Production Finance and Purchase Order Funding

Many companies often confuse purchase order financing with production finance. Although by name they sound sound like similar products, both products are very different and serve two very different client bases.

This short article will help you understand the differences between these two financing solutions.

Purchase Order Financing

This product has been very well covered in this blog. You can find a description here and read this article about it's value proposition. But in summary, it helps resellers that have received a large purchase order and don't have enough money to fulfil it. PO funding provides the financing to pay your vendors and deliver your product.

However, this financing solution has very specific qualification requirements. For example, you can only qualify for this product if the following apply to your company:

1. You have a large purchase order from a credit worthy client
2. You resell finished goods and don't manufacture your own products
3. You use a single supplier for your product
4. Your sale does not include services
5. Your profit margins are above 30%

The problem is that many companies don't resell completely finished goods. Instead, they get parts from a number of suppliers and perform light assembly to finish the product. Which brings us to the second problem. These orders require more than one supplier. These two criteria often derail many po financing transactions. 

Production Finance

Production finance is similar to po funding with the exception that it can provide financing to companies that perform light assembly (or manufacturing) and use multiple vendors. Companies that provide this solution are willing to take on "manufacturing risk", basically the risk that something could go wrong with the manufacturing process.

Manufacturing risk is an important risk factor because it leaves the purchase order finance company in a challenging position. They could end up in a position where they have paid your suppliers, but won't be able to recover their investment because the final product was not assembled to acceptable standards. Because of this, companies that offer this solution are very selective and the product is often more expensive than conventional purchase orderr finance.

In general, production finance companies want to work with companies that:

1. Sell at least one million dollars per year (or more)
2. Have solid purchase orders from credit worthy providers
3. Work with high quality suppliers
4. Have less than 5 total suppliers
5. Manufacture products that are not very complex

On a corporate note: We are now official members of the TMA and of OOIDA

VIDEO: Factoring Companies

There is one more video on our YouTube channel. This one covers the subject of factoring financing companies. It also shows a sample transaction. It's posted here:

VIDEO: Invoice Factoring Transaction Sturcture

There is a new video on the invoice factoring group's channel. This one details an invoice factoring transaction's structure.  It covers the advance, rebate and other details. You can watch it here:


 

VIDEO: Freight Factoring in Canada

And we have another video. This time is about Canadian freight factoring. Here it is:

VIDEO - Factoring Accounts Receivable

We have just released a video on the subject of factoring accounts receivable. Here it is:

VIDEO: Factoring Financing in Canada

We have just posted a video about factoring financing in Canada. You can learn about this product by watching this video:

VIDEO: Canadian Invoice Factoring

We have just posted a video about using invoice factoring financing in Canada. You can watch the video here:

Why Do PO Financing and Factoring Companies Do Background Checks?

One issue that almost always comes up during the due diligence process is the owner's background check. Factoring companies and PO financing companies often require it. Many business owners object to them using the common argument: It's a company - and a company is separate than it's owners. Why must you check me? The company is "clean".

The answer is simple enough - a company by itself can't do anything. It needs people - employees and owners - to do things for it. And that is why business financing companies will often check the background of the owners, since they operate on behalf of the company. Let me give you an example to illustrate a point:

Case 1: Jack just got out of jail. He was there for fraud an embezzlement. He just started a brand new company and it signed its first large client. He needs business financing.

Case 2: Jill has been in the corporate world for 20 years and decided to start her own company. She just signed a large client. She needs business financing.

In both instances you have a brand new company with a "clean record". Would you give business financing to both?  Case 1 shows a business owner with a track record of fraud and embezzlement. Clearly that company is a higher financing risk than Case 2. This simple case explains why factoring companies and po financing companies do background checks.

By the way - check out our new video to learn about factoring financing.

Factoring

We have launched a new video that explains factoring and shows a sample transaction. You can watch the video here:

Freight Factoring

You can view this video to learn how freight factoring helps carriers and brokers. You can view the video here:

Factoring Companies

We have created a new video that shows how factoring companies work to help their clients. You can view the video here:

Accounts Receivable Factoring Video

We have just produced a video about accounts receivable factoring. You can watch it here:

Factoring Video

Are you looking for information about factoring financing? As part of our financial education outreach, we have created a factoring financing video. You can watch it here:

Invoice Factoring Video

As part of our financial education outreach, we have created an invoice factoring video. You can watch it here:


 

Why Purchase Order Financing is NOT for you

Purchase order financing can provide very flexible financing to a very narrow set of prospects. This short post will help you determine if you are NOT a good candidate for po financing. While nothing is definitive, in general, purchase order financing will not be for you if:

• Your company does direct manufacturing. Purchase order financing can only help companies that re-sell 3rd party products without any customization/changes. Unfortunately, this rules out companies that do their own manufacturing in house. 

• Your profit margins are below 30%. Most purchase order finance companies can only contribute up to 70% of what your end customer will pay you for the product. Because of this, they prefer transactions with high gross margins - usually in the neighborhood of 30%.

• Your commercial customers don't have good credit. The main collateral for the transaction is the invoice that is generated by the sale of the product that the po funding company financed. Because of this, they only finance transactions where the commercial customers have good credit.

