I recently met with a client who owned a company that distributes computer parts. He just learned that he won a contract with a major customer. That contract would increase his annual revenues by $2 million. He was very excited since he had been trying for almost a year to win this business away from a competitor. He contacted his supplier only to find out it couldn’t extend him any credit terms, he would need to pay upfront. His excitement turned to dismay because this major customer’s requirements were to pay within 30 days after delivery of the computer parts. How was he going to be able to find the money to pay his supplier? That is when I received the frantic telephone call. He had been to several banks and was declined for a line of credit since his business was only a year old and not yet showing a profit.
The solution: Purchase Order Financing
Purchase order financing is a short-term (usually 60 days or less) commercial finance option that provides capital to pay suppliers upfront. When a business finds itself in the position of not being able to promptly fill a customer’s purchase orders, it can be in danger of losing those orders and the potential profit they represent. Worse yet is the potential loss of any future orders from the customer.
Here’s how it works: The company receiving a purchase order (you, the client) assigns it to a third-party cash-flow business, which then pays the client’s suppliers for raw materials or goods needed to fulfill the order. Advances can range from 80% to 100% of the confirmed purchase order cost to your supplier, which is tied to the client’s profit margins on that deal and/or other criteria. Purchase order financing is one of two types – finished goods and non-finished goods.
In a finished goods transaction, the client company never handles the goods. Typically the product is shipped directly from the supplier to the end customer. A non-finished goods transaction, the supplier ships the raw materials to the client for completion and shipment to the end customer. A finished goods transaction is easier to finance than one dealing with non-finished goods.
Repayment and costs: If the customer makes payment upon delivery or shortly thereafter, a simple notice of assignment is sent to the customer directing payment to be made to the cash-flow company advancing the funds. If the customer is being given terms (my above client’s scenario), a factoring company, asset-based lender, bank or leasing company funds the resulting invoice upon delivery of the goods and pays the cash-flow company the money to retire the purchase order advance plus earned fees. Costs vary amongst the different purchase order lenders but the average is 2-4% of the amount advanced for the first 30 days the money is outstanding and then 1% per 10 days thereafter. Some companies charge upfront due diligence fees and require a monthly or yearly minimum volume. If these volumes are not met, then there is an additional fee. If there are any other charges that the purchase order lender incurs such as for the letter of credit to be issued, etc. then those will be transferred to the client.
How do I qualify: Unlike bank financing, purchase order financing hinges mostly on the financial strength and creditworthiness of the company who has placed the order with a particular business and not on the business itself.
Benefits of purchase order financing:
- Allows companies to grow sales without being limited by existing capital
- Allows companies to grow without increased bank debt or selling equity
- Helps ensure timely deliveries to customers
- Can help increase market share
- Allows companies to make larger profits by fulfilling larger orders
- Offers fast, flexible funding
- Provides overseas manufacturers assurance to start production of goods
- Helps companies when seasonal sales spike and strain cash flow
Who uses purchase order financing: Purchase order financing is designed for growing businesses with poor cash flow and/or little access to sufficient working capital. The type of business that qualifies is usually a producer, distributor, wholesaler or reseller of manufactured products.
If your company finally landed that big order but doesn’t have access to capital to pay your suppliers upfront, you should consider purchase order financing, but there is an alternative, called supplier guarantee.
What is a supplier guarantee?
A supplier guarantee is a tri-party agreement between the finance company, you and your supplier. Once the finance company confirms your buyer has received the products (creation of receivable) the finance company will obligate their firm to pay your supplier directly for any goods you have ordered. At that time, they will verify with you any amounts owed to your supplier and pay them directly.
Only a few finance companies offer the supplier guarantee, so you need to ask upfront if that could be an option. A supplier guarantee is much less expensive compared with purchase order financing because it’s also less risky. The supplier delivers the products first — then it receives payment. Usually the cost is ½ -1% per 30 days the money is outstanding along with the fee for factoring the receivable.
Regarding my client’s situation, Alternative Funding Options was able to connect him to a factoring company that offered the supplier guarantee. The factor was able to speak to his supplier and explain how the guarantee worked, and the supplier agreed to it. Because my client’s customer was going to pay within 30 days after delivery of the computer parts, he also factored his accounts receivable. In this scenario, my client used two types of financing – the supplier guarantee and the factoring of his accounts receivable. This type of alternative financing allowed my client to get excited again — and increase his annual revenues by 400%!
Cheryl O’Neill Gowen is president and CEO of Alternative Funding Options. She works with business owners seeking cash flow from non-traditional sources, drawing on more than 30 years’ experience in banking, financing and staffing. Contact her at: firstname.lastname@example.org.
Article as it appears in the Business Observer.