What it means
Imagine a small distributor wins an order worth $200,000 from a large retailer, but needs to pay its manufacturer $140,000 before shipping. If it cannot raise that money, it must refuse the order.
Purchase order financing bridges the gap by paying the supplier directly, so the goods can be made and delivered. The lender looks mainly at the quality of the order, not the strength of the borrower.
Key questions are whether the end customer is creditworthy, whether the supplier is reliable and whether the profit margin is large enough to cover the fees. The arrangement is attractive to young businesses with limited credit history.
Once the goods are delivered and the customer is invoiced, the lender is usually paid from the customer's payment, and the balance goes to the business. Fees are generally charged as a percentage of the funded amount for each period the money is outstanding, often per month.
Total costs can be high compared with a bank loan, so the order needs a healthy margin. It is different from invoice financing, which advances cash against invoices already issued.
Purchase order financing comes earlier in the cycle, before the goods exist. Some businesses use both in sequence, first funding production and then financing the resulting invoice while waiting for payment.
The risks include delivery failure, quality problems or a customer who refuses to pay, any of which can leave the lender exposed and the business with a dispute. Lenders therefore often insist on verifying the order and on controlling the payment flow.
Thin margins, low-value orders and custom-made goods are usually harder to finance. Businesses should compare the cost with the alternatives before they sign.
A bank overdraft or loan is usually cheaper, but may not be available to a new company, and turning down a large order has a cost of its own in lost profit and customer goodwill. A short calculation of fees against gross profit makes the choice clear.
In practice
Real-world examples.
Example
A toy importer receives a $300,000 order from a national chain before the holiday season. It uses purchase order financing to pay its overseas factory $210,000. The goods ship on time and the importer keeps a profit after fees.
Example
A uniform supplier wins a government contract for $90,000 of clothing. The supplier has no cash to buy fabric, so a financier pays the mill. The government pays the invoice 45 days after delivery.
Example
A start-up food brand lands its first supermarket order of $60,000. The founders use financing to pay for ingredients and packaging. Without it they would have turned the order down, and the retailer might never have offered a second one.
Formula
Calculation
Financing fee = funded amount x fee rate per period x number of periods; profit after financing = sale price - supplier cost - financing fee
Suppose a business receives a $200,000 purchase order and the supplier cost is $140,000, which the financier pays directly. The fee is 3% per 30 days, and the customer pays after 60 days, so the fee is 140,000 x 0.03 x 2 = $8,400. The gross profit on the order is 200,000 - 140,000 = $60,000, and after the fee it is 60,000 - 8,400 = $51,600, a margin of 51,600 / 200,000 = 25.8%.Case study
Seen in the real world.
Fernlight Apparel is an illustrative, fictional clothing brand that received an order for $250,000 of jackets from a department store. Production would cost $170,000, and the company had only $25,000 in the bank.
The founders arranged purchase order financing at 3% for each 30 days and expected payment in about 75 days. They calculated that the fee would be about 170,000 x 0.03 x 2.5 = $12,750 and the profit after the fee would be about $67,250. Because the margin comfortably covered the cost, they accepted, and the illustrative lesson was that turning down the order would have cost more than the fee.
The jackets shipped on time and the department store paid after 72 days. The financier collected its principal and fees, and Fernlight received the balance. The illustrative founders used the profit to reduce their reliance on financing for the next season's order.
Watch out
Common mistakes.
- Accepting financing on an order with a thin margin, so the fees consume most of the profit.
- Forgetting that fees are charged for every period the money is outstanding, so late payment makes the cost grow.
- Assuming any order qualifies, when lenders require a creditworthy customer and a reliable supplier.
Questions
People also ask.
How is it different from invoice factoring?
Factoring advances cash against invoices already issued, whereas purchase order financing pays for the goods before they are made or shipped.
Who is paid first when the customer pays?
Usually the financier, which deducts its principal and fees before sending the remainder to the business.
Is purchase order financing expensive?
It can be, compared with a bank loan, so it suits orders with high margins and short payment times.
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