Factoring Blog

Structure of a Purchase Order Financing Transaction

how a purchase order financing transaction works - flowThis article will help you understand the basic details of how a purchase order financing transaction is structured. Although the article does not cover each and every detail of the transaction, it will cover the most important points of these transactions. Let’s first set the stage by creating the sample scenario. ABC Product Supplies sells widgets and just got a purchase order from Super Big Corporation to buy $100 worth of widgets. ABC Product Supplies does not manufacture the widgets themselves, rather, they buy them from a manufacturer. The widget manufacturing company will charge them $70 to fulfill this order. Unfortunately, ABC Product Supplies does not have the $70 to pay the widget manufacturing company and they don’t have open credit with them either. This is where purchase order financing comes in. ABC Product Supplies decides to enter into a purchase order financing contract in order to finance and fulfilled this transaction. The following steps will outline the transaction process. It is assumed that you have already executed a contract with the purchase order financing company:

  • Review Super Big Corporations’s commercial credit. The first step in a purchase order financing transaction is to review the commercial credit of Super Big Corporation. This is extremely important because the financing company is using your customers payment ability as security for the transaction. Most factoring companies will check the commercial credit of your customer using a commercially available credit bureau.
  • Review supplier track record.  The next step is to review the performance track record of the widget manufacturing company. This is usually done by checking their commercial credit and by doing a general search on the supplier. This review will help ensure that the supplier that you are working with has the wherewithal to fulfill the purchase order.
  • Review purchase order. The purchase order financing company will also review your purchase order from Super Big Corporation to ensure that there is no clauses that could prevent them from funding the transaction. Common pitfalls include having cancelable orders, guaranteed sales, or making sales on consignment. They will also review the gross profit margins of the transaction to ensure that they meet the funding criteria.
  • Send notice of assignment to Super Big Corporation. The next step is to send Super Big Corporation a notice of assignment letter. This letter is very similar to the conventional factoring notice of assignment that factoring companies use. This letter advises the customer that the transaction is being funded by a third party among other things.
  • Pay $70 to widget manufacturing company. The purchase order finance company will pay $70 to the widget manufacturing company directly. They can pay them through a number of options. If the widget manufacturing company is foreign-based, they will be paid with a letter of credit. Depending on circumstances, local suppliers can be paid either by letter of credit or by wire transfer.
  • Product gets delivered. Once the $70 has been received by the widget manufacturing company, they will begin manufacturing the product. Once the widgets are manufactured, they will be delivered to Super Big Corporation.
  • Transaction settlement. At this point there are a couple things that you can do to settle the transaction. One common way to settle the transaction is to use factoring. Once you send the $100 invoice to Super Big Corporation, you can factor it and use the proceeds to pay the purchase order financing company. At that point, the transaction proceeds as a conventional factoring transaction until Super Big Corporation pays. In other cases, you can wait until Super Big Corporation pays the purchase order financing company directly – at which time they will settle the transaction also. Note that settlement procedures vary by company.

One of the most important advantages of purchase order financing is that it allows you extend your financial resources in order to tackle larger orders that exceed your current capital availability. This enables you to grow your company organically – and in some cases exponentially – if used correctly and with the right transactions.

Disclaimer: This article is provided for informational and sample purposes only. It does not guaranty accuracy and is not intended as legal or financial advice. If you require it, get legal or financial advice from a professional.

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