Purchase Order Financing Explored
Purchase Order financing is gaining popularity as an innovative tool that allows companies to get cash advances from financiers against certain Purchase Orders. This allows the company which might be short on cash to borrow the funds required to purchase supplies required to manufacture goods rather than use their cash. Purchase Order financing differs from factoring or invoice financing in the sense that it provides advance funding which covers the purchase and manufacturing legs instead of just the post-shipment credit period. Because of this fact, PO financing is slightly riskier for banks to fund as compared to funding and thus is slightly more expensive as well.
To reduce the risk of the Buyer / Supplier Relationship, I recommend that the Buying organization deploys online Vendor Portal Software to collect, scorecard and monitor various aspects of the suppliers’ financial stability as well as performance and relationship related data
Purchase Order Financing Benefits and constraints
PO financing has the obvious benefit that it is an advance payment before the raw materials are sourced and the goods manufactured. If the company is short on cash, then it is imperative to obtain funding for manufacturing and sourcing, and the only other option is direct bank funding. However, bank funding would depend on the strength of the balance sheet and financials of the company and might require too much collateral as compared to PO financing. With PO financing, the Purchase Order from a trusted and credit-worthy client would offer the bank or financier some comfort and would thus be cheaper and easier to obtain as compared to direct bank funding.
The constraints of Purchase Order financing relate mostly to the qualification of clients. To qualify, the company has to ensure that the financier is convinced that the PO will be fulfilled, and the payment made once the invoice is generated. This means that the bank will want the products manufactured are relatively standardized and of good quality so that the risk of rejection is minimized. The creditworthiness of the client who raises the PO is also assessed and so is the underlying nature of the transaction – meaning the order should be non-cancelable and not a consignment order.
Client Company – The company which receives the PO and requires funds to fulfill the order
End customer – The company which raises the PO and pays the final invoice
Supplier – The company which supplies raw materials/ semi-finished goods to the Client Company for fulfilling the order
Bank/ Financier – The bank or financial institution which lends money to the Client Company or (more likely) to its supplier based on a PO from the end customer.
Once it is satisfied with the underlying transaction, the bank or financier will either set up a credit line for the company based on the PO or make payments directly to the company’s suppliers for raw material purchases, although most banks follow the latter method. The amount of funding might be 100%, but usually, the banks would keep a margin and fund up to 70%-90%. The bank fee may also be adjusted upfront at this stage itself. If the end customer agrees to route all payments to the company through the PO financing bank, then the risk would be further reduced to the bank and consequently, the funding cost as well.
Once the final shipment is made and the invoice generated, the company may choose to liquidate the PO financing either through a back to back factoring transaction or through the proceeds received from the payment of the invoice. Concluding the PO financing leg of the transaction.
PO financing is ideal if you have good customers, a standardized product and require funds in advance to fulfill an order. PO financing allows you to leverage your balance sheet more than any traditional funding option since it relies heavily on your end customer’s ability to pay once the order is fulfilled rather than your financial strength. In case the end customer is a government entity or a large commercial corporation, banks would be willing to fund a large portion of all your confirmed POs at a much cheaper rate.