• You don't have purchase orders. This is self explanatory - but you need po's if you want po financing.

• Your purchase orders are cancellable. Most po funding companies will not finance these type of orders because there is a risk that they will be cancelled after they have paid your supplier - leaving you with the product and no customer.

• You are responsible for installation/assembly of your product. Companies wont fund these types of transactions because there is a risk that the installation/customization could fail which would cause the end customer to refuse payment.

Purchase order financing lines are usually deployed alongside factoring financing lines as a combined solution because. 

Disclaimer: This article is for information purposes only. Please consult a CPA or attorney if you require legal or financial advice.

Purchase Order Financing And Multiple Suppliers

One common situation we see in purchase order financing prospects is when they have multiple suppliers to handle order fulfillment. This usually creates problems because it increases transaction complexity and therefore transaction risk. And in our type of business financing, it's all about managing risk.

 Most purchase order finance companies like to work on the types of transactions where one single supplier is used to fulfill the whole order. These transaction are relatively easy to finance as long as all the requirements are met. However, when you work with multiple suppliers you have a number of issues that come up. Generally, these types of transactions are broken down into two categories:

a) Different Finished Products from Different Suppliers
In this case, the client gets a large order that requires that the products be procured from different suppliers. Each supplier is selling a finished good. For example, let's say that a sample order calls for 10 Dell Computers and 10 HP Computers. This order would require that you buy the finished computers from Dell and from HP. Generally speaking, these orders can be financed using purchase order financing as long as all the suppliers have a good track record and as long as the customer is willing to pay for partial deliveries. This is important because the biggest risk in this type of a transaction is to have one (or all) suppliers fail. Allowing for partial payments offsets that risk.

b) Parts from Different Suppliers Used to Manufacture a Final Product
This is also a very common request where the client is purchasing different parts from separate suppliers that are to be shipped to a manufacturing company (usually offshore) for final product assembly. These transactions are very difficult - if not impossible - to finance. The reason is that if any of  the suppliers or the final manufacturer fails to deliver the transaction will fall through. Worse, all the suppliers that DID performed well will still need to be paid. This generates a net loss.

Benefits and Disadvantages of Purchase Order Financing

Examining the advantages (or disadvantages) of any type of business financing solution is often a complicated task and depends on your individual situation and specific transaction details. In this post, I'd like to tackle this subject for purchase order financing. Let's start with the basics.  Skip this part if you are familiar with purchase order funding.

What is purchase order finance? It's a funding tool that helps resellers that must prepay their suppliers before the goods are shipped to the end customer. A factoring company handles the supplier prepayment and settles the transaction once the end customer pays.

What is po financing good for? PO financing works well for product re-sellers that have received a large purchase order from a credit worthy supplier and need funding to fulfill the order.

What are the requirements to qualify for PO funding? Here are the basic requirements:

• Transactions must be for at least $50,000
• Gross margins must be at least 20%
• Company must re-sell finished goods 
• Both supplier and the end customer must have good commercial credit
• Your company must not have legal or tax problems
• Company owners must have good reputation and industry experience

What is purchase order funding NOT good for? Unfortunately, po funding cannot be used for direct manufacturing companies, real estate transactions or any transactions that require assembly.

Purchase Order Financing Benefits / Advantages

• It's easier to obtain than other business financing solutions
• Simpler application process that most bank financing options 
• Your business does not need to have assets other than receivables and the po to qualify
• Quick setup
• Flexible transaction limits that can usually be increased with larger orders

Purchase order funding Disadvantages

• More expensive than other financing products. It works best for companies that have at least 20% - 30% gross margins
• It can only help a narrow group of companies - resellers that sell high margin items to credit worthy companies
• It's not completely transparent to your customers and their cooperation is required  (they must be willing to verify invoices)

Although this list is not complete, it gives you a good glimpse of the advantages and disadvantages of purchase order financing. Given that each situation is unique, your should give your funding needs careful thought and consult a financial expert if you need help. And as you know - I don't give financial or legal advice, so this article cannot be considered as such.

Sample Purchase Order Financing Transaction

I'll take this post to show a sample purchase order financing transaction. It is a little oversimplified but it does get the basics across. Here are the details of the transaction:

• The client is selling widgets for $100,000. They are importing them from China.
• The manufacturer is selling the widgets to the client for $70,000
• Gross margins are 30%
• The end customer is a large big box retailer who will pay for the widgets on net 30 terms
• There are no consignment or guaranteed terms

In this case, the finance company will check the credit and reputation of the manufacturer and the big box retailer. If they pass muster, the finance company will issue a Letter of Credit for $70,000 to the supplier on behalf of the client. The letter of credit ensures that the supplier will be paid. And if written correctly, it will ensure that all parties in the transaction have some credit and performance protection. Once the goods are received by the customer, they will inspect them and pay for them 30 days later. At that time, the transaction is settled. 

It's common for companies to combine both factoring and purchase order financing. Usually, the factoring line is deployed once the customer receives the goods and is used to take the PO financing line out. Generally, combining po financing and factoring will result in lower total transaction cost.

