Ultimate Guide for Purchase Order Financing
What is Purchase Order Financing
Purchase order financing is a short-term solution to fund the purchase of goods. The percentage of the value of the purchase order you may borrow varies from lender to lender. The interest rate is also subject to an assessment by the lender. It is commonly used for trading businesses, i.e. businesses that buy and sell. This form of finance allows such companies to fund the purchase from their suppliers of goods destined to end buyers. Financing is based on the purchase order issued by the buyer.
Purchase Order Finance is usually available for one specific purchase at a time, some lenders offer solutions for repeat financing through ‘Supply Chain Finance’ products. As the name says, those products look at the whole supply chain, not just a single purchase and may involve co-ordinating the financial requirements of more than one company in the supply chain itself.
Usually, a purchase order financing loan has a relatively short life and must be repaid in a matter of months. The logic behind this form of finance is to cover the seller until the buyer settles the invoice. When the supplier has issued the invoice, the borrower settles it. Paying the invoice repays the initial loan disbursement, the borrower also has to settle interest and fees. Some lender requests that the full payment is processed through them so they can include the settlement of interest and fees in the transaction.
Purchase Order Financing and Business Loans
The main difference between purchase order finance and a business loan is the life of the loan and the logic behind the loan.
When a borrower applies for a business loan, the lender usually asks the reason for the loan but the decision is based on borrowers, creditworthiness, their ability to pay, etc. If the application is successful, the lender disburses the cash to the borrower who can use it for a different purpose from the one stated when the application was made. The borrower repays the loan over a specific period of time that may extend to a few years, depending on the arrangements agreed with the lender.
When a borrower applies for purchase order financing, the lender disburses a specific percentage of the value of the PO. The lender will assess the borrower in the same way they would assess it for a business loan, but they also assess the reliability of the supplier and the creditworthiness of the buyer. That assessment will determine the “Loan to Value” (LTV) or ‘the percentage’ mentioned earlier. The borrower does not have the opportunity to receive the cash and use it for something else because it is disbursed directly to the supplier.
Purchase Order Financing and Invoice Finance
The purpose of a Purchase Order financing loan is to make funding available before an invoice can be issued. The buyer’s firm commitment to purchase is enough to support the funding; in other words Purchase Order Financing can be accessed one step earlier in the supply cycle than invoice financing. The seller confirmation of a purchase may happen long before the order reached the invoicing stage, when a company can apply for invoice finance. Purchase Order financing becomes especially useful when the seller must cover various costs before the order is ready to be delivered and the invoice issued. This can be particularly useful for a trading business, e.g. an importer that buys goods from overseas to distribute them locally.
Who can apply
Different lenders have different eligibility criteria for purchase order financing. A google search of such lenders in Singapore has revealed one lender that is willing to consider Sole Proprietors, Limited Liability Partnerships, and Private Limited Company. Most lenders require a company, some a company registered with ACRA. Bear in mind that the financing is granted based – amongst other things – on the creditworthiness of the borrower. Some lenders have minimum revenue and minimum operating history requirements. Lenders are also interested in the overall credibility of your customers.
How does it work
The basic process to apply for a Purchase Order loan is fairly straightforward. For instance, if you are a trading business:
(1). You receive a Purchase Order from your customer and a Proposal from your supplier.
(2). You apply for Purchase Order Financing with a lender. The lender may request the usual paperwork: 6 months of Bank Statements, Financial Statement, or Management Account for the past fiscal year, etc. If they ask for a guarantor they may require a Credit Bureau Statement for the guarantor.
(3). The lender will pay the agreed percentage of the value of the Purchase Order to your Supplier, you pay the remaining balance
(4). The supplier delivers the goods to your Customer (or delivers them to you first but the lender will only act when the goods are delivered to your Customer).
(5). Your Customer will pay the lender in full upon receipt of your invoice.
(6). The lender will then deduct the fees incurred and the interest and return the balance to you.
Some lenders have a product they call ‘supply chain finance’ that basically works in the same way except it does not just cover one specific purchase order but all purchase orders to one (or more) supplier.
Is it limited to trading businesses?
Purchase Order Financing provides cash to fulfil an order before you are ready to invoice. Technically it is not limited to trading businesses but, in practical terms, you have to have a specific purchase tied to a specific sale. If your business is not a straightforward trading business you could probably find a better way to finance the purchase of the goods and services required to fulfil an order to your client. Purchase order finance works well when you have an almost direct relationship between a sale and the need to finance a specific purchase to deliver what you have sold. For instance, it could be a way to finance the raw material to create a unique product for your client. In any other instances, there are other way of financing your purchase (e.g. Business Loans, Business Credit Lines, etc.)
What are the drawbacks?
The main drawback of Purchase Order Financing is its short term nature, this is why it is mostly considered a product for trading businesses where the time difference between paying your supplier and invoicing your clients is relatively short. If the life of the financing arrangement is longer than 90 days you may struggle to get funding based on a PO and if you do it may turn out to be very expensive.
What happens if it is not for you?
You have other options if you cannot meet the business criteria for Purchase Order Financing, or decide that it is not for you, or you do not find a lender. Most of those other options are based on the nature of your business. Do you need to invest in equipment, have more capital available? Then you can explore a Business Loan, secured or unsecured, or maybe P2P lending. Do you need to cover a funding gap that will be filled when you receive payment from your client? Maybe try a revolving Business Line of Credit.
Purchase Order Financing is very convenient to cover specific situations where there is a short term gap in the cash flow between purchase and sale. It allows you to use your capital for other purposes, but if the gap is not short term or there is not a direct correlation between a sale and the need to have funds available then there are other alternatives you can explore.