What is purchase order financing? How it works and alternatives

Is purchase order financing your golden ticket to scale?

Competing against bigger companies can feel like David vs Goliath, especially when they have deeper pockets. They seem to get those important contracts effortlessly, and smaller companies are left struggling to keep up.

And it's not just about size; even landing a larger contract can become a double-edged sword. According to a report produced by Xero and Accenture, late payments impact half of all small businesses, costing them £684 million in the United Kingdom alone.

Landing a big order can go from being a reason to celebrate to a source of stress when you don’t know how to fund the upfront costs of production and delivery. No wonder purchase order financing for small businesses can be so appealing – it offers a way to bridge the gap and fulfill orders even when those invoices haven't been settled. 

In this article, you’ll learn what purchase order financing is and how it works. We’ll also go over the details, the good and the bad, and even some other financing options you may not have thought of.

What is purchase order financing?

Purchase order financing (PO financing) is a type of short-term funding option that helps businesses cover the costs associated with fulfilling a specific purchase order from a buyer. 

This type of financing acts as a bridge between your company, your supplier, and your customer, ensuring that you have the necessary funds to complete the order even if you lack the immediate capital.

This type of financing is particularly beneficial for small and medium-sized businesses (SMBs) that operate with tighter margins, experience rapid growth spurts, or work with clients who have extended invoice payment terms.

Key features of PO financing:

• Not a loan: It’s a short-term cash advance. You're not making monthly payments; repayment happens when the buyer pays the invoice
• Focus on the order: The financing is specifically for this one purchase order. You're not getting a general business loan
• Cost factors: Fees vary based on the size of the order, the risk involved (buyer's creditworthiness matters), and how long it takes the buyer to pay

How does purchase order financing work

Unlike traditional loans, figuring out how to get purchase order financing means understanding it involves more than just you and a lender – it's a collaboration between your business, the financing company, your supplier, and your customer.

• You (the borrower): Seeks funds to fulfill a large customer order
• Financier: Provides the funds to your supplier, bridging the gap between order and delivery.
• Supplier: Receives payment upfront to produce and deliver the goods.
• Customer: Places the order and pays the financing company upon receiving the goods

Here's how this collaborative process unfolds:

1. Confirmed purchase order: It all starts with you receiving a confirmed purchase order but need help to cover the upfront production costs
2. Financing application: You approach a purchase order financing company and apply, providing details about the purchase order and your buyer
3. Financier due diligence: The financier will verify the purchase order and assess your buyer's creditworthiness. They want to ensure that the buyer is reliable and will pay for the goods or services
4. Funds disbursement: Upon approval, the financier will directly pay your supplier to cover the costs of manufacturing or procuring the goods outlined in the purchase order
5. Order fulfillment: Your supplier, having received payment, will then manufacture and deliver the goods or services directly to your buyer
6. Buyer payment: Once your buyer receives the goods or services, they make the payment directly to the financier according to the agreed-upon terms
7. Financier fees: The financier deducts their fees, which typically include interest and administrative costs, from the payment received from the buyer
8. Remaining funds released: Finally, the financier forwards the remaining balance to you, completing the purchase order funding cycle

Purchase order financing example

Let's bring this process to life with an example. 

You own a small business specializing in custom-designed athletic wear. You land a fantastic deal with a university based overseas to supply their sports teams with new uniforms for the upcoming year. The order is worth $50,000 – a significant boost for your company.

However, there's a catch. You need $30,000 upfront to purchase the fabrics, pay your production team, and cover other manufacturing costs. The university, like many large institutions, operates on net-30 payment terms, meaning you won't see the $50,000 for another 30 days after delivery.

This is where purchase order financing swoops in. You have the university's official purchase order for $50,000 worth of uniforms, so you approach a financing company and present the order details. 

The financier verifies the purchase order and, seeing the university's strong credit history, approves your request. The company transfers $30,000 directly to your fabric suppliers and other production partners.

With the funds secured, you begin production and deliver the uniforms to the university on schedule. 30 days after receiving their stylish new uniforms, the university pays the financing company the agreed-upon $50,000. The company deducts their fees (let's say $2,000 for this example) and then releases the remaining $18,000 to your business.

In this scenario, purchase order funding empowers you to fulfill a major order, build a valuable relationship with the university, and ultimately grow your business – all without having the $30,000 readily available in your account.

Learn more: What is export finance and how can it help small and medium-sized businesses?

Pros and cons of purchase order financing

Like any financial tool, purchase order financing for small businesses comes with its own set of advantages and disadvantages. Weighing these pros and cons will help you determine if it's the right fit for your needs and current financial situation.

