If you have customers waiting on orders that you're not sure your company funds can fill at this time, purchase order financing could be a good borrowing option for you.
Purchase order financing is a specific type of business lending program that helps businesses fill their existing orders to their customers. By financing purchase orders, businesses can capitalize on existing business relationships to gain liquidity in order to fill new orders, rather than using up existing cash or other credit lines. Maintaining steady cash flow is difficult as it is, but purchase order financing provides one method to make sure a business never has to turn down orders or pass up growth opportunities.
Typically, purchase order financing is utilized by business owners who receive larger orders than average and is especially useful when a business is going through periods of rapid growth. In these situations, growing pains can be alleviated by capitalizing on purchase order financing to gain support in filling orders, putting borrowing businesses in the right position to take on bigger and bigger orders.
Purchase order financing is an effective and popular funding method for business-to-business (B2B) industries, providing support for businesses to fill their purchase orders. Because purchase order financing centers on the purchase order itself, the lender can typically use the value of the purchase order as collateral to secure the funds. This means that during the underwriting process, lenders typically consider the credit and trade strength of the customers rather than the credit history of the borrowing business. With purchase order financing, the emphasis for the lender is on the risk that the customers will not be able to pay their invoices once their orders are filled.
Purchase order financing is a relatively quick method for businesses to obtain the resources necessary to fill their purchase orders. Especially with the internet, it is easy and fast for business owners to find information about purchase order financing. In some cases, the entire application and qualification process can be completed online, and funds can be received in as little as a day. However, there is some confusion about the process of using purchase order financing to fill orders.
Typically, there are seven steps in the purchase order financing process:
- The customer places an order.
- The borrowing business gets a cost breakdown from the supplier.
- The borrowing business submits the purchase information to a lender.
- The lender pays the supplier directly
- The supplier provides the goods or services to the customer.
- The customer completes the invoice to the lender.
- The lender returns the balance to the borrower.
1. The customer places the order.
The first step in the process for purchase order financing is when your customer places an order with you, the borrowing business. For whatever reason, you want to obtain funds from a lender in order to pay your supplier to fill the order to your customer. Whether you do not have the funds available or want to free up working capital for other expenses, you might decide you need financial support to fill the order for your customer. Once your business receives a purchase order from your customer, you can use the purchase order itself to obtain funding to fill the order.
2. The supplier provides a cost breakdown.
After you receive the purchase order from your customer, the next step is for you to contact the supplier. Your supplier needs the details of the purchase order to determine the cost of filling the order. Once the supplier determines the price for filling the order, you can apply for purchase order financing.
3. You submit purchase information to the lender.
Once your supplier determines the cost of filling the order, you will reach out to a lender. Typically, when considering applications for purchase order financing, the lender will need to see a cost breakdown from the supplier to match up with the details of the purchase order agreement. This is how the lender will validate the amount you need to fill the order and determine your business's eligibility based on the terms and cost breakdown of the purchase order.
4. The lender pays the supplier.
After they receive the purchase information and the cost breakdown from your supplier, the lender will determine your business's qualification and restriction eligibility, usually based on the terms of the purchase order and the trade and credit history of the customer. If you're approved, the next step is for the lender to pay the funds to the supplier to fill the order. This step is commonly misunderstood in business: Instead of paying the funds directly to the borrower or directly to the customer, as with other types of financing, the lender typically pays the supplier directly to complete the purchase and fill the order for the customer.
5. The supplier fills the order.
After the lender sends the funds to the supplier, the next step is for the supplier to make the product, ship or deliver the goods, and then invoice the customer. If you decide your business cannot use company funds to fill your orders, purchase order financing allows you to apply for funding where the lender will make the payments to the supplier so that the orders are filled for their clients. Once the lender makes the payment to the supplier, the customer gets what they ordered from you and they receive an invoice.
6. The customer pays the lender.
After the customer has their orders filled from the supplier, they make their invoice payments directly to the lender. Instead of making the payment directly to your business, the supplier typically provides an invoice to the customer at the time of delivery, and the invoice is paid to the lender. At this point, the supplier has already received payment from the lender on behalf of your business. Now that the customer has received their purchase, they make their invoice payments, which go directly to the lender.
7. The lender pays the balance.
Once your customer pays the invoice to the lender, the lender pays out the remaining balance to your business. Typically, the rates and fees associated with the purchase order financing agreements are established by the lender and applied to the cost of filling the order, not the value of the invoice. Once the lender receives the customer's invoice payment, they get their payment via the fee and rate taken out of the cost to fill the order, and the outstanding balance is returned to your business.
Purchase order financing vs. invoice factoring
Many business owners have expressed confusion over the similarities and differences between purchase order financing and invoice factoring. Both are specific types of asset-based lending products that consider the value of different types of transaction agreements as collateral to secure funding.
With most B2B sales, there is a standard chain of events: The buyer places the order to the seller (usually via purchase order), the seller fills the order through their suppliers, the supplier completes the order to the buyer, and the buyer receives an invoice and makes their payment to the seller.
Both purchase order financing and invoice factoring add more steps to this chain of events. The difference between the two is the time in which the goods are delivered to the buyer. With purchase order financing, the goods or services are yet to be delivered, which makes the transaction a higher risk for a lender. With invoice factoring, the goods or services have already been delivered and accepted, which reduces the risk for the lender and ultimately will provide lower rates and fees for the borrowing business. [If you're interested in learning more about this type of funding, you can read our reviews of the best invoice factoring services.]