Qualification Criteria For Purchase Order Financing

Qualifying for purchase order financing is easier than qualifying for most conventional business financing products, however, there are some qualification criteria that must be met. The purchase order financing company will need to perform some due diligence to ensure that the transaction is a good match for its capabilities. This blog post will help you understand what the purchase order financing company is looking for.

1. Does the transaction qualify?
Purchase order financing companies tend to get involved in transactions that have high gross margins. Usually, the minimum gross margin that they will consider is 20%. However, there is some flexibility to this. Additionally, the transaction will need to meet these criteria:

• It must be a straight finished product resale
• Your company must buy the finished product from a third party distributor or manufacturer
• The product must be delivered to the end client with little, if any, modifications
• The purchase order must be non-cancelable
• The transaction must not be a guaranteed sale

2. Do my customers qualify?

To qualify for purchase order funding your commercial or government customers must have good credit. This is critical because the whole transaction depends on their ability to pay for the order.

3. Does my company qualify?

Although purchase order finance companies look at your purchase order as their most important collateral it does not mean that that is the only thing they look at. They will also look at your company to make sure that it has the ability to fulfill the transaction, should it get funding. Most purchase order finance companies will request the following:

• Company financial statements - to ensure that the company at least has some capital
• Tax records - to ensure that your company's taxes are up to date
• Public records searches - to ensure that there are no hidden surprises

4. Does my supplier qualify?

To qualify for purchase order financing your supplier must be able to fulfill the product order. They must also be in good financial shape because the purchase order financing company will usually pay them through a letter of credit or at shipment. If a deposit is required, it will usually also be covered through a letter of credit.

5. Do the company owners qualify?

The purchase order finance company will also look at the background of the company owners. They will do the required records searches and review important findings such as liens,bankruptcies, tax problems, and legal problems. Basically, they are looking for any personal items that could negatively impact the company.

Conclusion

These are not all the requirements to qualify for purchase order funding because many times companies will ask for additional information based on specific transactions or situations. However, these points should give you a very good idea as to what to expect through the due diligence process. 

Finding the Right Vendor - How it Affects Your Financing

The WSJ recently published an article about the importance of finding the right vendor for your business. This is pretty critical for companies that are looking to use purchase order financing to fund their orders.

To have a successful po financing transaction you need four ingredients that need to work  in concert with each other:

1. An order that can be financed
2. A customer that is credit worthy
3. A reliable vendor
4. High enough profit margins to support purchase order financing costs

As you can see, having the right vendor for your business is critical to the success of the transaction (for obvious reasons). However, many start up businesses ignore this key requirement. Many times, the prospective client will find their vendor on the Internet and do only a minimal amount of due diligence. Very often willing to trust a key business transaction on the reliability of someone they know very little about. They are often surprised when they find out that we do perform detailed due diligence.... any many are even more surprised when we inform them of critical deficiencies that we find of their selected vendor.

When we review a vendor we will try and determine if they:

1. Have a good track record of product delivery
2. Have a good financial record
3. Have any legal or tax problems

You should not leave it up to your purchase order financing company to do this research for you though. Because if they find issues with your selected vendor they will start questioning the reliability the rest of the transaction, especially if the supplier had some flagrant problems. More often than not, the funding company will shy away from the transaction(or the client all together!)

At the very least, companies should consider doing the following due diligence:

1. Get a detailed business credit report (i.e. Dunn & Bradstreet)
2. Do a public records search to look for legal problems
3. As for references 

Why We Can't Finance Your Supplier

Every so often, we speak to customers that need purchase order financing because their supplier is unable to give them terms. Notice that I didn't say unwilling - I said unable. Usually the supplier has had some cash flow problems of their own and are asking for full payment before being able to produce the goods. They ask  for the advance payment because they need it to pay for their own raw materials and labor. IN effect, they are asking their client to finance them.

Unfortunately, if a client of ours was buying from the above mentioned supplier, we would not be able to finance the order. And personally, I don't think that any business financing company that offers PO financing would be able to fund this order either.

Why? For one simple reason. Purchase order financing is a tool that wholesalers can use to guarantee a payment to their suppliers who are not willing to give them payment terms. However, it is not a tool that is used to finance your suppliers that have cash flow problems. Think about it this way, if a purchase order financing company prepaid that supplier so that they could manufacture the goods, it would be as if they were giving them an unsecured loan. Why would a purchase order financing company do that? PO financing companies are in the business of financing their clients - not their client's suppliers. If the supplier needs business financing - they should look for it themselves!

Most purchase order financing companies protect themselves (and their clients) and minimize supplier problems by insisting to pay suppliers by letter of credit or a similar instrument. This protects all parties in the transaction. However, if your supplier has cash flow problems, it's unlikely that they will accept this type of an agreement.

Financing Commodity Transactions with Purchase Order Financing

Every so often we get an inquiry from a company that wants to use purchase order financing to fund a commodities transaction. Unfortunately, I have never seen a single transaction succeed. At the surface, purchase order financing would seem like an ideal solution to finance a commodities transaction. But once you look at the details, transactions always fall through.

