Managing cash flow effectively is crucial for the survival and growth of any company. One financing option that is gaining significant attention from growing businesses is purchase order financing. For companies that frequently deal with large purchase orders (POs), this type of financing can be a lifeline, allowing them to fulfill orders and grow without draining cash reserves to take on new business.
Growing companies, especially those with high demand for their products, often encounter outsized purchase orders that far exceed their available cash, receivables, and inventory. Purchase order financing bridges this gap, empowering businesses to take on larger orders that they otherwise couldn’t fulfill due to cash constraints.
What is Purchase Order Financing?
Purchase order financing is a short-term funding solution designed to help businesses manage their working capital and meet customer demands. When a company receives a PO from a customer but lacks the cash to fulfill it, a purchase order financing company can step in and provide the necessary capital to pay suppliers. Once the goods are delivered, the company repays the financing lender from the revenue generated by the sale.
This type of financing is often used by businesses in sectors such as manufacturing, distribution, and retail, where large orders may be placed by customers but the business lacks the cash to pay suppliers upfront.
Why Purchase Order Financing is Critical for Growing Businesses
For a growing company, landing a large purchase order can be both exciting and overwhelming. While the order represents increased revenue and market share, it can also place immense pressure on the company’s finances. Many companies in growth phases experience cash flow imbalances due to larger orders outpacing the available working capital. In fact, these companies often have outsized POs relative to cash, receivables, and inventory.
Outsized POs Relative to Cash, Receivables, and Inventory
When a company receives an outsized PO, it means the value of the order is disproportionately large compared to the company’s current cash reserves, receivables, and inventory. This imbalance creates a significant challenge: the company needs to procure raw materials or finished goods to fulfill the order, but it lacks the funds to pay its suppliers upfront. As a result, the company risks losing the order, damaging its reputation, or turning away growth opportunities.
Purchase order financing solves this problem by providing businesses with the necessary funds to cover supplier costs, allowing them to complete the order and earn the associated revenue.
How Purchase Order Financing Works
Understanding how PO financing works involves grasping the life cycle of a purchase order and the various stages at which financing can be used. Here’s a step-by-step breakdown of the PO financing process:
1. Receiving the Purchase Order
The life cycle begins when a company receives a PO from a customer. This document outlines the products or services the customer wishes to purchase, along with the agreed-upon price and delivery timeline.
2. Financing the Purchase Order
After receiving the PO, the company may realize that it lacks the capital to pay its suppliers for the goods or materials needed to fulfill the order. This is where a purchase order financing provider comes in. The financing provider agrees to cover a significant portion of the supplier costs, typically up to 100% of the purchase cost, allowing the company to proceed with fulfilling the PO.
3. Supplier Payment and Goods Delivery
Once the financing is in place, the lender pays the supplier directly for the goods. The supplier manufactures or delivers the goods, and the company then ships the finished product to the customer, as per the terms of the PO.
4. Converting to Invoice Financing
After the goods have been delivered, the PO converts into an invoice. At this point, the company can opt to use invoice financing (also known as accounts receivable lending or factoring) to cover any remaining cash flow needs. With invoice financing, the company receives a cash advance on the customer invoice, typically 70-90% of its value, which helps bridge the gap between delivery and payment.
5. Customer Payment and Loan Repayment
Once the customer pays the invoice, the company repays the purchase order financing provider. The cycle is complete, and the company is free to take on more orders and continue growing.
Example: PO Financing Calculation
Let’s walk through a practical example to illustrate how purchase order financing can support a growing company.
- Purchase Order Value: $100,000
- Gross Margin: 50% (The company expects to make $50,000 in profit after costs.)
- Cycle Time: 60 days (Time from when the vendor is paid to when the company collects payment from the customer.)
In this scenario, the company’s cost of goods sold (COGS) is 50% of the PO value, which is $50,000. However, the company needs to pay the supplier upfront, long before receiving payment from the customer. Here’s how much capital the company would need:
- Supplier Payment: $50,000
- Gross Margin: $50,000
- Cycle Time: 60 days
Without purchase order financing, the company would need to have $50,000 in cash on hand to pay the supplier and fulfill the order. Given that many growing companies have limited cash flow, securing this amount of capital can be challenging.
With purchase order financing, the company could finance the $50,000 needed to pay the supplier, allowing them to fulfill the order and earn the $100,000 in revenue. Once the customer pays the invoice, the company would use the proceeds to repay the financing provider, keeping the remaining profit.
Why PO Financing is the Perfect Fit for High-Growth Companies
One of the biggest benefits of purchase order financing is its scalability. As a company continues to grow and land larger purchase orders, the need for additional working capital increases. Traditional bank loans often aren’t flexible enough to meet this growing demand. PO financing, on the other hand, scales with the size of the orders, allowing businesses to take on more orders and continue expanding without straining their balance sheet.
Leveraging PO Financing for Business Expansion
Purchase order financing not only helps businesses manage cash flow but also enables them to seize growth opportunities that would otherwise be out of reach. Consider a company that has just secured a major order from a new client. The order could catapult the business to new heights, but fulfilling it would require significantly more working capital than the company currently has.
Rather than turning down the order or risking its financial health by stretching its cash reserves, the company can use PO financing to bridge the gap. By paying suppliers upfront with financing, the company can deliver the order on time, impress the new client, and solidify its market position.
How Receivables Financing Compliments PO Financing
As mentioned earlier, purchase order financing often works in tandem with invoice financing to optimize cash flow management. Once a company delivers the goods and converts the PO into an invoice, invoice financing can provide the additional capital needed to cover operating expenses while waiting for the customer to pay. Together, these two financing options ensure that businesses can continue fulfilling orders and growing without disruptions.
FAQs
What is PO financing?
Purchase order financing is a funding solution that allows businesses to finance the cost of fulfilling customer purchase orders when they lack sufficient cash reserves.
How does PO financing differ from invoice financing?
Purchase order financing covers supplier costs to fulfill a purchase order, while invoice financing provides an advance on customer invoices once the goods are delivered.
Can startups qualify for PO financing?
Yes, many purchase order financing providers work with startups and growing businesses, as long as they have confirmed purchase orders from creditworthy customers.
How much can I finance with PO financing?
Depending on the financing provider, businesses can typically finance up to 100% of the supplier cost.
What industries use PO financing?
Industries such as manufacturing, retail, wholesale, and distribution commonly use purchase order financing due to the large volume of orders they handle.
What are the costs associated with PO financing?
Costs vary by provider but generally include financing fees based on the size of the purchase order and the duration of the financing.
Conclusion
Purchase order financing is a powerful tool for growing companies, enabling them to take on larger purchase orders without overextending their financial resources. By providing the capital needed to pay suppliers upfront, this type of financing helps businesses fulfill orders, satisfy customers, and continue their growth trajectory. When used strategically, PO financing can become a cornerstone of a company’s financial strategy, allowing it to expand operations while maintaining a healthy cash flow.