So, how do you get around this? Do you have to turn the customer away? And if you do, will you ever see the growth you desire?
Fortunately, you do have other options. One of these is Purchase Order Financing.
What is purchase order financing?
Purchase order financing is where you essentially borrow money in order to fulfil a purchase order. This allows you to borrow money for anything from a few days to a few months.
This helps you to stay cash-positive and not completely wipe out your cash reserves, just to keep a new big or fast-growing client.
How does purchase order financing work?
Purchase order financing is very simple to understand, once you know how it works.
Essentially, it prevents you from having to turn down a sale because you can’t afford to order stock for your client. For example, if you’re a wholesaling business for pet stores, you may find that a large state-wide chain turns to you when their normal supplier lets them down. Their order is big – bigger than you have the cash to purchase on their behalf.
Of course, you don’t want to let this order go, because it’s your chance to win one of the biggest pet store chains in your area. So, instead of telling them you can’t do it, you turn to purchase order financing.
The steps will then look something like this:
- You get your purchase order from your client
- You get an accurate quote from your supplier for how much the goods cost
- You apply with a purchase order financing lender and give them their required information plus the purchase order from your client, and your suppliers quote
- When approved, they pay your supplier, and the order moves ahead as normal
- Your customer receives the product and you invoice them
- The customer will pay your lender
- The lender will send you the revenue from the order, minus their fee
Who should use purchase order financing?
Any business that sells products to another business (B2B) or public or government organization (B2G) can use purchase order financing to grow their business and help them get through tight financial periods.
The only limitations on who can use purchase order financing is that you can’t sell parts of another product or direct to consumers.
The types of businesses that typically benefit from purchase order financing are:
- Businesses that experience seasonal spikes
- Distributors
- Wholesalers
When should you use PO Financing?
PO financing is a great option when you’ve got a client you don’t want to let down, but you can’t afford to finance their order alone. If you’re in good financial standing otherwise, and know this client will make a big difference to your growth as a company, then PO financing is a great option. Other common reasons to use it are:
- You sell a lot of products at one time of year: for example, if you sell gifts and decorations for celebrations at the end of the year, or patio furniture and barbeques for the summer. Often, you’ll see a large sales spike and it’s difficult to hold on to cash ready for that time of year.
- A marketing campaign has knocked it out the park, and you see a huge sales spike: we all hope for substantial fast growth, but if you’re not ready for it and can’t meet customer demand, a huge sales spike can leave you scrambling. In worst case scenarios, it has even killed businesses because they couldn’t keep up on their promises. Purchase order financing can help you cover those extra orders so you can take full advantage and grow to meet demand.
- You have consistently tight cash flow: if you work on tight cash flow but a large volume or size of orders, then purchase order financing can be a great way to grow to meet demand.
What are the qualifications for purchase order financing?
Purchase order financing can be difficult to attain for small businesses and startups, so that is something you should be aware of. Generally, the loan amount starts at a minimum of $20,000, though this is $50,000 with some lenders.
There are a few other things you need to have to qualify for PO financing:
- You must serve B2B or B2G customers
- You cannot sell part of another product
- You cannot use it for anything other than physical products (no services or digital products)
- Your profit margin on the order must be 15%+
- Your customer’s credit must be relatively good, otherwise there’s too much risk
- Your supplier must be trustworthy and in good standing
- You need to be a reputable company in good financial standing, though they won’t look at your finances as closely as they will your customer’s.
What are the rates for PO financing?
PO financing has the benefit of being different from traditional bank loans, so you won’t pay an interest rate per month over a long period of time. However, they do still charge interest, and this can quickly eat into your profits (hence why they ask for a good-to-high profit margin).
Most purchase order financing companies charge per month, based on how long it takes your client to pay them. So, if you know your client takes a full 90-day cycle to pay you, you’re going to need to prepare to pay 3 times the interest on your purchase order.
It’s important that you calculate this before you agree to your purchase order financing, so that you don’t end up making nothing (or worse, be in the red) because of their order and pay time.
Most rates are 1-6% for the first 60 days, though some increase thereafter. The longer it takes your client to pay, the more the lender will charge.
How much does purchase order financing cost?
Obviously, this varies significantly based on the lender, purchase order amount, and how long it takes to pay. Let’s return to our pet supplies wholesaler example to see what it might look like for your business.
The state-wide chain wants to buy $100,000 worth of dog harnesses through you.
Your PO financing lender requires you finance 40-60% of the order yourself, so you plan only to finance $50,000 of the order.
You talk to your PO financing lender, give them all the required paperwork, and they say they can offer you an interest rate of 5% a month. This is high, but many other companies charge interest every 10 days after the first 30 days, and you trust this client to pay within your encouraged 30 day window.
Most lenders will charge fees, but for this example, we’ll say they’ll charge 1% in fees, so $500.
You sit down and take a look at whether or not this order will be profitable for you. You know you’ve got a good margin to work with: 20%.
20% of $100,000 is $20,000, so clearly you don’t want to lose too much of this profit, especially since you’ll be financing 50% yourself.
If your client pays in the first thirty days, you’ll make $7,000 from the financed part of the purchase order – so $17,000 profit total. (5% of $50,000 is $2,500, plus the 1% in fees is $3,000)
If the client takes 60 days to pay, their interest rate will take another $2,500 from your profit, so you’ll only make $4,500 from the PO financed part of the order.
If they take 90 days, you’ll see another $2,500 slip through your fingers, at which point you’ll only be left with $2,000.
That means, that for the total order, your profit can range from $17,000 to as little as $12,000. It will be up to you to figure out if it’s worth it for you or not.
What are the pros and cons of PO financing?
Pros
The pros of PO financing are:
- Allows you to take on big clients
- Smooths over seasonal spikes
- If a client doesn’t pay, your lender will act as a collection agency
- You can rise to meet sudden demand
- It’s easier to get if you’ve had bad credit in the past
- Once you’ve developed a relationship with a PO financing company, you can use them again and again
Cons
The cons of PO financing are:
- Your profit margin can shrink fast if your customer doesn’t pay
- The order purchase price has to be high for you to be considered
- You can only use it for one order at a time
- Your customer will likely know you’re using a financing company to work with them, and they may not like it
How to Apply for Purchase Order Financing
Fortunately, applying for purchase order financing is a simple process, once you’ve got all the right documents. Plus, once you’ve got a relationship with a lender, you can use them again and again, and get approval almost immediately.
To apply for purchase order financing, you simply need to do your research and find a reputable purchase order financing company you meet the requirements of (how long you’ve been in business, etc).
Then, you get your purchase order from your customer and an accurate quote from your supplier, and submit them to the lender.
If they approve all your documentation and deem your customer creditworthy, they’ll fulfill the order for you and you’ll have your approval. From there, it will be easy to use them again in the future.
Purchase order financing can be the perfect solution for wholesalers, distributors, and other “middlemen” businesses that have to work on tight margins and require volume to make a lot of money. If you don’t qualify for PO financing, Invoice Factoring is another form of financing that may better suit you.
