How does purchase order financing work?

You’ve probably heard of invoice factoring: a B2B or B2G company sells invoices (usually for large orders) to a third party so they can receive payment for the invoice before their customer issues payment. This process can work fairly well if your business has the cash/credit available to pay for everything that's needed to fill the order (we’ll explore invoice factoring more a little later). But what happens when a customer wants to place an order and the company lacks the cash flow to buy the raw goods/pay for labor to fill the order?

In this case, purchase order financing may be a solution. Of course, to use PO financing, your business needs to issue purchase orders—and not every business does so. When a purchase order is used, there are two steps in the accounts receivable process before the customer pays. First, the purchase order is completed, and the goods are ordered. When it’s time to deliver the order, the business issues an invoice which the customer must pay within a set number of days.

Example: Company ABC makes and sells high-end cat clothes. They receive a purchase order in the summer from a new customer for Christmas cat outfits and a large purchase order is completed. Now, the company needs to buy all the materials to make the cat outfits and pay their team of specialty tailors.

But they won’t get paid until after their customer receives the invoice in November. Because of the size of this order, they can’t cover the costs of the outfits and they need a working capital solution that allows them to offer payment terms to their customer. They look into purchase order financing.

Many small businesses with seasonal sales need a solution that gives them a cash advance or similar funding solution in order to fulfill their orders.

Advantages of PO financing

One of the nice things about purchase order financing (sometimes called purchase order funding) is its simplicity. The process is straightforward, and you get your money quickly—potentially solving your cash flow problems. After filling out an application, you’ll know if you’re approved within 24 hours.

For many businesses, this feature is a welcome change from the laborious process involved with borrowers trying to get a bank loan or business line of credit from a traditional lender. There are also no long-term payments like there would be with other forms of financing. When the invoice is paid, the financing company gets paid, and the process is complete. And, with cash in hand from the purchase order financing, companies can go directly to their suppliers to negotiate better terms on their own purchases.

Purchase order financing is a good solution when a small business gets its first large customer order. In a sense, the financing option allows them to sell goods like a large, established business—even if they’re a start-up or have a poor credit score. This is a big selling point for startups that need to get those first few big orders under their belt. The financing company is primarily looking at the customer’s credit—not your company’s creditworthiness.

Challenges of PO financing

When a company decides to use purchase order financing, they must pay the financing fee upfront—even if they have an excellent credit history and strong balance sheet. This fee is typically a calculation involving the amount of the order and the length of time before the customer pays. PO financing fees tend to be anywhere from 2 to 6% of the total invoice per month.

Using PO financing means giving up control to the financing company. Your accounts receivable is not responsible for collecting the invoice payment—the purchase order financing company takes over. In theory, this could be a good thing. After all, it’s less work for your AR department.

But PO financing companies can pursue that payment in any way they choose. Sometimes, customers aren’t happy to be dealing with a third party—especially if that third party is aggressive. While it isn’t your company that's treating your customer poorly, it will absolutely reflect on your business.

Whether you’re a business owner of a small business or a large one, customer relationships are important, and anything that negatively impacts this relationship can have a long-term impact.

When a third party approves your application for purchase order financing, they don’t always approve the whole amount. As part of their own risk mitigation policies, they may only finance a portion of the PO—especially if your customer is not considered creditworthy. This may not be enough to cover the costs required to fulfill an order.

Owners of a small business at a warehouse accepting orders

Can a small business get approved for PO financing?

Every lender is different, but there are some things that all PO financing companies look for. First, you’ll need to sell something tangible. This type of financing won’t work if you sell services. Next, you’ll need to prove that your company meets their minimum gross profit margin—you’ll need to show enough of a mark-up for your products.

You’ll also need to show that you’ve worked with similar customers in the past and were always able to fulfill their orders. The financing company may investigate the order to ensure it is legitimate. Finally, the order needs to be big enough to meet the financing company’s minimum order limit.

Once an order is approved for PO financing and you’ve issued the purchase order to your customer, the financing company will deduct any fees and charges, and issue you a payment for the balance of the purchase order. Businesses that are known for using PO financing include manufacturers, distributors, sellers of high-value machinery, and government suppliers.

How is factoring different from PO financing?

The biggest difference is that you can only qualify for factoring if you’ve already issued the invoice to the customer. (Remember, factoring involves selling an invoice to a third party and relies heavily on credit-worthy customers.)

Example: A delivery company has a contract to deliver goods to a large warehouse. Once the goods are delivered, they issue an invoice. However, the large warehouse only pays after 90 days, and the delivery company needs to pay its employees during those 90 days.

They use invoice factoring, sell the invoice to a third-party factoring service, and receive a portion of the invoice amount soon after. This is enough to cover their expenses until the warehouse pays them for the delivery.

Invoice factoring can be used for goods and services, where PO financing is only applicable to companies selling actual products. And the funds paid out can be used for any business expenses that you choose. Businesses that are likely to use invoice factoring include members of the transportation industry, importers, and landscapers. The cost of factoring tends to be several percentage points higher than a conventional loan.

Most factoring agreements are not non-recourse financing. This means that even if you’re approved and receive funds for an invoice, if the customer doesn’t pay that invoice you’ll need to reimburse the amount of the invoice back to the factoring company.

Female business owner in medical mask processing order in shop

Cash flow alternatives to PO financing or invoice factoring

Business term loan

When your business needs a financing solution, you’re not limited to choosing between PO financing and PO factoring. If you’re an established business with good credit, you may consider a business loan from a traditional lender like your bank. In this case, you can spread out the repayment terms past receipt of payment from your customer. (This also means you’re carrying debt on your business.)

Another type of business loan is invoice financing, where you receive financing from the bank by using invoices as collateral.

Business line of credit/Business credit card

Other financing options include a business credit line or a business credit card. Along with a bank loan, these tend to take weeks for approval. In the meantime, you’ll need to still cover the costs of supplies and labor for your orders.

Resolve: net terms-as-a-service

Another financing solution is net terms-as-a-service, and it’s an excellent alternative to PO financing while offering additional benefits. It allows any business that needs to offer net terms to their customers an avenue to quickly determine what terms to extend, close substantially larger orders, and receive payment for purchase orders within one day to increase cash flow and reduce financial risk.

In addition, Resolve offers an online payment portal that allows your customers to easily make payments. This gives your business customers more ways to pay: Credit card, ACH, wire transfers, and checks. You get your purchase orders or invoices get paid upfront while offering your customers net terms and providing an accessible payment portal.

Resolve credit checks your customers in the application process, but it involves a ‘quiet check’, rather than an invasive process that’s often used for PO financing/factoring. With the insight you gain from Resolve through this process, you can mitigate non-payment risks while extending excellent net terms to your customers and having the resources to fill those big orders.