Order financing a viable alternative for entrepreneurs

By Francis Chitambira | Nov. 28, 2022

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In the Book of Proverbs 4:7 it says, “Wisdom is the principal thing; therefore, get wisdom; Yea, with all thy getting get understanding.”

This verse by Solomon reiterates the importance of getting wisdom and at the same time understanding. Indeed, Solomon’s verse remains true forever and touches all entrepreneurs too. Entrepreneurs need wisdom to grow their businesses and to understand the options available to finance their businesses.

Purchase order financing also known as order financing is an alternative way to crowd funding that business leaders and entrepreneurs can tap into to attract financing for the business.

This model capitalises the business. It is one of the fastest ways of financing a business. It only requires the business to have a purchase order from a reputable client. It is used to pay for inventory. Because of this, purchase order financing can help keep your business running smoothly, even when times are tough.

It gives corporates borrowing options. SMEs can access funds to pay suppliers before invoicing the buyer. Cashflow problems present significant challenges for small business owners. Big companies or corporates may give a significant order to the company, but the company does not have enough liquidity to pay its own suppliers upfront for it to be able to meet this order. So the company uses the purchase order to approach financial houses for funding.

Parties involved in purchase order financing (borrower)

The borrower is the business that needs financing to pay for goods or services already ordered by its customers. It is the entity that received a purchase order. The company borrows funds from a purchase order financing company or lender to fulfil the order.

Purchase order financing company

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This is the finance house or lender which can be a bank, a microfinance, a discount house, or such. This company provides the financing to the borrowing company above. The lender confirms the borrower’s purchase order details and then sends funds directly to the relevant supplier.

Supplier

This is the raw material provider. It supplies or provides the services to the customer after receiving its payment from the financing company. In some cases, the supplier may also be involved in financing the purchase order.

Customer

The customer is the party that buys the goods or services from the borrowing company. Under a purchase order financing agreement, the supplier sends goods to the customer, and the customer’s payment goes directly to the lender.

What is purchase order financing

Purchase order financing or simply order financing is a short-term funding that improves business (Borrower)‘s liquidity so that they are able to pay for the goods or services needed to fulfil their customer’s orders.

It involves financing companies like banks, microfinances etc. It is a process whereby lenders are approached by the borrowing company for funding, and in return the lender releases funds directly to the supplier.

This reduces misuse of the funds. This type of financing helps businesses to avoid missing out on sales opportunities because of a liquidity crisis. In other words order financing (including financing for tenders) applies where a borrowing company gets an order or a tender which the company needs to fulfil, but is unable to finance the cost of servicing the tender from its own resources. It is typically for a period of 30 to 90 days.

Why purchase order financing

It is like a short-term loan. It is not very different from short-term advance payments. It is used to stand as a stop-gap measure. It is an in-between financing option. PO financing shares a lot of similarities with short-term loans. It is a special designated funding method. It is used specifically for the production of goods that are to be supplied by the company. It thus means that the applicant or the company may not use the money to settle any other outstanding debt.

This financing solution makes sure the buyer’s orders are fulfilled and keeps a clean track record of (other) business loans.

How does purchase order financing work?

It is important to note that order financing only works where the borrowing company is dealing with a well-established and creditworthy corporate.

The company receives an order from a credit worthy corporate. The company does not have the funds to prepare or finance production costs of this order. In the event of a trader, the trader does not have funds to procure the goods for resupply.

The customer issues an undertaking that they will pay the financing company directly after receiving their ordered goods. The company, therefore, takes the order plus the quotations or invoices from the manufacturer of the raw material or tradeable goods to financiers like banks, credit bureaus etc, the financing company then vets the documents and after approving pays directly to the raw material supplier.

Thus the bank or financing company pays the supplier for the inventory and the supplier in return send the inventory to the borrowing company. The borrowing company then manufactures the finished goods and sends them to the corporate or customer which issued the purchase order. The customer then prepares the payment and sends it directly to the lender. The financing company then receives its payment from the customer directly. Finally, The borrowing company receives its sales proceeds from the financing company minus interest and all fees involved including establishment costs.

Purchase order financing pros and cons

Although this is an alternative to cashflow financing there is great need for the borrowing company to carefully weigh the pros and cons of PO financing. It is not hidden that it is a way to solve cashflow issues and that it allows small businesses to fulfil an order that would not have been possible otherwise. It is, however, important to note that it may not be the best solution for every company. Some goods have margins that are small, therefore, taking this alternative way may not be profitable at all.

Pros

It is a helpful way to finance your orders before receiving payment from customers. Since this is a way of capitalising the business the business is catapulted to grow by allowing it to take bigger orders than it can finance on its own. Some of the other benefits of this type of lending include:

Access to working capital. Purchase order financing can provide the working capital needed to fulfil customer orders. This can help you maintain or expand your business by taking client orders you would not have had the funds to complete.

Easier to qualify for. Financing companies typically base approval decisions on a customer’s creditworthiness. The lender still considers your business’ financials and credit profile, but this can make it easier for start-ups to qualify for financing.

Improved supplier relationships. Purchase order financing can help improve your relationships with suppliers by allowing you to pay for goods on time. This can lead to early payment discounts and better terms in the future.

Cons

There are also some potential drawbacks to purchase order financing, which includes:

High costs. This form of financing can be expensive depending on the financing house and the legislated rates.

Affected by customers. Your customer’s purchase order secures your loan, so many lenders approve the borrower company based on the creditworthiness of their customers. What’s more, the longer it takes for a customer to pay their invoice, the more the interest levied by the financing company.

Reduced control over operations. Because purchase order financing companies pay suppliers directly, this financing method takes some power away from the business owner. The supplier may also send products directly to the customer, further separating the business from operations and client relationships.

My advice

Entrepreneurs are human beings and thus they do not know everything. In this regard when they get huge orders or when they need a financing solution I encourage them to engage experts like the writer to get the best solution for the particular need versus the cost of financing. Financing costs may become another burden if the business is not appropriately advised.