, a short-term loan is an installment loan. You borrow money from a lender and then pay back the money over 3 to 18 months, in weekly or daily installments. Unlike purchase order financing, you can use short-term funding as working capital, to pay staff, to pay for marketing, or for other business activities.

Purchase Order Financing vs. Business Credit Cards

If your primary reason for using purchase order financing is to cover temporary gaps in cash flow, consider using a business credit card. You can use a business credit card to borrow small amounts of money when you can’t afford to buy supplies for an order. And then you can pay off the amount you borrowed when your customer pays for the goods.

Many are surprised to learn that business credit cards are actually a relatively affordable type of financing. The average APR on a business credit card is around 14%, compared to the 20% to 75% APR range on purchase order financing. The drawback to business credit cards is that your credit limit might not be high enough to purchase supplies for several orders (or even for one large order).

See Your Loan Options

The Bottom Line

Purchase order financing is a great way for growing businesses, seasonal businesses, and temporarily cash-strapped businesses to receive advance funding. But make sure you understand all the pros and cons and alternative types of funding.

No matter why your business needs purchase order finance, we hope this guide helped you to better understand the ins and outs of this great opportunity.

Vice President and Founding Editor at Fundera

Meredith Wood

Meredith Wood is the founding editor of the Fundera Ledger and a vice president at Fundera. She launched the Fundera Ledger in 2014 and has specialized in financial advice for small business owners for almost a decade. Meredith is frequently sought out for her expertise in small business lending. She is a monthly columnist for AllBusiness, and her advice has appeared in the SBA, SCORE, Yahoo, Amex OPEN Forum, Fox Business, American Banker, Small Business Trends, MyCorporation, Small Biz Daily, StartupNation, and more. Email: meredith@fundera.com.
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