Imagine a supply store accepting an order for 1,000 office chairs, a figure above what it has available. Believe it or not, this is a purposeful strategy. To stay competitive, companies sometimes take customer orders at volumes that exceed existing inventory—a common practice among business-to-business (B2B) companies that resell or distribute goods.
In these cases, purchase order financing, or PO financing, lets the businesses pay suppliers to fund purchase orders (PO). A purchase order is an agreement between a buyer and seller, and it usually includes details about pricing, payment terms, shipping timelines, and other specifics.
Compared to a traditional small business loan, PO financing requires a lower commitment and can work on a shorter timeline. Learn more about how purchase order financing works.
What is purchase order financing?
Purchase order financing is a type of financing agreement where a lender pays a supplier on a business’s behalf—up to 100% of the costs to produce and deliver products to the customers who put in an order. The lender then recoups those costs from the money the customers pay for their orders.
PO financing functions similarly to a cash advance for a B2B business owner, except the lender pays the business’s supplier directly. Since B2B companies don’t always accept customer payments upfront, PO financing enables B2B companies to accept larger customer orders with less financial risk.
How does purchase order financing work?
- You assess purchase orders
- You calculate order fulfillment costs
- You apply for PO financing
- The supplier receives payment
- The supplier delivers the orders
- You invoice the customers
- The financing company pays the difference
With a traditional small business loan, the arrangement is simple: A business applies to a traditional financial institution, usually a bank or credit union, for a set amount of funds or a line of credit. If it receives approval, the business then uses those funds to meet its needs and agrees to make regular monthly payments back to the lending institution with interest.
The process for a business entering into a PO financing agreement is more complex and involves more parties. Here’s what it entails:
1. You assess purchase orders
PO financing isn’t always an appropriate strategy for order fulfillment. If you can fulfill customer orders by relying on your inventory or cash, that’s usually preferable to relying on PO financing.
However, if you determine you can’t fulfill the purchase orders you’ve received, entering a PO financing arrangement can ensure you don’t damage your business’s reputation and brand image.
2. You calculate order fulfillment costs
Before applying to a purchase order financing company, understand exactly what costs the lender will cover. For example, you might only need to cover half an order or only a few parts of the manufacturing process—either scenario changes the amount of financing you’ll seek.
📚Learn more: How To Win at Order Fulfillment
3. You apply for PO financing
The next step is to apply for financing from a PO financing company. Your application will include the purchase orders that need coverage and an estimate of supplier costs.
A PO financing company may approve up to 100% of the costs related to order fulfillment. Approval will likely hinge on your finances and the supplier’s track record. If a PO financing company extends coverage for only a portion of the supplier’s costs (say, 85%), you are responsible for covering the remaining balance.
4. The supplier receives payment
Once you get the green light, the PO financing company pays the supplier to produce and deliver the goods necessary to fulfill a customer’s purchase order. Payment can include cash but more often involves a letter of credit, which is a statement the PO financing company’s bank issues to guarantee it will render payment.
A letter of credit usually makes payment dependent on the fulfillment of certain conditions—for example, the completion of order shipments.
5. The supplier delivers the orders
After you receive a letter of credit from the PO financing company, the supplier will deliver goods directly to the customer. When the customer receives the goods, the PO financing company receives a confirmation of delivery.
6. You invoice the customers
After the customer receives the goods, you furnish them with an invoice. The customer then pays the invoiced amount directly to the PO financing company.
7. The financing company pays the difference
To close out the transaction, the PO financing company collects payment from the customer, deducts its fees from the overall amount, and pays the difference back to your business. Therefore, the amount for which you invoice a customer and the amount you ultimately receive will be different.
Pros of purchase order financing
The pros of PO financing revolve around the ease and speed with which your business can access funds (compared to traditional financing options):
The bar to qualify is lower
Most purchase order financing companies will look primarily at the creditworthiness of a business’s customers and the reliability of its suppliers when determining whether to extend coverage. They’ll still look at your business’s financial statements, financial history, and credit history. These factors won’t necessarily make or break your application in the same way they might for a traditional small business loan.
