And Why Should Business Owners Care?
Many business owners who are unfamiliar with the many forms of commercial financing, misinterpret what exactly Accounts Receivable Financing or Purchase Order Financing can do for growing a business.
The biggest misconception people make is something like:
“I am about to get a big purchase order and I need some working capital to get it started.”
So, first of all, P.O. Financing will not pay you cash up front so you can start working on an order. It also will not provide capital upfront to purchase inventory to be sold at a later date (when a purchase order comes in.)
The typical P.O. Financing scenario is:
- A creditworthy customer who issues a bona fide P.O. – an obligation to purchase once the goods have been delivered.
- The client borrower who needs PO financing then negotiates with a supplier to fulfill the order.
- The supplier is asking for cash up front or a guarantee of payment.
- The borrower has the order they are trying to fill but lacks the capital to guarantee payment to the supplier.
- When the supplier feels confident they will get paid, they produce the product and drop ship it to the end user who placed the initial order.
This is a very clean example of where the purchase order finance company steps in.
First, the finance company needs to actually see the P.O., to see if it’s real and has been issued. Next, they determine whether the purchaser or account debtor (customer) has qualified for credit on the sale. Then the supplier side of the equation is introduced and due diligence is prepared to know exactly where everything is going, how long it will take, breakdown of the costs, etc.
Ultimately the P.O. finance company is going to issue an Irrevocable Letter of Credit made out to the supplier. When the supplier ships the goods, has the order inspected, and the required documents sent to the bank, the supplier will be able to invoke the letter of credit made payable to their bank, and be paid for the shipment.
4 things to know about Purchase Order Financing:
- 1. P.O. Finance companies like situations where all the parts have worked previously. A new start-up with their very first purchase order is riskier than a company who has been selling the same product from the same supplier over and over, this time just happens to be a significantly larger order.
- 2. The P.O. finance company must be paid in full when the customer accepts the shipment, which means the borrower will also be using an invoice factoring company. The factoring company lets the P.O. finance company know the customer has credit, then when the shipment is accepted, an invoice is produced and the advance from the factor goes directly to pay the outstanding amount to the P.O. finance company.
- 3. The client borrower must have at least 30% profit margin on the transaction to qualify.
- 4. Most PO finance companies require the goods to go directly to the end user. It is rare they will allow the client borrower time to accept the goods, work on the product (add things, put it together) and then re-ship the order.
An over looked aspect of purchase order financing is having a professional finance company oversee the issuance of the letter of credit and deal with inspections of the shipment. Banks can be tricky enough with letters of credit, but many problems can arise when you add a foreign country where the supplier is located. Having the experience of a good finance partner can make all the difference.
About the author
Gary Honig has been active with the factoring industry since the early 1990’s where he began as a business development officer for the existing Creative Capital Associates. In March 1997 he spearheaded a takeover of the company and reformed it as a Maryland corporation. Mr. Honig has been at the helm since and oversees all aspects of running CCA which still provides commercial invoice factoring nationwide. He is a participating member of the International Factoring Association (IFA) which is the long standing factoring industry association. He is routinely called upon as an expert with thorough knowledge of the receivables factoring industry.
He can be reached at [email protected] and on Twitter @garyhonig.
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