By the way, I am not saying that purchase order financing has never been used to finance a commodities transaction..... I am just saying that I have never seen one done and I have been at this for a decade. Here are some reasons why these transactions fail:

Gross Margins: Most PO financing companies will only work with transactions that have minimum gross margins of 20%. In fact, many prefer to see 30% gross margins. Having high margins offers some protection to the business financing company if there are any problems with the transaction. For example, if some product if damaged during transport, a high margin transaction will be less impacted than a low margin transaction.

Also - and this is very important - finance companies prefer to work with high margin transactions because purchase order financing is expensive. There are no two ways about it - PO funding costs more than conventional funding. Working with high margin transactions helps ensure that clients still have plenty of profit left after financing costs.

First Timers/Novices: The commodities field is full of startups that have high hopes but little transaction experience. Many of these companies have unrealistic expectations about their transactions. For example, many will claim they can sell oil or coffee at 30% gross margins if they could get the funding. Unfortunately, that is not believable. Commodities tend to sell for single digit margins. PO financing companies prefer to steer clear of these types of transactions.

Questionable Suppliers: Many novices also tend to work with what I will call "questionable suppliers" that are located in far flung places of the world. Usually these suppliers offer products at "very cheap prices" but also have questionable demands. For example, this type of supplier may be able to sell product at a substantial discount but demands prepayment of the full amount by wire transfer and will not accept a third party product inspection. Many novices tend to want to work with these suppliers ,which again scares of funding companies.

MT1099 (Proof of Funds): Most po financing companies will not get involved in a transaction where the supplier demands proof of funds (e.g. MT1099). Most purchase order finance companies will not provide an MT099 to your supplier. Contrary to popular belief, MT1099's can be misused so many po financing companies steer clear from them. Most PO financing companies will be happy to pay your supplier with a letter of credit that is contingent on an inspection from a third party company. If you think about it, showing a letter of credit should be proof enough that funds are there.

On a similar subject, factoring won't be able to help many commodity trading companies either for the exact same reasons.

Why Do Purchase Order Financing Applications Ask For So Much Information?

This is a common question that we get from prospects looking for purchase order financing -  Why do purchase order financing companies need to ask for all these documents before funding an opportunity? Some include:

1. Income statement
2. Balance Sheet
3. A/R Aging Report
4. Copies of the purchase order
5. Other information

Simple - because they want to be certain they don't lose their money. Although many people have the notion that a purchase order financing transaction is almost "risk free", this is not accurate. Actually, PO financing transactions can be quite risky for the company. This is why they ask for this information. The company wants to make sure that:

1. Your company has some track record selling this product successfully
2. Your company is in stable financial shape
3. That your customers and suppliers are solid
4. That your invoices are free of liens or encumbrances

This is where all the information that the purchase order financing requests comes in. They use it to determine the risk level of the transaction. 

Also, I'd like to mention a few things that can go wrong with a purchase order funding transaction - if only to prove they are not risk free:

1. Your supplier can deliver faulty goods and not correct the problem (supplier risk)
2. You could deliver the product and have a customer that refuses to pay (credit risk)
3. Your goods could meet the specifications but the client could still claim the goods are not satisfactory (disputes)
4. There could be a mismatch between your customer requirements and the requirements that you gave your supplier (operational risk)
5. The transaction could go well but a previous lien holder (i.e. tax lien holder, judgement lien holder) that has a higher position lien than the po financing company (asset security risk)
6. And more!

All of these could go wrong and you would have a situation where the purchase order financing has already paid for the goods, but with a minimal chance that the transaction will conclude successfully. This is also why purchase order financing rates are higher than factoring rates - the risk is higher.

Are Suppliers Guarantees Useful?

Supplier Guarantee

The sort answer is - yes - provided your supplier is willing to work within the terms of the guarantee.  We have covered supplier guarantees (also known as vendor guarantees) in a previous post. But in summary, in a supplier guarantee the factoring company agrees to pay your suppliers our of the factoring proceeds. This gives your supplier the assurance that they will get paid before you do. But, only if the order creates a factorable invoice that is funded.

There are two advantages to the supplier. First, since the factoring company pays the supplier, the vendor guarantee reduces the concern that the vendor may have about your company's credit. Second, it allows the supplier to sell additional goods to your company.

However, using this type of an arrangement is not without risks to the supplier. There are two common risks. First, your company could fail to deliver the order. This can happen and it means there is no invoice to factor and thus no payment. Or second, your company could chose NOT to use invoice factoring for that particular invoice. Remember, the factoring company only pays the supplier out of factoring proceeds. Obviously there are other risks - but these are the two that most suppliers focus on.

For a supplier guarantee to be useful to your company, you need to convince your supplier that  your company can deliver on the order AND that the invoice will be factored. Said simply, you need to prove that you are a safe risk. In my experience, supplier guarantees work best when you already have credit (and therefore trust!) from your supplier but have an increase in orders that exceeds the credit that your supplier is willing to provide. But when used appropriately, and with the right factoring company, they can help your company grow.

Government Contractors May See Tough Times Ahead

The US Government has a number of programs that are designed to help small businesses sell to the government itself. These are great because the US Government is a great customer, a steady payer and more importantly, a customer that buys goods and services even during recessions. On the other hand, we have all seen the recent debt ceiling discussions that emphasized that government must cut back their expenditures. This may be a tough awakening for many entrepreneurs. Here is a link to the WSJ article about government belt tightening.

