When a buyer issues a purchase order to a seller and the latter accepts it, this document becomes a legally-binding agreement between the two parties. The problem here is that, the final customer gets a long payment terms to pay for the product, which can sometimes stretch for months, while at the same time, the buyer needs to pay the supplier. This means that the buyer has to have a substantial fund already, otherwise the PO will disrupt their cashflow.
There is a solution to this problem, however, and it is called purchase order financing. In this article, I will explain what PO financing is and how it works. Hopefully, this will give you a good idea if this is the right thing for your business or not.
What is Purchase Order Financing?
Purchase order financing or purchase order funding is an advanced payment that a bank or other financing organization issues to the buyer to help them pay their supplier for the goods. In other words, this is funding a buyer receives before sending the goods to the end customer and before it invoices them.
This type of financing is dependent on your past history with the suppliers and customers and your credit record. This is why it’s more suitable for already established companies like business-to-business (B2B) or business-to-government (BTG) than, for example, startups.
Another thing of note to remember about PO financing is that you can only receive it for finished goods and products, not for raw materials, parts and components.
How Does Purchase Order Financing Work?
I’ll explain the whole process of PO financing at greater length in a future article, but for now, I’d like to give you an example of how it works.
Let’s say your company sent a PO for $1000 worth of construction equipment. The supplier then charges you $800 for this equipment and asks you to pre-pay for them. Unfortunately, you don’t have this money on you (remember the two problems with purchase orders we talked about in the introduction of this article?).
So how to get around this? By using purchase order financing and having a financial institution pay the supplier in your name, until you get paid by the customer. With this money, you can repay the financing institution, thus completing the circle, but without causing damage to your cashflow.
How does this work?
- You issue a PO to the seller for X amount
- The seller asks for a prepayment
- Your company turns to a bank for purchase order financing
- The bank reviews your credit, company and the transaction to make sure you check all categories
- They then pay the supplier. Directly. The money doesn’t go to the buyer and then to from him to the supplier, but directly from the bank to the supplier
- Once the supplier receives the money, they manufacture the equipment and send it to the buyer
- The buyer next inspects the goods and sends them to the customer, which they then invoice themselves.
This is, of course, a very simplified explanation of how purchase order financing works. There’s a lot more involved here and the process also involves other parties, like the shipping company. Also, should the goods fail the inspection and the customer refuses to receive them (either for being damaged or for some other reason), then that is a whole other problem, which this article is too short to deal with. We can talk about it in the future.
Purchase order financing is an excellent way to protect your cashflow when using POs. However, you need to have a good credit record and reputation. Have you ever used purchase order financing? How did it work out for you? Let us know in the comments and don’t forget to subscribe your email to receive important updates to our Purchase Order Plus software.