How Does Purchase Order Financing Work?

Understanding Purchase Order Financing

Purchase order (PO) financing offers a short-term funding solution for businesses that need capital to fulfill large customer orders. It functions as a cash advance provided to a seller, allowing them to pay third-party suppliers for goods requested by a creditworthy buyer. This financial instrument is useful when a business secures a significant order but lacks the immediate cash flow or inventory to cover production or procurement costs.

The process involves three primary parties: the seller, the buyer, and the purchase order financier. The financier acts as a middleman, providing funds to the supplier. This arrangement allows businesses to accept and fulfill large orders they might otherwise decline due to insufficient working capital. PO financing helps bridge cash flow gaps, manage increased demand, and maintain operational continuity without straining existing cash reserves.

For a purchase order to be eligible for financing, it must meet several criteria. The order needs to be confirmed, non-cancelable, and placed by a creditworthy buyer. PO financing applies to tangible goods that are resold or distributed, rather than services or goods manufactured in-house by the seller. The order’s value must be substantial, often with a minimum gross profit margin of at least 20%, to justify financing costs.

The Application Process

Initiating purchase order financing begins with an inquiry to a specialized financier. Businesses contact providers to discuss their funding needs and the specifics of the large order. This conversation helps determine if PO financing aligns with the business’s situation and the financier’s offerings.

Following the initial inquiry, the business submits various documents for assessment. This includes the purchase order(s) from the customer, details about the buyer, and information regarding the supplier(s). Financial statements, such as profit and loss statements and balance sheets, along with company history, are required to evaluate eligibility and risk.

The financier conducts due diligence, focusing on the buyer’s creditworthiness and the supplier’s reliability. This assessment ensures the buyer has a strong track record of timely payments and the supplier can reliably produce and deliver goods. The arrangement’s success hinges on the buyer’s payment and the supplier’s performance.

If due diligence is successful, the financier presents a financing offer. This offer outlines terms, including fees, conditions, and the percentage of supplier costs the financier will cover. Upon agreement, both parties sign a formal financing agreement, solidifying the terms and paving the way for funding.

The Funding and Collection Process

Once the purchase order financing agreement is signed, the financier pays the supplier for the goods. This payment often occurs through a letter of credit or direct transfer. The financier may cover up to 100% of the supplier’s costs, depending on the agreement terms and perceived risk.

After receiving payment, the supplier manufactures or prepares the goods and delivers them directly to the buyer. In some cases, delivery might first go to a third-party logistics provider overseen by the financier. This direct shipment streamlines the process, bypassing the seller’s physical handling of inventory.

Upon the buyer’s receipt of the goods, an invoice is issued for the fulfilled order. This invoice includes instructions for payment directly to the purchase order financier, not the seller. The seller sends a copy of this invoice to the financier to confirm the order’s completion and delivery.

The financier then collects payment directly from the buyer. This mechanism ensures the financier recovers advanced funds. Once the financier receives full payment, they deduct pre-agreed fees and the original amount advanced to the supplier. The remaining balance, representing the seller’s profit, is then remitted to the seller.

Costs and Repayment

Purchase order financing involves specific fee structures. Financiers charge fees as a percentage of the total purchase order value or the supplier’s costs. These fees commonly range from 1% to 6% per 30-day period the financing is outstanding. Some agreements may also include a flat fee or a tiered fee structure.

Additional charges may apply for administrative services, due diligence, or wire transfers. Factors influencing these costs include the buyer’s creditworthiness, the order’s size and complexity, and the expected duration of the financing. A longer repayment period by the customer results in higher total fees.

Repayment to the financier occurs directly from the payment received from the buyer. The seller does not make direct payments from their operating capital. The process is self-liquidating: once the buyer pays the invoice, the financier deducts fees and the principal advanced, then remits the remaining profit to the seller.