What Is Purchase Order Finance & How Does It Work?

Purchase order finance is a specialized financial solution designed to help businesses fulfill customer orders when they lack upfront capital. It allows companies to procure necessary goods from suppliers, providing the liquidity needed to accept and execute larger sales opportunities. This method ensures growth opportunities are not missed due to temporary cash flow limitations.

Defining Purchase Order Finance

Purchase order finance is a short-term arrangement where a third-party finance company provides capital directly to a business’s supplier. This capital covers the cost of goods needed to fulfill a confirmed customer order. It is tailored for businesses dealing in tangible products, such as distributors, resellers, or wholesalers, and does not apply to service-based operations.

This mechanism differs from traditional business loans. It relies on the customer’s purchase order validity, not solely on the borrowing business’s creditworthiness. The finance company pays the supplier for the goods, allowing the selling business to fulfill the order without using its own working capital. This structure means the financing is non-debt for the seller, as repayment ties to the successful completion and payment of the customer order.

Eligibility and Required Information

Businesses must meet specific criteria to qualify for purchase order finance. This includes operating within a business-to-business (B2B) model and dealing in physical goods, not services. The purchase order must be confirmed and non-cancelable, issued by a creditworthy customer with a reliable payment history. Finance providers often look for transactions with a minimum gross profit margin, typically 20% to 30% or more, to cover financing costs and yield a profit. Some providers may also have a minimum transaction value, which can be around $50,000 or higher.

To assess a deal’s viability, finance companies require documentation during the application phase. This includes the confirmed customer purchase order, along with supplier quotes or invoices detailing goods costs. Businesses must also provide customer credit history information to evaluate payment reliability. Basic business financial statements, such as profit and loss statements and balance sheets, are usually requested to provide an overview of the company’s financial health.

The Purchase Order Finance Process

Once a business has gathered the necessary information and identified a suitable finance provider, the purchase order finance process begins. The business submits its application, including the confirmed customer purchase order and supplier details, for review. The finance provider then conducts due diligence, evaluating the end customer’s creditworthiness, the supplier’s reliability, and the transaction’s profitability.

Upon approval, the finance company directly funds the supplier for the cost of manufacturing or procuring the goods. This payment is often facilitated through a letter of credit, which guarantees payment to the supplier. After receiving payment, the supplier produces and ships the goods directly to the end customer.

Following delivery, the business invoices its customer for the fulfilled order. The customer then remits payment directly to the purchase order finance company, not to the business itself. This direct payment mechanism ensures the finance company recoups its advanced funds and fees before the remaining balance is paid out.

Cost Structure and Repayment

The cost of purchase order finance is typically a fee, calculated as a percentage of the purchase order’s value or the supplier’s cost. These fees commonly range from 1% to 6% per month or per 30-day period. They vary based on financing duration, total amount funded, and transaction risk. Some finance companies may also use a tiered fee structure, where an initial fee covers a set period, with lower rates applying if financing extends beyond the initial term.

The finance company recovers its funds and charges directly from the customer’s payment. Once the customer pays the invoice amount to the finance company, the agreed-upon fees and the initial amount advanced to the supplier are deducted. The remaining balance, representing the business’s profit from the sale, is then remitted to the selling business. This process ensures the finance company is repaid from the proceeds of the sale.