Purchase Order Financing: What Is It & How Does It Work?

Having enough cash flow is vital in running a business. Unfortunately, many businesses often experience cash flow issues that could render them unable to operate their business well. Business owners know how damaging it can be for their sales and reputation if they turn customers away because they’re not confident that they can fulfill their orders.

To prevent this from happening, most of them apply for purchase order financing. This article will outline what you need to know about P.O. financing, including what it is, how it works, and how to qualify for one. 

Let’s start.

What is Purchase Order (P.O.) Financing?

Purchase order financing, or P.O. financing for short, is one of the most common funding options businesses use when they need funds to purchase inventory that will help fulfill customers’ orders. This gives companies the necessary working capital they need to proceed with business without waiting for their customers to pay them.

Unlike other types of business loans, the business owners won’t get a hold of the money. Instead, the financing company will pay the suppliers directly. Once paid, the suppliers will get to work and ship the orders to the customers. The customer pays the P.O. financing, and the P.O. financing will deduct the advanced cash plus fees before returning the money to the business.

The funds from the P.O. financing like from SMB Compass can cover the raw materials, manufacturing, and shipping of the products. Having enough funds on hand is vital for business survival. It enables business owners to continue taking in orders even with most of their capital tied up in outstanding invoices.

How Purchase Order Financing Works

While others may find it complicated, the process of P.O. financing is actually more straightforward than it sounds. Typically, the P.O. financing process involves three key people:

• Business
• Customer
• P.O. financing company
• Supplier

Here’s a breakdown of how P.O. financing works:

1.    The business receives a large order

Customers looking to buy specific products from a product-based business submit a purchase order outlining the type of product, quantity, and specifications they would like to order. The company evaluates the purchase order, gives a rough estimate of how much it’s going to cost to fulfill, then decides whether they need to apply for P.O. financing.

If they do, it marks the beginning of the process of purchase order financing.

2.    Supplier sends a quote for the order

The business then approaches the supplier they will work with to manufacture or supply the products. They send over the purchase order and ask for a quote. Basically, a quote is a document that lists the price at which a specific product is sold for. They will also give an estimate of how much the whole purchase order is going to cost, from manufacturing to shipping, plus taxes.

At this point, you’ll know for sure whether you can afford to fund the order yourself or not. If it’s the latter, then it’s time to start your purchase order application.

3.    The business applies for P.O. financing

Using the quote sent over by the supplier and supplying the necessary financial documents, you can start your P.O. financing application. The lender will assess the documents and perform their due diligence. Approval will depend on your customers’ credit scores, supplier’s reputation, and your business’ qualification requirements.

If all goes well, they could approve a business of 100% funding. However, this only happens often. A more realistic amount would be between 70% to 90% of the purchase order’s total value.

4.    P.O. financing company pays the supplier

Once the lender approves the purchase order financing application, they will start processing the funding. This step typically takes one to two weeks, depending on the lender. If the business only qualifies for 70% to 90% of funding, the company would have to cover the remaining 10% to 30% of the amount out of pocket.

5.    Orders are shipped to the customers

After the supplier confirms the payment, they will start working on manufacturing or obtaining the products. Once everything is set, they will ship the products directly to the customers. In turn, the customers will confirm the receipt and wait for the invoice from the business.

6.    The business sends an invoice to the customers

Upon confirming that the customers have received the products, the business will then generate the invoice and send it over to their customers. Depending on the agreement, the business gives customers the choice of whether they want to pay the products immediately in full or within a specific period (usually 30 to 90 days). Usually, the customers prefer the latter.

If the customer plans to pay overtime, the ledger or accounts receivable will be handed over to the P.O. company. Once the invoices are in the financing company’s hands, they will handle everything from there – from payment chasing to the collection.

7.    The customer pays the invoice to the financing company

Since the P.O. the financing company will take responsibility for the invoices, the customers would have to pay the lenders directly. It’s worth noting that in this arrangement, the customers would be aware of the fact that the business is working with a financing company.

8.    The financing company gets paid

Once the customer(s) settle their balance, it’s time for the P.O. financing company to take their cut. They will deduct the amount they paid the suppliers, plus the fees associated with the financing. The remaining balance is then your cut of the profits, which the lenders will send back after they’ve deducted the advanced amount.

P.O. Financing Qualifications

Like any other type of business financing, purchase order financing isn’t suitable for all businesses. Generally, you’d have to be a product-based company to qualify.

If you’re wondering what a business needs to be or have in order to qualify, here’s a quick run-down:

• Must sell fully assembled finished-products
• Must be a B2B (Business-to-Business) or B2G (Business-to-Government) company
• Highly reputable suppliers
• Creditworthy customers

Purchase order financing is most commonly used by companies that accept purchase orders in large volumes. Here are the typical companies that take advantage of this type of funding:

• Import/Export Companies
• Retailers
• Wholesalers
• Government contractors
• Resellers
• Manufacturers

The best thing about this financing is that even start-up companies can qualify. Since lenders primarily base the approval on your customers’ credit rating and supplier’s reputation, even if the business has bad or insufficient credit, you can still qualify for P.O. financing.

Final Thoughts: Is Purchase Order Financing for You?

Businesses experience unique challenges. When it comes to choosing which financing solution is best for a business, the answer will mainly rely on the company’s needs. In other words, there’s no one-size-fits-all financing solution for businesses.

Purchase order financing is just one of the many businesses, specifically, those that sell tangible products in bulk, used to boost their cash flow and afford large customer orders. When used the right way, it’s a financial resource that will open up bigger and better opportunities for your business.