How much of this will affect small businesses - that's hard to say. However, one has to keep in mind that small business grow is needed if the economy is to start adding jobs. Recent small business optimism numbers are not very encouraging so my personal belief is that - if possible - government should minimize any changes to the small business programs.

Many purchase order financing companies do business with government contractors. Obviously, they stand to feel a squeeze in their revenues if the government reduces their help programs to small government contractors. This may also affect conventional factoring companies because many of them offer factoring to government contractors. It's hard to say how it will play out. 

Small Businesses Are Depressed

The Small Business Optimism Index is going down - and that's not good. Small businesses are one of the engines of economic recovery and without them any employment recovery will likely stall and spiral down. Small businesses are of strategic importance and therefore the government should promote conditions where they can succeed - or at least have a go at trying to succeed.

Some experts say the problem is lack of sales not lack of funding. Other experts say it's lack of funding, not lack of sales. Personally, I think it's a little bit of both. There is a problem with sales demand but also a problem of access to capital and business financing. Stimulating demand/sales is a politically charged subject - so I will avoid it. However, most would agree that appropriate access to properly (risk adjusted) priced business financing would help the situation. And at this point in the economic cycle - this is not happening.

We see this all the time on the purchase order financing side of our business. We have noticed that there is an influx of prospects that have good financials and should qualify for bank financing - but they aren't. They are being declined by banks. They come to us because we are their "Plan B".  The problem is that Plan B is more expensive that conventional bank financing so these companies are seeing increased financing costs - which drags down profits. I think this is a problem of our current economic environment that needs to be addressed.

Small Business Lending Increasing - And An Interesting Caveat.

It seems that today is the day for good news. In my other blog, I posted about the increase in construction activity and how manufacturing is in positive territory. Now, for more good news, small business lending is up. You can read about it here.

The interesting caveat, about half the companies looking for business financing went with smaller or mid sized banks (instead of a big bank). We have actually seen this happen in our business as well. About six months ago we noted that we were loosing some invoice factoring and purchase order financing prospects to banks. But not to large banks.  With few exceptions, we lost it to small or medium sized mid west banks which seemed to have escaped the real estate mistakes of their bigger rivals.

An increase in conventional lending is good for the economy as a whole. In my view, purchase order financing has it's place in the business funding ecosystem. It's a solution that is used by small and mid sized companies that have a large order that can't be financed through conventional means - usually because the company has limited credit history or limited experience. In other words, it's more expensive than conventional funding. However, during the credit crunch, banks started turning companies away simple because they had no money to lend. This forced companies with good credit profiles to seek alternative funding as a last resort. Since products like factoring and purchase order financing are more expensive than conventional loans, companies saw their funding costs increase.

It seems that slowly (but surely?) we are heading towards a normal environment, where companies with solid credit profiles will be able to secure conventional bank financing at appropriate rates. I sure hope this happens  fast - the economy needs it!

Vendor Guarantees - An Alternative to PO Financing

Although purchase order financing is usually much easier to obtain than conventional bank financing it's not as easy to get as factoring. Most po financing transactions carry more risk than factoring transactions so that qualification requirements tend to be more stringent. Also, since purchase order financing transactions are considered riskier, they carry a higher cost.

However, there is an often overlooked alternative called vendor guarantees. Many times, vendor guarantees can be used in place of po financing. And, these can easily be integrated into most invoice factoring programs and have similar pricing.

How do vendor guarantees work? This is easier if explained by an example. Let's first look at a conventional invoice factoring transaction:

1. You deliver the goods to your customer
2. You send the invoice to the factoring company
3. The factoring company advances you 80% of the invoice
4. You get the remainder 20%, less a fee, once the customer pays in full

In a vendor guaranty situation, the factoring company agrees to pay your supplier out of factoring proceeds before paying you. Your company, the factoring company and your vendor/supplier sign a three party agreement that allows the factoring company to pay your supplier before paying you.

A vendor guarantee can be used to get higher (or better) credit terms from your vendors because a financial intermediary is involved. The transaction would works as follows:

1. You deliver the goods to your customer
2. You send the invoice to the factoring company
3. The factoring company advances your vendor funds to cover their invoice (up to 80% of your invoice). Any difference is remitted to you.
4. You get the remainder 20%, less a fee, once the customer pays in full

Why would a vendor accept this type of arrangement? They would because they know that the payment is coming from the factoring company. However, and this is very important, the factoring company will only forward a payment to your vendor if you factor the invoice and only up to 80% of the invoice (this varies).

Many times, a vendor guarantee can be used instead of purchase order financing, making this solution something you should consider.

This short article is only a summary of how vendor guarantees work. One word of advice, be sure to use an attorney to help you understand them and their ramifications.

Disclaimer: This post is for information purposes only. Please consult an advisor if you require financial/legal advice.

Combining Factoring and Purchase Order Financing

In my last post, I wrote about the benefits of combining factoring and purchase order financing. Generally, combining both products yields a lower total cost. To some, this sounds counter intuitive so today I'd like to expand on that by giving one example with numbers, which will help readers understand this.

