During these times of uncertainty and occasional hiccups, purchase order financing, a new-age financing system, comes to the rescue, helping businesses keep their operation running and sustain the competition quite well.
In this blog, we will shed light on what is purchase order financing and what are its pros and cons, so you can make an informed decision. Let’s find out:
Also known as PO financing, it is a short-term financing option for businesses that don’t have enough cash to meet large orders from their customers. In this process, a financing company lends money to a business based on its purchase orders, so that the business has enough funds to fulfill the order. So, there are three main parties involved: the business, the customers, and the financing company.
The processes involved in purchase order finance are as follows:
a) The customer agrees to buy goods from a business. While the business immediately generates an invoice for the transaction, the customer sends a purchase order detailing the terms of the sale. The purchase order contains details about the quantity and value of the products to be bought.
b) Small businesses may not usually have the finances to meet huge orders from their customers. Traditional financial institutions such as banks do not provide easy loans to small businesses for various reasons. So, these businesses have to resort to other types of financing such as PO financing.
c) The business now approaches a financing company for a loan based on these purchase orders. The lender conducts a thorough assessment of the purchase orders and the creditworthiness of the customers. In the case of export/import transactions, the financing company or the lender asks for a Letter of Credit from the customers as well. They go through all these documents carefully, and sanction loans to the business only if its customers have a good credit history and reputation.
d) Once the financing company is satisfied with the quality of the purchase orders, it disburses quick funds to the business. Usually, this is about 80 to 90% of the value of the purchase orders.
e) In the purchase order finance process, a lot of importance is given to the creditworthiness of the customers of a particular business. Once the customers are approved as corporate clients or have a good credit history, purchase order financing is done quickly and efficiently.
f) With these quick funds, businesses start preparing to buy raw materials and other things required to fulfill the orders for the customer.
g) Once the order is fulfilled, the customer pays the lender directly. The PO finance company, the lender, pays the business the remaining funds after receiving the payment from the customer. However, it deducts its fee before paying the business the final settlement.
Thanks to its strict processes, detailed analysis, and quick disbursal of funds with limited documentation, purchase order financing is quite a popular financing option among exports, importers, wholesalers, distributors of goods, and resellers. All of these businesses are likely to have reputable, corporate clients. Therefore, they are highly likely to qualify for a quick loan from purchase order financing companies.
Businesses can benefit in the following ways when they opt for financing through their purchase orders:
a) Timely cash inflow – Small businesses can benefit a lot from the quick influx of cash they get through this type of financing. They can use the cash to prepare themselves for the big orders they receive from their customers.
b) Scope for business growth and expansion – Lack of funds is one of the major reasons why businesses stagnate and don’t grow to their full potential. However, with purchase order financing, they can easily overcome all challenges that make them hold back their growth and expansion plans earlier.
c) Quick disbursal of funds – Banks and other traditional financial institutions take a long time to process the loans, and they also ask for a lot of documentation to complete the process. However, in PO financing, the disbursal process is quick and efficient, provided businesses meet the quality standards completely.
d) Increased reputation among customers – When businesses complete big orders on time, it increases their reputation among their customers. Increased customer goodwill results in increased business and profitability. This is where purchase order financing plays a vital role in the success of small and medium businesses.
Some disadvantages of purchase order financing businesses must be aware of before opting for it are:
a) Costly loans – Due to the quick process and limited documentation, this type of financing carries a higher interest rate than the ones charged on loans from banks. When customers default on their payments, it can prove to be a costly process for businesses.
b) The creditworthiness of customers is mandatory – Purchase order financing can be availed of only by those businesses that have a list of creditworthy customers. This means that small businesses that have just started their operations or have a limited number of new customers do not qualify for loans through their purchase orders.
c) Not ideal for small orders – PO in finance terms is a confirmation about a transaction between a business and its customer. The value of this confirmed order should be of a sizable quantity for a finance company to disburse loans. For small-value orders, businesses shouldn’t opt for these loans, as the interest rates would impact their profit margins.
d) Not a good solution for beginners – New businesses and startups cannot opt for loans based on their purchase orders, as they wouldn’t have an impressive list of clientele.
PO in finance is often interchangeably used with invoice factoring. However, purchase order financing is quite different from invoice factoring in many ways. Financing through POs is used when businesses need funds to complete a huge purchase order from their customers, and it usually involves only companies dealing with tangible goods.
On the other hand, invoice factoring is used when you have already delivered and completed a customer order but haven’t received payment from them yet.
Though purchase order financing comes with a few challenges, it is one of the easiest and quickest sources of financing for businesses. Small businesses that have been in the business for a long time with excellent creditworthy customers can benefit hugely by monetizing their purchase orders through this type of financing.