Purchase order financing is probably one of the most misunderstood products in trade finance. In part, this comes from the fact that the product has a generic and all inclusive name. The purpose of this article is to help you understand what po financing is and how it works. However, let’s start with what it’s NOT.
It will not give you cash for purchase orders
This is biggest misconception about the product. The finance company will not give your company cash directly, using your PO’s as collateral. The reason for this is very simple, if for some reason your company does not fulfill the order requirements the collateral will be worthless. It’s a tough pill to swallow for some business owners, but finance companies have to protect themselves against this possibility.
It’s not a solution to build inventory that will be sold later
Unfortunately, this is not a solution that can be used to purchase inventory that will be stored for later sale. If you think about it, you need a purchase order that needs to support the financing. Remember that the solution uses the purchase order from your client as collateral.
So, what is purchase order funding good for?
This solution is good for a transaction that is the resale of finished goods. Basically, you have a purchase order from a credit worthy commercial or government client. And, you need money to buy finished goods from your supplier to fulfill the order. If this is the case, then order funding can help you as long as your gross margins are above 20% and as long as the orders meets the qualification requirements.
Most transactions follow a simple structure where the po finance company pays your supplier directly, usually through a letter of credit. That enables the supplier to ship the goods to your client. The transaction concludes once your clients pays for the goods. You can follow this link for more information on po funding transaction structure.
Managing costs the smart way
One challenge of this product is that it can be expensive, especially when compared with conventional bank financing. One way to reduce the total cost of a transaction is to use this solution in combination with a factoring financing facility. Basically, you can use the order financing line to handle the supplier expense and then close that account by financing the receivable as soon as the product is delivered. When used correctly, this technique will yield lower total transaction costs.