Transaction Assumptions
Let's assume that Reseller Inc is buying widgets from China and selling them to a Big Box retailer in the USA. Let's assume that Big Box issued a po for $100 to Reseller Inc. Reseller Inc will need to pay his supplier $70 for the the goods (making the Gross Margin 30% - $30/$100 * 100).  Let's assume it takes 30 days to manufacture  the goods in China and bring them to the US. Likewise, it takes Big Box 30 days to pay the invoice in full.

The purchase order financing plan advances 70% of the $100 Big Box PO and charges 3% for every 30 days. The factoring plan charges 2% and advances up to 80% of the gross invoice.

Using PO financing + Factoring:
1. On day 1, the PO financing company writes an payment covering the $70 cost of goods to supplier
2. On day 30 the goods are  delivered to Big Box along with an invoice for $100
3. On Day 30, the invoice is sold to the factoring company.
4. The factoring company advances 80% of the invoice (or $80), split as follows.
    a) $72.10 to the po financing company ($70 + $2.10 fee. The $2.10 comes from $70 * 3%)
    b) $7.90 to the client
    c) Note that $72.9 + $7.90 = the $80 dollar factoring advance
5. On day 59, Big Box pays $100
6. The factoring company settles the transaction as follows:
    a) $80 to the factoring company (recoup their $80 advance)
    b) $2 fee to the factoring company ($100 * 2%)
    c) $18 is given to the client

Total fees for this transaction are of $2.10 for po + $2 for factoring = $4.10. The client got $7.9 from the factoring advance on day 30 and $18 at factoring settlement for a total of $25.9.

Using PO financing alone:

1. On day 1, the PO financing company writes an L/C covering the $70 cost of goods

2. On day 30 the goods are  delivered to Big Box along with an invoice for $100

3. On day 59, Big Box pays $100

6. The po financing company settles the transaction as follows:

    a) $70 to the po financing company (recoup their $70 supplier payment)

    b) $4.2 fee to the po financing company ($70 * 6%)

    c) $25.8 is given to the client

The client gets $25.8 on day 59 at settlement.

One thing that usually confuses people is that invoice factoring plans and po financing plans are charged differently. The purchase order financing fee is based on the funds paid to the supplier, in this case the $70. The factoring fees are based on the gross invoice of $100 and NOT on the factoring advance of $80.

Selling More Without Going Broke

Most product resellers think that getting a large order, or a number of large orders, is the best thing that can happen to their business. In reality, it's only a good thing if you have the capital or business financing to fulfill the order. If you don't, it can quickly turn into a nightmare.

Let's look at a typical example scenario. Johnson Products Supplies imports widgets from China and sells them to big box retailers in the US and Canada. His Chinese suppliers demand prepayments, or payment by letter of credit. His clients pay invoices in 30 to 60 days. For any order, Johnson products needs to pay the supplier, wait 30 days for the goods to reach the US and then wait an additional 30 to 60 days to get paid. In total, the the transaction may last 60 to 90 days. It will take that long before Johnson Products sees any money out of the transaction.

In the meantime, the company needs to pay employees and other expenses associated with the business. It's easy to see how without a large capital cushion, the company could run into problems. Depending on the size of their cash cushion, a few large orders could decimate savings, forcing the owners to delay critical payments (or orders) until current invoices get paid.

One way to solve this problem is to use business financing to cover supplier payments. One alternative solution is to use purchase order financing. PO funding is a specialized tool that can be used by resellers. It covers your supplier costs, enabling to fulfill large orders without having to worry about how to pay your suppliers. That transaction is then settled when the customers pay for the goods.

In many instances, combining factoring and purchase order financing may help a company achieve lower financing costs. These combined transactions are usually structured as follows:

1. The purchase order financing company pays your supplier
2. The supplier delivers the goods to your client
3. Once the goods are accepted, you invoice your client
4. You factor the invoice. The factoring company pays off the purchase order financing company
5. Once the end customer pays for the goods, the transaction is settled with the factoring company

Although combining factoring and purchase order financing can add some minor complexity to the transaction, it can usually decrease the total cost. This is because (on average) the cost per dollar of po funding is higher than the cost per dollar of factoring. PO funding is more expensive than factoring for a simple reason: financing a purchase order (a promise to buy) has higher risk than financing an invoice (a promise to pay).

Why a Purchase Order Financing Company will NOT pay your Suppliers in Cash

One common request we get from purchase order finance clients is to pay their suppliers in cash, rather than by letter of credit. While po financing companies can pay suppliers in cash (or wire) after the goods have been shipped and inspected, most will not prepay for the goods in cash.

Why? Simple, an advance cash payment to a supplier is the equivalent of giving them an unsecured loan.

Let me give you an example. Let's say that ABC Importers if buying widgets from a supplier in another country. Let's say that the supplier is demanding either a deposit or a full payment of the goods paid by wire (TT) prior to the start of manufacturing. There are usually two reasons why they may be making this request:

a) They don't trust you
b) They need the money to be able to fulfill their order

If their issue is a), lack of trust, then that can easily be solved with a properly executed letter of credit. In my experience, the reason most suppliers ask for cash is because they really need it.  If you (or the purchase order financing company) pays them, you are giving them an unsecured loan (or use of your cash). Now, what happens if they default in your order, provide unacceptable product or just go bankrupt? How do you get your cash back?... The short answer is that you don't.