The wait for business financing is short
Bank loans can take weeks and sometimes months to process. PO financing can put all the necessary pieces into place in a matter of days.
There are no monthly payments
PO financing isn’t a loan—repayment to the PO financing company comes directly out of sales to customers. Therefore, businesses that receive PO financing approval don’t have to worry about budgeting for monthly payments like they might with a traditional small business loan.
Cons of purchase order financing
Despite the advantages of PO financing, there are still a few drawbacks for B2B small business owners:
- There is a limited scope. PO financing can’t cover all of your business’s working capital needs, as it’s only available to pay suppliers.
- It requires stiff profit goals. Many PO financing companies require a minimum expected profit margin of at least 20% from a covered order.
- You may receive only partial coverage. If a PO financing company doesn’t approve coverage of 100% of your business’s supplier costs, your business will have to cover the difference.
- You risk straining customer relationships. Customers pay the PO financing company directly, which might lead them to question the financial integrity of the business. Having to pay a third party might also inconvenience your customers’ accounts payable departments.
How to apply for purchase order financing
The application and approval process for PO financing usually begins with a representative from your business filling out an online application form or calling the PO financing company directly.
To assess the application, the PO financing company will need a copy of any customer purchase orders you expect it to cover. It will also need a copy of pro forma invoices (preliminary invoices or quotes you send to a buyer before confirming the sale).
Approval can take anywhere from just a few days to several weeks, depending on the strength of your business’s application and whether you have an existing relationship with the PO financing company.
Alternatives to purchase order financing
If PO financing isn’t a suitable option for your business, there are alternatives to consider:
Line of credit
A business line of credit lets a business borrow up to a certain amount of money and only pay interest on the portion it uses. Think of business lines of credit like credit cards. Applying may not require collateral, like small business loans do, and businesses can typically use the proceeds for any purpose, including purchasing inventory.
Invoice financing
Invoice financing is a kind of short-term loan that allows a business to borrow against the value of its outstanding invoices, also known as accounts receivable. Invoice financing is a good option for businesses that have a healthy cash flow but need short-term coverage for a specific expense, such as new inventory.
Invoice factoring
Invoice factoring is a form of financing in which a business sells its unpaid invoices to a third party (usually a factoring company) at a discount in exchange for cash upfront. This can be a good option for businesses that have a lot of invoices from customers and tend to process them slowly but also need to cover cash flow gaps immediately.
Merchant cash advance
A merchant cash advance (MCA) allows a business to borrow against future credit and debit card sales. Instead of using a traditional loan repayment structure, MCA lenders take only a percentage of a business’s credit and debit card sales until it recoups the cash advance. This percentage is the “holdback rate” or “retrieval rate” and can range from 5% to 20%.
*Shopify Capital loans must be paid in full within a maximum of 18 months, and two minimum payments apply within the first two six-month periods. The actual duration may be less than 18 months, based on sales.
Purchase order financing FAQ
What is the risk of purchase order financing?
A PO financing company may only cover a percentage of the business’s supplier costs, leaving the business to cover the difference. And because customers pay the PO financing company directly, the business forfeits a degree of control in ensuring the repayment of supplier costs.
How much does purchase order financing cost?
PO financing fees typically range from 1% to 6% of the supplier’s costs per month (or 30-day period). Fees tend to increase the longer it takes a customer to pay their invoice. For example, say a business has a purchase order financing agreement in place in which the supplier receives $25,000, and the PO financing company charges 5% every 30 days. If a customer takes 30 or fewer days to pay their invoice, the total fee would be 5% of $25,000, or $1,250. If it takes that customer 60 days to pay their invoice, the fee would be 10% of $25,000, or $2,500.
Who uses purchase order financing?
PO financing is typically available only to B2B companies such as distributors, manufacturers, wholesalers, resellers, outsourcers, startups, importers, and businesses with seasonal cash flow.
