What is a Purchase Order?
A purchase order is a legally binding document that shows an agreement between a buyer and a seller on the prices and quantities of certain products or services. It is commonly known as PO
While sellers send out invoices to their customers, a purchase order is sent by a customer (who has agreed to buy a particular quantity of a product or service at a particular amount) to their seller.
Sometimes, a business cannot afford to finance its purchase order due to the restriction of cash flow created by payment terms. This is especially particular in the cases of a small business that has received a large purchase order or multiple orders at once. In a situation where a business is having such experience, the business can turn down the PO but this could lead to a business losing its customers. A better option for the business will be alternative financing more specifically, in this case, Purchase Order Financing.
What is Purchase Order Financing?
Purchase order financing is an arrangement that provides working capital for businesses (especially small businesses) that can't fulfil their purchase orders due to a restriction in cash flow. This involves a cash advance from a third party to fulfil their customer's purchase orders.
Who uses Purchase Order Financing?
• Distributors: Purchase Order financing helps distributors reduce the immediate costs of production while still meeting buyers' demands and providing quality services. PO financing helps distributors maximize inventory, especially during periods of high demand.
• Outsourcers: Businesses that engage in outsourced manufacturing use purchase order financing to fund their inventory and production cost. This helps them fulfil their PO without the risk of loss and fraud.
• Retailers: PO financing helps free up cash flow for retail businesses. It helps to lower the amount of inventory the retailer maintains and this helps them to take on more customers and not focus on investing all their funds in inventory.
• Wholesalers/Manufacturers: Sometimes, wholesalers require a large amount of inventory or raw materials and they still need money to fund other expenses of their business. PO financing gives them a chance to fund their inventory and buy the raw materials they need to fulfil their order while directing their working capital to the other expenses of the business.
• Businesses that are experiencing tight cash flow
• Businesses that have a high seasonal sales structure.
How does Purchase Order Financing work?
Purchase order financing usually involves a party of four. The parties include:
• The Business/Borrower: This refers to the business seeking financial assistance to fulfil its purchase order.
• The financier/Lender: This is the purchase order financing company. They confirm the authenticity of a purchase order and provide funds to the supplier.
• The supplier:This is a third party that sells goods or manufactures raw materials for the goods sold by the business/borrower. They receive their payment from the financier and supply the business with what they need to fulfil their Purchase order.
• The customer:This is the company trying to buy the goods. It is their Purchase Order the borrower/business is trying to fulfil. Usually, once the PO is fulfilled and the goods have been sent, they pay the financiers directly.
The process of purchase order financing
Here is a breakdown of the steps involved in PO financing:
• The business receives a purchase order from the customer. This is usually for a large supply of products.
• Cost Determination: The business contacts its supplier to find out the cost of fulfilling the purchase order. The supplier then sends over a cost proposal which helps the business determine if it requires financing from a third party like a purchase order financier.
• Apply for purchase order financing: Once the business realizes that it requires financing, they find a good PO financing company and apply for financial aid. The financier checks out the authenticity of the business. They check out the Purchase order and the cost proposal. Usually, the financier might approve up to 100% of the supplier's cost but it is dependent on the reputation and credibility of the other parties involved. If the financier finances only a certain percentage(e.g 80%), then the business/borrower is required to take responsibility for covering the remaining cost(i.e the 20%).
• Once the Financier has verified the authenticity of the business and the request is approved, the supplier gets paid. This is usually done by a letter of credit ( a document from a bank that guarantees payment of the agreed amount by the buyer to the seller at the approved time once certain conditions are met). The conditions of the letter of credit, in this case, might be delivery of goods and proof of delivery.
• The supplier might deliver goods directly to the customers or deliver materials for production to the business and then the business delivers to the customer. Once the customer gets goods, the order is complete and the letter of credit is honoured.
• Invoice customers: After the customer has received the goods, the business sends an invoice and states the terms of payment. This invoice is also sent to the financier so that they know the amount to expect from the customer and when it is due.
• Customer pays PO financier: when the agreed time of payment comes, the customer pays the purchase order financing company directly
•The PO financier then pays the business after deducting their fees.
Benefits of using Purchase order financing.
Some of the advantages that a business gains by using Purchase order financing include:
• It is a good option for seasonal businesses or businesses growing, as it provides them with the extra working capital to fund large orders. This allows such businesses to take on more customers rather than turn them away.
•Businesses do not have to go through the stress of collecting payments from customers.
• The process required to access purchase order financing is not very rigorous. It can be set up quickly and easily.
• Businesses do not have to take a loan and pay monthly installments.
• It allows business owners to retain ownership as they do not have to sell equity to other parties.
Disadvantages of using Purchase order Financing
•It can be expensive.
• When using a PO financier, the business loses control of the process and this might lead to a risk with customers as business dealing might not be handled in a manner that the business owner would prefer
• It only covers the expenses associated with the production or purchase of physical goods.
• It is not flexible and can only be used for purchase orders. It can not cover any other business expenses.
• It might give customers the idea that a business has problems with cash flow.
Cost of purchase order finance
Usually, a purchase order finance fee ranges from 1.5% to 6% of the total supplier's cost per month. Generally, the longer it takes for a customer to pay back, the higher the fee is deducted when the customer pays back. At bridger, we care about business growth and so we offer customers purchase order financing with a 5% rate fee per month. This does not involve any extra charges. Also, we provide a platform where a business can create, manage and send invoices to their customers at no cost. To find out more about Bridger and our services, visit here