As a rule of thumb:

a) Most po financing companies will not prepay your foreign suppliers by wire (in cash)
b) Some po financing companies may do a "cash against shipping docs" arrangement for foreign deals
c) Some po financing companies MAY prepay your US suppliers if they are large and credit worthy (think Dell or GE).

Some companies just don't like dealing with letters of credit, mostly because they require some additional work on part of the parties that want to do the transaction. In our view, the extra work is well worth the protection that a properly worded letter of credit (usually in conjunction with an inspection of goods clause), can provide you.

Why PO Financing does NOT work for commodities transactions

Lately, I have seen an increase in the number of prospects looking to use purchase order financing to fund a commodities transaction. Unfortunately, these transactions seldom work. The pain reason why they don't work is that commodities usually sell for low margins - 5% to 10%. Purchase order financing only works for transactions where are margins are 20% and above. This ensures there is an adequate margin of safety if things don't go as planned.

Purchase Order Financing and Manufacturing (Debunking Myths)

One of the disappointing aspects of purchase order financing is that it can't be used by most manufacturing companies. This saddens me a bit because I am a big believer that manufacturing should be play a big role in our economy and would like to help with that.

Most people believe that purchase order financing works as follows: a finance company advances funds against the po, which enables the client to buy supplies, manufacture goods and fulfill the order. Unfortunately, this concept is not 100% accurate. Not even close.

First, let's debunk some myths:

1. The PO finance company will advance me a % of the po: Not true. The po finance company will only pay your product supplier directly.

2. I can use PO financing to cover payroll and other manufacturing costs: Not true. See #1.

3. I can use PO financing to buy supplies - then use to make a product: Not likely. See #2.

So, if a po financing company will not do #1, #2 and #3 - what DO they do?

The Typical PO Financing Client
Let's start with the typical client. A PO financing company will only work with a product re-seller or a manufacturing company that sources their product out to a 3rd party. The common denominator is that the only companies that qualify are those that buy the product from someone else. This is done to eliminate so called "manufacturing risk" and will be clear in the next section.

Common Transaction Structure
The structure of a transaction is relatively simple. It works as follows:

1. You get an order from a client
2. You then place an order with your supplier
3. The funding company pays your supplier. But payment is either done:
    a) By letter of credit payable once goods are verified to meet requirements
    b) Cash against shipping documents with verification - a variant of a)
    c) Prepaid, if the supplier is a large reputable company (i.e. a member of the S&P 500)
4. Supplier ships goods
5. Goods are delivered to end customer
6. End customer pays for goods - transaction is settled

Manufacturing risk is reduced drastically by making sure that the company only pays for goods that conform to what the customer needs - and verified by a 3rd party. Obviously if something goes wrong in the manufacturing or production process, the supplier can't collect and the risk is minimized.

Why is manufacturing risk so scary?
Imagine a scenario where the finance company pays your vendors, who then ship supplies to your company. Your company then begins the manufacturing process - but for some reason - something goes wrong the the product you make does not meet your customers requirements. Your customer refuses to take the goods and the transaction falls through. Now what....? Remember that the financing company has already paid your suppliers and you needed that sale to be able to pay the financing company back. Suddenly you have a big mess and unfortunately it becomes your problem to solve. Not a good situation to be in...for either party. Let's keep in mind that most companies that look for purchase order financing don't have substantial assets - otherwise they'd go to a bank.

I get it! So purchase order financing is risk free for the finance company (at my expense!)?
Not even close. It's easy to think that, but even without manufacturing risk, things do go wrong.... more often that you'd think. There is substantial risk in the transaction.  However, by reducing/eliminating manufacturing risk, the purchase order financing company can make the risk manageable to them.

Can Purchase Order Financing Be Combined with Other Types of Funding?

In a recent post, I talked about combining purchase order financing with factoring from a cost perspective. Now, I'd like to broach the subject from a different perspective. Here are two scenarios:

1. Company A: They have a line of credit based on accounts receivable (similar to factoring). The line of credit has a UCC Lien that encumbers all assets, including receivables.

2. Company B: They have no financing whatsoever. Assets are unencumbered.

Assume that both companies are good candidates for purchase order financing. Could they both get it? Well, Company B could get it for sure. Company A's situation is a little bit trickier because they have their invoices/receivables encumbered by a UCC.

Think about it this way - the collateral for a purchase order financing transaction is the invoice that is generated when the goods are delivered. In Company A's situation, that invoice is already collateral for an existing loan, leaving the purchase order finance company (who paid for the goods) in a bad collateral position.

There is a solution to this problem though. The purchase order financing company and the bank that offers the line of credit could enter into an inter-creditor agreement, where the purchase order financing line would be taken out by the line of credit as soon as an invoice is generated. This allows both funding lines to co-exist while being reasonably collateralized. These can be tough to negotiate but can be done. On a tricky subject like this one, is best to consult a legal or financial advisor.