Advantages of purchase order financing

• Bridge the cashflow gap: The most significant benefit is its ability to bridge cashflow gaps, allowing you to fulfill large orders even when you lack the immediate working capital
• Unlock growth potential: By providing the necessary funds to take on larger orders, PO financing can be a catalyst for business growth and expansion
• Strengthen supplier relationships: Secure financing strengthens your relationships with suppliers. The guarantee of timely payments, facilitated by the financier, can lead to better pricing, priority service, and stronger partnerships
• Fast access to capital: The approval and funding process is relatively quick, especially compared to traditional bank loans
• Easier qualification: It often has more lenient eligibility requirements compared to other financing options, making it accessible for startups or businesses with limited credit history

Disadvantages of purchase order financing

• Higher cost of financing: It may come with higher interest rates and fees compared to traditional bank loans or lines of credit
• Dependence on buyer's credit: The success of PO financing hinges on the creditworthiness of your buyer. If they delay payment or default on the invoice, it can create complications and potential financial strain for your business
• Limited scope of use: This financing option is designed for fulfilling purchase orders. You cannot use it to cover general expenses, payroll, or other operational costs
• Loss of control: While you maintain business equity control, relying on purchase order funding for significant orders can create a degree of dependence on the financier and their processes, potentially impacting your operational flexibility

Alternatives to purchase order financing

While purchase order financing for small businesses can be a valuable option, it's not a one-size-fits-all approach. Depending on your specific circumstances and needs, other financing alternatives might be a better fit. Here are some worth considering:

1. Invoice financing

Invoice financing (IF), also known as accounts receivable financing, allows you to borrow money against outstanding invoices. You receive a percentage of the invoice value upfront from the financier, and the remaining balance (minus fees) once the client pays.

Compared to PO financing: Like purchase order financing, IF improves cashflow. However, it relies on existing invoices rather than future orders. It can be more accessible for businesses without large purchase orders but with reliable clients and a steady stream of invoices.

2. Revenue-based financing

With revenue-based financing (RBF), you receive a lump sum upfront in exchange for a percentage of your future revenues. Repayments are typically tied to your monthly revenue, making it a flexible option for businesses with fluctuating sales cycles.

Compared to PO financing: Revenue-based financing offers more flexibility as it's not tied to a specific order. If you want to know more about RBF, we highly recommend diving deeper with this insightful read: What is revenue-based financing? How does it work?

3. Stock financing

Stock financing, or inventory financing, allows you to use your inventory as collateral for a loan. This option is suitable for businesses with significant inventory value but facing short-term cashflow needs.

Compared to PO financing: Stock financing is useful for managing overall inventory costs rather than funding specific orders. It can be a good option if you have high-value inventory but slower sales cycles.

4. Merchant cash advance

A merchant cash advance provides a lump sum upfront in exchange for a percentage of your future credit and debit card sales. The lender automatically deducts repayments from daily or weekly sales.

Compared to PO financing: Merchant cash advances, while convenient and fast, often come with higher fees than other options. They are better suited for companies with strong and predictable credit card sales.

5. Business line of credit

A business line of credit provides access to a revolving credit line that you can draw from as needed. You only pay interest on the amount you borrow.

Compared to PO financing: A line of credit offers more flexibility as you can use the funds for various purposes, not just purchase orders. However, interest rates can be higher than traditional bank loans, especially for smaller credit lines.

6. SBA loans

The Small Business Administration (SBA) offers various loan programs designed to help small businesses access affordable financing. SBA loans usually have lower interest rates and longer repayment terms than conventional loans.

Compared to PO financing: Qualifying for SBA loans is more challenging and involves a longer application process. But they offer advantages in terms of cost and repayment flexibility.

Read more: What is non-dilutive funding? Options, benefits, and the different types.

Is PO financing your golden ticket?

Purchase order financing can be a powerful option, no doubt. It gives businesses the muscle to grab those big opportunities that could be out of reach – to act quickly, even when facing those cashflow challenges highlighted earlier. But it’s not always the perfect fit.

Need to cover some other business expenses? Tough luck. Want funding that’s not tied to one specific order? You’re out of luck again. You might need funding that’s a bit more versatile.

At Stenn, we believe in funding that's as agile and ambitious as you are. That's why we offer alternatives designed to give you the financial freedom to grow on your terms, not just one purchase order at a time.

Here’s the deal:

• Invoice financing: Get paid faster. Win new clients. And get approved funding in hours, with minimal paperwork. Stop waiting for those invoices to clear and get back to doing what you do best – building your business
• Revenue-based financing: Put your cashflow in free flow. Get your future revenue now and put it into marketing, inventory, or sales. Or whatever else you like. It's your business, after all

The golden ticket to smarter financing? It's got Stenn written all over it. Let’s talk.