Purchase order financing, also known as PO financing, is when a third party loans a business the money to increase production and meet the needs of a customer in exchange for payment with interest once the customer pays. It is similar to a small business loan in that you can get the financing you need to buy raw materials or increase inventory and production, but the approval times are faster, you only make one payment with interest vs. multiple, and it likely costs you less money overall.
PO financing may require a hard pull just like taking a business loan from a traditional or alternative lender, so it does have a temporary negative impact on your business credit score. If this is a concern for you and you have the time, look for other lending companies and ask them if they do hard inquiries as part of the application process. Or see if a current supplier to your company would be interested in being the lender.
Purchase order financing is the total amount you borrow with interest, which should be lower than the profit margin you sell for if making a profit on the sale is important to you. Otherwise, you’ll be doing the work to break even or come in at a loss.
One exception could be securing a larger contract for the long run, where the first transaction is meant to break even and you can finance the next orders without interest payments. This situation lets you gradually increase profits over the length of the contract with the new or existing customer.
If you borrow $10,000 to fulfill an order for $100,000 and it has a 10% profit margin but a 2% interest rate, you’re now at a loss of 2% or $200.
$10,000 profit
– $10,000 borrowed and paid back
– $200 in interest payments
= -$200 as a loss
If you had a 14% profit margin, you’d be profitable by $200 in the scenario above on the first sale.
Below, you’ll learn how the process of purchase order financing works, when it makes sense, when to avoid using it, and alternatives to let you take new contracts and grow your business.
The Purchase Order Financing Process
Purchase order financing has a 5-step process:
- A customer places a purchase order with a business.
- The company with the purchase order finds a lender, which could be a traditional bank, alternative lender, or a supplier, and asks if they’ll fund the production or inventory costs.
- The lender finances the company so they can meet the obligations from the contract.
- The customer pays for the order, once delivered.
- The company pays the lender back with interest.
It is an easy process and can help you build a strong bond with suppliers as they now have multiple ways to make money with you including selling directly to your business and loaning you money at reasonable interest rates. You can grow your business and, as your business grows, so does theirs.
When PO Financing Makes Sense
Purchase order financing is a good idea when:
- You cannot get a traditional small business loan.
- The new customer or larger order is time-sensitive and you don’t have time to wait for a traditional bank.
- Building a stronger relationship with a supplier or vendor can lead to mutual growth and you want to build their loyalty.
PO financing makes sense when you don’t have enough cash flow to cover the materials, supplies, inventory, or other items needed to fulfill the order, but you’re certain you’ll meet the order with additional funding and your customer will pay when you deliver.
A supplier that sells t-shirts to gift shops on boardwalks knows the buyers will be placing orders shortly before the season begins. If the gift shop merchant opens two new locations because they had a good previous season, they need to stock more inventory. The supplier knows the sales will come in for the shop as demand is strong. This is a good opportunity to use purchase order financing with the gift shop or an alternative lender that offers a manufacturing loan.
Your total profit on the deal won’t be as high with PO financing because of the interest you’ll pay on the loan. But don’t think of it as a one-time deal. Look at the potential lifetime value of keeping this customer happy vs. the slightly smaller profit on the initial deal. If the gift shop expands to new beach towns, you can expand and grow with them.
This applies to non-seasonal businesses like a restaurant owner who is now supplying food to a stadium or a large corporation as their official caterer. The suppliers know sales are going to be consistent because of the contract. By financing the supplies to open the location or provide the service, their future orders could be higher because the relationship between the two companies is strong.
The supplier for paper cups and to-go bags provides the purchase order financing for increasing the restaurant’s ability to meet new customer demands. The company uses the financing to order the supplies from all vendors and grow. Once the revenue comes in, the company knows the supplier is their ally and keeps purchasing with them.
This sounds great for a lot of businesses, but purchase order financing can have downfalls that sour business relationships and can hold businesses back. Learn more below.
Times to Avoid PO Financing
The times to avoid PO financing include:
- When you do not have confidence in your customer’s ability to pay you back.
- When you have the cash flow to fund the new orders even if it reduces your savings temporarily.
- If there will be a strain on supplier, customer, or vendor relationships.
- Interest rates from traditional and alternative lenders are lower.
When you have a relationship with a customer that is strong, but their industry is in a temporary downturn that will last a year or two, a small business loan will be better than purchase order financing. This is because you pay back the money borrowed over time vs. as a lump sum, keeping your cash flow stronger.
If you don’t think the customer will be able to make the full payment or they will be a hassle to collect from, avoid using purchase order financing. If the lender is a supplier or a different customer, your not being able to pay them back quickly can sour their relationship with you and put you in a worse situation.
Another time to avoid this type of financing is when there’s uncertainty regarding whether you can deliver in full because of supply chain issues or difficulty finding the right people in the labor market. This is especially true if your contract has easy out clauses that let the customer walk away if the deal isn’t delivered in full.
When you have time to wait for a traditional loan from a bank or alternative lender offering lower interest rates, you may want to go with a loan instead of PO financing because you’ll save money and there’s no rush. There are plenty of alternatives you can use.
Alternatives to PO Financing
Invoice factoring, also called PO factoring or accounts receivable factoring, is similar to purchase order financing in that you get the financing you need to complete an order but you sell the purchase order vs. borrowing the money and using the purchase order as collateral. Factoring companies will give you a lump sum payment in exchange for getting paid in full by the customer.
Lenders won’t pay the full amount because they need to make a profit based on the risk they’re taking, so the amount you get will be based on a factor rate (the amount lenders use to determine the repayment amount) applied to the total PO amount.
Factoring is great for new businesses or if you have taken multiple loans recently and don’t want to impact your business credit score. Since it’s not a loan, there won’t be a hard inquiry on your credit report and no impact on your score.
Two other types of small business loans also make good alternatives to purchase order financing, including working capital loans and inventory financing loans.
- Working capital loans are another option to fund supplies, materials, or payroll. They’re short-term business loans and can have a higher interest rate than PO financing because they likely won’t have the purchase order as collateral.
- Inventory financing loans work well when you’re using the funds for inventory or raw materials. With this financing, you can use those as collateral for the loan instead of the PO and still get good terms.
Using purchase order financing can allow you to focus on operations and customer service to ensure your new client is completely satisfied. For times when it doesn’t make sense, invoice factoring or other types of small business loans can help you take on new customers and keep your business growing.