Should you Combine Purchase Order Financing with Factoring

One of the most common sales pitches that factoring and purchase order financing companies use is to say that combining factoring and purchase order financing is cheaper - because you are refinancing an expensive transaction (po financing) with a less expensive one (factoring)

In general, this holds true. But like everything, the devil is in the details. Here is one important detail. Combining po financing and factoring, when margins allow, will be cheaper from a TOTAL TRANSACTION COST perspective if:

1. You can only factor enough of the invoice to close the po funding line. This means that in large margin transactions, you factor a partial invoice.

2. The rate differential between factoring and purchase order financing is such that the cost per dollar is cheaper for factoring. This is not always true!

Note that I am talking from a total cost perspective, not a cost per dollar perspective.

This graph shows two transactions at different Gross Margins. One transaction is for PO only, the other one combines PO and Factoring. This transaction assumes the whole invoice is factored (no partial factoring)

Combined Products vs. PO Finance Only

(click on graph to enlarge!)

The first conclusion I saw was that in transactions that have a gross margin that is higher than 25%, combining products yields a higher total cost.

Some assumptions for the model:
1. Transaction time - 30 days for PO and 30 days for factoring
2. Factoring rate - 0.075% per day
3. PO financing rate - 0.01% per day
4. Invoice size: $125

Like all models, this is not all inclusive and certainly it's not perfect. But the lesson is the clear - model your own transaction before assuming the "industry truth" that combining products is always cheaper applies to you.

Addendum 11/7/10 - Here is a post to help you better understand the cost of factoring.

How to get Purchase Order Financing

Today we will be doing a back to basics post. If you own a company and need purchase order financing, this post should help you find the best way to get to it. So, how should you approach getting purchase order financing?

The first step is to get educated. There are a lot of misconceptions about what purchase order financing is - and how it works. You can find a lot of resources in the Internet. One good place to start is at the po financing resource center. Or you can also go here.

The next thing you need to determine is if your company will qualify for it. Here are some questions you should ask:

1. Are your gross margins more than 20%?
2. Do you resell products that are manufactured by someone else?
3. Do you have a non cancellable purchase order from your customer?
4. Does your customer have good commercial credit?
5. Is your business up to date in it's taxes?
6. Is the company free of liens, lawsuits and judgments?

If you answered yes to these questions, there is a good chance that purchase order financing will be a good fit for you. There is also a good chance that you will be able to obtain po financing.

The next step is to start calling companies that offer po financing to get details of how their specific plans operate. Many of them will be able to give you an approximate quote over the phone. Be sure to do you due diligence and call a few companies to learn their plans.

Some companies, though not all, may recommend that you also get factoring. Many times, factoring is offered in conjunction with purchase order funding (learn about the advantages and disadvantages of factoring).

Bear in mind that po financing transactions can be complex and have many requirements. I haven't listed them all here, but this should give you a good idea if you qualify for po funding.

The Dangers of Over Selling

Many years ago, I was involved in a sales call with a prospect that needed a purchase order financing solution in place to be able to complete a large sale. The prospect really wanted to work with us, but in his excitement, she embellished things and oversold us on the opportunity. Here is a small sample of what transpired.

What she said:
1. My business has years of profitable operations
2. My business has lots of assets
3. My suppliers are financially strong and  technically capable

Here is what we found out after the due diligence:
1. The business only had a limited operational history
2. Depends how you "value assets". Many where not valued realistically
3. The supplier companies she worked with had a marginal track record

Initially we were excited about this opportunity. But got less and less excited as new surprises started appearing. Once our due diligence was complete, we found that the real story differed from what the prospect had told us. In fact, it did not look like such a great deal after all. More importantly, we started wondering what other things had been embellished in the purchase order financing application.

Ultimately, we decided not to go forward. Even though the deal was doable, we were now uncertain of what other surprises would be lurking out there. In my view, it would have been better for the prospect to be upfront with us. For starters, we would have determined that they had a good handle of their business since their description would have matched our findings in the due diligence. Obviously, this would had increased their chances of being successfully funded.

Timing is Everything in Purchase order Financing

One of the fun aspects of working in purchase order financing is that we deal with entrepreneurs on a daily basis. Many of our clients are startups that have been around for less than a year. It's not uncommon for us to be dealing with a business owner that is juggling one thousand things at the same time. Unfortunately, we have also seen many owners drop a ball or two or three.

One of the biggest mistakes I see if when an owner postpones applying for financing early in the game. Many postpone it because they have other "more important" things to handle - such as working with suppliers and clients to get a large order ready. There is a problem with that theory - our prospects come to us because they CAN'T deliver the order without our funding. Wouldn't it be logical that they spend some time ensuring they will have funding before committing to a client?

I see this every day. We get contacted by prospects early but then, they delay their application until the absolute last moment - say three weeks before a supplier needs to be paid. This gives us very little leeway to correct any problems that could crop up. If something goes wrong - the transaction usually falls through because the company is out of time.

The better approach is to begin financing discussions early - so that there is ample time to handle any potential problems. Here is a list of some common "problems" that derail purchase order financing transactions:

1. Suppliers won't accept our payment terms (e.g. letter of credit)
2. Supplier has a bad commercial credit record or bad delivery record
3. Clients are buying the goods as a guaranteed sale or a consignment sale
4. