Businesses should apply for purchase order financing to purchase the supplies they need to start a job or deliver a product. Invoice financing allows businesses to get capital in exchange for a missing or delayed invoice payment after a job is completed.
One of the most common challenges small business owners face is cash flow issues. You want to keep growing and expanding your company’s capabilities, but you’re limited by access to a very important resource: money. If your company relies on invoice payments, you might be forced to wait to collect the revenue on work you’ve already completed. On the other hand, you may not have the cash you need to start your job at all. That’s when you can consider purchase order financing vs. factoring.
B2B or B2G businesses that are growing faster than their current capital can allow might consider either purchase order financing or factoring (aka invoice financing)—both of these types of business loans give small business owners access to the cash they need to take on new opportunities.
But there’s a crucial difference between purchase order financing vs. factoring: Businesses apply for purchase order financing to purchase the supplies they need to start a job, and invoice financing makes up for a missing or delayed invoice payment after a job is completed. We’ll tell you more about purchase order financing vs factoring, and how to figure out which option works best for your business.
These two financing products may seem similar on the surface, especially because they’re both options for businesses that rely on invoicing for their payment. But in reality, there are quite a few more differences between purchase order financing vs. factoring than there are similarities. Let’s go through them.
Basically, purchase order financing provides businesses with the necessary funds to buy materials to complete a job. Often, high-growth businesses turn toward purchase order financing to tackle big opportunities that their current cash flow can’t yet cover. But purchase order financing can make sense for any business that needs to fulfill many orders (or one extra-large order) using expensive materials. Construction, manufacturing—any industry that requires the purchase of supplies for the job or order to be completed can use purchase order financing.
This form of financing moves linearly. The lender will front you the cash you need to purchase goods from your supplier. Then, when you finish the project or service, the lender will collect their portion of your revenues on that task.
Here’s a step-by-step look at how the purchase order financing chain works:
Purchase order financing is applicable to businesses that rely on their relationships with vendors. As you know, the business-vendor relationship is built on trust, and being able to purchase your materials from your supplier up front could greatly help that relationship. Sometimes a full cash purchase can promote a lower price tag on the goods. Opting for purchase order financing also means your supplier won’t need to wait for their bill to be paid.
How does this payment chain actually pan out? Take a roofer, for instance. He needs funds to purchase his materials before the job can even begin (and those wooden shingles aren’t cheap). So, he could go to a purchase order financing company and get the $10,000 he needs to purchase the items. Once he completes the work, he’ll ask the customer for his $40,000 check. The lender would get the first $10,000 plus fees, and the remainder will go to the business owner. Pretty simple.
Factoring, or invoice financing, is another tool that B2B or B2G firms can use to close cash flow gaps. If you opt for this kind of financing, you won’t need to count down the days until you get paid for goods or services rendered, or chase down funds from your late-paying customers—you’ll already have those missing funds delivered to your business bank account, via your invoice factoring lender.
A trucking company would be a great fit for factoring. Consider this scenario: The trucking company owner has completed her routes for Walmart. All the goods were delivered on time and intact—a plus. However, Walmart’s payment schedule is such that they won’t pay for the goods for 90 days. What is the company to do over the next three months? They want to continue operating their fleet, but there are costs involved. They need that check right away.
This is a great opportunity for invoice financing. To apply, all you need to do is provide a credible invoice to the lender. Your lender will look at your credit score and business financials too, but the quality of this invoice accounts for a majority of their underwriting decisions—after all, it’s up to your client to fulfill their debt obligation.
If your invoice is going to a company with good credit and strong financials—like Walmart, for instance—then your lender might offer you funds in the amount of up to 90% of that invoice. (Don’t worry, that remaining percentage will be paid back to you, minus the lender’s fees, once your client fulfills their debt.) To be clear, these funds come in the form of cash, and aren’t tied to any specific use. So, you can use them for anything you need—payroll, rent, you name it. Invoice factoring is a flexible product.
The right loan for your business will always depend upon two major factors:
1. What kind of business do you have?
2. What are you using the funds for?
These two are inherently linked. Certain kinds of businesses, with certain kinds of needs, are better suited toward purchase ordering financing or factoring.
Purchase order financing deals strictly with the purchase of supplies needed to complete a job, so the businesses that are most aptly suited for this sort of loan would fall in with construction, contracting, and the like. Any business that needs to purchase materials up front, then render the product, before waiting to get paid for some time, is matched up nicely with this type of loan.
While you’re limited in how you can use your purchase order financing funds (for buying supplies, that is), that constraint also makes it easier to qualify for than other types of loans. Since there’s less opportunity for the borrower to use these funds irresponsibly, the lender views this as a safer loan. Therefore, you are more likely to get approved for purchase order financing than a traditional business loan or business line of credit.
There are some fees involved, however, that can make this debt expensive—the typical rates range from 1.8% to 6% per month. But ideally, the end customer pays upon receipt of the goods, so that you don’t have to hold onto the money for too long.
Regardless, purchase order financing should be treated as a means to an end, rather than just a cushion for the business’s cash flow. (If you do need a flexible cash cushion, shoot for a business line of credit, instead.)
Factoring scenarios differ from purchase order financing scenarios in a critical way: the nature of the work. That doesn’t necessarily mean the industry; that means the status of the job itself.
If you haven’t yet completed your job, then you likely don’t have a complete invoice ready for a lender to use as a factoring line. That’s when you can consider purchase order financing, which will get you the funds you need to start that job.
However, if the job is done, you’ve sent your invoice to your customer, and you’re waiting for that invoice to be fulfilled, then you might be eligible to consider factoring. Industries that typically get caught in these scenarios are trucking, consulting, and manufacturing, just to name a few.
It’s easy to identify who’s a fit for invoice financing by who your clients are. If you’re working with smaller businesses or individuals on smaller contracts, then invoice financing may not be the loan product for you. But if your clients are big companies or government organizations, then you could be looking in the right direction. That’s because credibility of the company that owes you the invoice will be more heavily considered in the underwriting process than your own credit history, since they’re responsible for coming through on their payment.
It’s pretty much impossible to know whether you’ll qualify for any loan before you apply for it. But the big note is to remember that, with these types of loans, you will have to be in good standing. This involves a decent credit score and being up-to-date with your business licenses and registrations.
But it’s even more crucial that the other companies involved in these transactions—whether that’s your suppliers or your clients—are in good standing. This is what will make or break your success in qualifying for these loan products.
Purchase order lenders will more closely evaluate the intangibles around your business than your business’s finances. Since the lender’s money will only come in when you complete the work, they want to make sure you are going to finish that project.
Of course, you need to show good payment history, an ability to cash flow for basic business needs, and strong profit margins (about 15% – 20%) to show that your business is growing—but a large portion of a lender’s analysis will fall on the relationship between you and your supplier. Luckily, that means business owners with challenged credit might still qualify for purchase order financing.
Factoring lenders, on the other hand, will look more at your clients’ financials and credit scores, rather than your business’s. Because you completed the work, the responsibility now lies with your customer to get you your money. And if you decide to factor your invoice, then the customer would be paying the lender directly.
Just keep in mind that if the customer defaults on the invoice, the lender will often hold you responsible for the debt—so you’re not completely off the hook.
Whether you’re thinking about purchase order financing, factoring, or any other type of loan, there are essentially only two key points to consider: why you need a loan, and what type of loan your business is qualified for.
Why you need a small business loan should be the number one reason informing which type of loan to choose. If you’re receiving invoices, you are by definition waiting to get paid on services you’ve already completed. Invoice financing is a great product for amending that issue, as long as your clients can prove that they’re in good financial standing.
But if a massive company wants your small business to produce a product for them, you’ll likely need to purchase materials outside of your current means. Purchase order financing, if you qualify, will allow you to get access to more capital specifically for the purchase of those supplies than any other loan product would.
Keep that in mind as you navigate small business loans (or work with a loan specialist to think about them for you), and you’ll land on the right tool to help your business grow.