A purchase order is a legal trade document a buyer provides a vendor to purchase goods or services. The purchase order itself describes the product or service in terms of type, quantity, and price per unit or hour. Since no currency is exchanged, the document becomes a contract between the two parties.
Purchase orders may be used to purchase finished unpackaged products from distributors, wholesalers, or importers. Apply for PO Finance
Purchase orders may also be used to aid in costs associated with packaging and repackaging products as well as for “total in-house manufactured” parts, pieces, components, and modules purchased by customers.
Purchase Order Financing
Purchase order financing, obtained through purchase order funding companies, assists the business in purchasing raw materials and goods needed to manufacture finished products when the business does not have funds to pay suppliers directly without severely impacting its own cash reserves, or when lenders are not willing to give the business a loan. Purchase order financing also provides funding to the business in order to contract with a manufacturer to complete an order when the business lacks the working capital to do it in its own facilities. The requisition may be also be for finished products obtained from a foreign source or domestic supplier that will be distributed to a customer. Goods needing packaged or repackaged prior to distribution may also be funded through purchase order financing agreements.
Purchase order finance companies issue a letter of credit to the business based on creditworthiness. Goods may then be purchased or work may continue without interruption. The business is able to fill (resell or ship) the order within a short period or pay a subcontracted manufacturer to produce and fill the order immediately without interruption to production. The financing is paid back with interest after the products or services are received. Typically a financed purchase order is issued and repaid within a short time – typically two to three months or less.
Types of purchase order funding
Two primary types of purchase order funding are 1) funding finished products and 2) funding work-in-process.
1) The most common purchase order financing is the purchase of finished goods or services. The purchase order is an open-account agreement the supplier gets from a pre-approved creditworthy seller. The purchase order funding company assesses the planned transaction (“due diligence” evaluation) and if satisfied with its merit, issues a letter of credit to the supplier. The purchase order funding company reserves the right to dispatch its own independent inspector or inspection team to ensure products made and shipped have not been modified except for packaging and labeling and comply with the original order.
The supplier or manufacturer shows paperwork supported by the letter of credit to their bank for payment. The purchase order funding company honors the payment. When goods are received they are shipped to the warehouse or customer.
2) Work-in-process funding is not the purchase of a finished product. It is the funding of components of a larger product. It is therefore riskier for the purchase order funding company to assume this type of open contract with the business. In this instance the business requests funding with the intent of purchasing a variety of pieces, parts, or modules. These will be assembled in either the business' facilities or plant, or sent to another manufacturer to be assembled. The purchase order funding agent determines the ability of the manufacturer (business or subcontractor) to effectively fabricate a quality product in the required quantities within the specified deadline prior to awarding the purchase order advance.
When does purchase order financing work?
Purchase order financing should only be used when all other resources and options such as obtaining credit lines and borrowing against real estate, assets, inventory, and equipment have been exhausted.
Purchase order financing works in high profit margin transactions and when the agreement or contract terms are specific. The more specific the terms, the more likely the purchase order funding arrangement will work. The purchase order must explicitly state the product, specifications, units and quantity or quantities, timeline and deadline for delivery, and the manufacturer's information including location and contact number and responsible person.
Who uses purchase order financing?
Purchase order financing is intended to assist small businesses, growing businesses, and businesses with little working capital, insufficient capital, or poor cash flow. It is also intended for businesses that sell products not services. Businesses that produce goods, distribute goods, wholesale products, drop-ship, or that operate in reselling already manufactured items are likely candidates to use purchase order financing. Businesses that sell products in conjunction with services may also qualify.
A business may seek purchase order financing when
- it is a start up or small business
- bull; they cannot get a conventional bank loan
- they are engaging in import and export exchanges and contracts
- they are supplying foreign buyers
- they need to rush orders
- they have a very large order or extensive number of orders to fill
- they have an overload in orders that must be shipped
- they are undergoing a business growth or expansion phase
- they need to place raw materials orders or increase and fund direct labor
- they want to maintain an ambiguous relationship between the manufacturer and the end-buyer
- they want to avoid incurring (foreign or domestic) credit risk
- they want to add to their profits.
Only creditworthy businesses should be afforded purchase order financing since the intent of the process is to provide funds and working capital to companies and small businesses in particular, that do not have the necessary funds to complete transactions in order to continue manufacturing, production, or business.
- the business' invoice to the buyer
- the business' invoice to the supplier
- the purchase order given to the supplier
- the business' documented gross profit margin (business solvency and demonstrated financial strength)
- a history of the business including the P&L and balance sheet (operations)
- the planned product production time frame (shipping deadline)
- the buyer's credit information
- the supplier's information, and
- the type of purchase order funding requested (Finished Goods of Non-Finished Goods (Work-in-Process)
A main benefit of obtaining purchase order financing is the ease and simplicity. It resembles a line of credit and is easier to get than applying for a bank loan. It can be created within two weeks or less. Businesses should therefore use this option only when necessary and on a short-term basis.
The size or establishment of the company does not qualify or disqualify the business from obtaining purchase order funding. Start ups and small businesses may qualify and have their line of credit increase as the business and revenues grow.
There are general disadvantages of obtaining purchase order financing. For the instrument to be fully beneficial, the business should engage in producing finished products that do not need assembly or customizing. Suppliers are paid with a letter of credit, that only includes direct expenses, and that must be transacted through their bank, which may incur bank fees.
The purchase order funding company risks losing part of all of its investment if the goods fail to be produced and delivered on time or are of poor quality or insufficient quantity. The business, supplier(s), or buyer(s) could renege on their part(s) of the agreement or that unforeseen circumstances hamper the production process or deadline placing the financier (purchase order financing company) holding the bag.
- Factors businesses should consider before collaborating with a purchase order financing company are
- minimum loan requirements
- conditions pertaining to underwriting (underwriters always require a personal guarantee before awarding purchase order financing, and some require a personal financial statement to guarantee repayment and lessen risk)
- purchase order financing fees and interest charged by the purchase order finance company, and
- timeline constraints, including international transit, delivery deadlines, and billing schedules.
The purchase order funding company performs a “due diligence” evaluation to determine if the business qualifies for purchase order financing. The due diligence evaluation determines that
- the business is transacting a straight resale (non-modified goods coming from the supplier straight to sale)
- the transaction meets the minimum value (a recurring $50,000/mo. or individual transaction between $100,000 and $2 million)
- the transaction meets minimum profit margin requirements (typically 30%)
- the customer is credit worthy
- the supplier is reputable (delivers on time)
- the business can fill the order and has no tax or legal problems pending, and
- the business' owners are reputable, effective, proficient, with no legal problems.
The purchase order advance is paid back to the purchase order funding company in any of several ways. The letter of credit from the business to the supplier/customer may state that payment will be made when the product is received. The invoice's accounts receivable financing statement is shown when the supplier/customer receives the product. Or, the leasing company may purchase the goods when they are delivered to the supplier/customer.
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