December 12, 2022

Top 10 Advantages and Disadvantages of Purchase Order Financing

Almost 60% of small business owners face cash flow problems every month. Let that sink in.

If you are one of them, you understand the need for short term financing, especially to keep your working capital afloat. This is where purchase order financing comes in.

Purchase order financing also becomes critical when you can’t gain access to traditional banking finance. In such cases, Purchase Order Financing companies step in to ensure that your operations never stop.

If you have a large order to fulfil but a dearth of capital, purchase order financing would be the perfect way to go. With minimal interest rates and faster processing time, this is the answer to your working capital woes.

We have curated a detailed guide on purchase order financing for you, covering what it is, its top advantages, disadvantages and alternatives. Let’s explore!

What is meant by Purchase Order Financing

Purchase Order Financing or PO financing is a third-party arrangement where a PO financing company agrees to provide funds to a supplier to complete a customer’s purchase order.

This type of financing is necessary when there is lack of liquidity with a supplier to complete a large purchase order. These are also called purchase order loans and such an arrangement may fund a completed purchase order or it may fund it in a partial manner.

This form of financing is more prominent for small businesses that have little to no access to traditional banking finance. Banks do not provide easy access to small businesses; hence, third parties step in to fill this financing gap.

These third parties can be Non-Banking Financial Companies (NBFCs) or dedicated purchasing order financing companies (PO). These institutions are less worried about the credit score of the supplier and more focused on the creditworthiness of the buyer placing the order.

Moreover, PO loans are much easier and faster to claim than traditional banking loans and provide a reasonable interest rate. Following are some supplier examples who tend to use purchase order financing:

Resellers
Wholesalers
Businesses with seasonal sales pattern
Businesses with tight cash flow and longer receivable cycles
Distributors
Outsourcers

It is also important to understand how purchase order financing works. Following would be the steps that any supplier follows while applying for a purchase order loan:

The first step to purchase order financing is when a customer places a large order with a buyer.
The supplier then approaches PO financing company with the purchase order/invoice.
The supplier also provides clear details on the amount he wants to get financed.
The PO financing company does a credit check on both the supplier as well as the customer.
Once all the financial checks are done, the PO company then provides the required funds to the supplier.
These funds are then utilised to fulfill the order.
Next, the PO company directly collects the payment from the customer once the goods are supplied.
And finally, the PO company deducts its fee and transfers the remainder of the payment to the supplier.

Top 10 Advantages of Purchase Order Financing

Following are the top 10 advantages of purchase order financing:

Inventory management: Purchase order financing provides flexibility in managing inventory in conditions where capital is limited.
Growth Momentum: This method ensures that a company continues its growth momentum without taking excessive debt or diluting its ownership.
Maintains cash flow: This type of financing ensures there is sufficient liquidity with a supplier to keep their working capital intact.
Increased sales opportunities: By opting for PO financing, there are added sales opportunities and the scope of increased market share for a supplier.
Improves invoice timelines: Purchase order financing helps ensure a supplier does not get stuck with its invoices as funds are immediately available from a PO financing company.
Its not a loan: This is one of the biggest advantages of purchase order financing as it is an advance on working capital alone and not against any collateral.
Easy to procure: As the burden of credit score lies on the customer and not the supplier, it becomes easy for the latter to procure PO financing. Moreover, small businesses are easily eligible for purchase order financing.
No long term payment plans: As the fee is directly deducted out of the invoice, the repayments are quick with no long term liabilities.
No middlemen: As the PO financing company directly pays the supplier, there are no middlemen involved, hence no commission fee.
Can be combined with other methods: This method is easy to combine with other financing methods such as invoice factoring, to make a more robust borrowing mechanism.

Top 10 Disadvantages of Purchase Order Financing

Despite how convenient this sounds, there are a few disadvantages this financing types coms with. Here are the top 10 disadvantages of purchase order financing:

Only works on high-profit margin transactions: Purchase order financing is best suited for high-margin transactions. Thus, small orders may not qualify for this. In general, a gross margin of 20% is the minimum for transactions, but higher margins are preferred. Thus, companies must carefully monitor the impact of funding costs on margins.
Is a short term solution: This financing type is not a long-term solution to business problems. It does not solve things in the long run and may even affect future orders.
Upfront fee: The purchase order financing company charges an upfront fee, usually a percentage of the order. The receiving company has to pay a dedicated amount of fee to the PO service provider before availing the service.
Assist dealers/resellers: This can only be used by companies that resell their products, not companies that manufacture their products. Companies involved in manufacturing should consider financing their supply chain.
Covers direct supplier costs only: The financing company will only cover the supplier's costs associated with the fulfilment of the order. Purchase order funds may cover the freight charges but do not cover other business expenses such as salaries, rent, and development.
Communication: As soon as the financial company steps in, client communication is no longer in the company’s hands. As the PO financing company directly takes over all communication with the buyer, it has access to sensitive information of the company, posing a risk for the supplier.
Unsatisfied clients: Seeking help from a contract finance company can strain your relationship with your client. The borrower's customer deals directly with the lender. This can be a problem for some clients who are unhappy that their invoices have been "sold" to third parties.
Confidentiality: Using purchase order financing reveals potential problems in the business that may prompt the customers to look for other solutions, since the customers may think that the company has liquidity issues.
Qualification: This funding is not available for service-oriented businesses. A physical product is required to qualify.
Potential risk: Working with a purchase order financial company can be tricky. The company may be required to sign a payment guarantee form even if the client does not pay.

Best Purchase Order Financing Alternatives

If purchase order funding doesn't seem to be the right funding tool for your small business, there are many contract financing options you can use to get the funds you need to grow your business. It's also great as an interim solution when you need a short-term solution to get the job done. Below are some of the most common ones.

Invoice financing: Invoice finance is a type of small business loan in which a company borrows outstanding invoices rather than selling them to a factoring company. You will only receive quick cash equal to your outstanding bill. Your customers will never know about this funding since it is a confidential agreement.
Outside Investors: Outside investors may fund your business if you willingly give up your equity or incur debt. When you work with the right investor, you benefit from someone who knows what they are doing and has a lot of establishments that can help your business grow.
Cash Advances: Merchant Cash Advances are assigned to eligible businesses that have a large number of credit card transactions every month. Though this form of funding is very expensive, you will get a percentage of future credit card earnings cashed, so instalment payments might be reduced.
Business line of credit: It is similar to a business credit card, but with higher credit limits. It has lower interest rates and is great for funding small trade purchases. It can also fund bigger expenses with quick access to revolving cash and flexible financing that can be used for almost everything.
Term loan: A term loan provides access to a lump sum payment that you repay periodically. It is not as fast as short-term loans, but it can get you more money with longer reimbursement terms, and low interest rates. It requires higher credit and has expected payments.
Non-bank lenders: Borrowing from non-bank lenders has emerged in recent times as a way to fund small businesses. Qualifying for these types of loans is easy and the application process is not tedious. However, they often come with very high interest rates and the lender is obligated to repay the loan plus interest – even if the business goes bankrupt.

Final Words

Even though purchase order financing may not be the only source of financing for working capital needs, it definitely ticks a lot of boxes for a small business owner. From being a quicker alternative to traditional bank loans and consequently, ower stress for a business owner, purchase order financing provides various benefits.

However, there are no free lunches. Purchase order financing comes with its own set of disadvantages - that range from its limited feasibility in the short run and the fact that it is only useful for high-margin transactions. Hence, even though it may be a viable source of short-term funding for small businesses, it has its own cons.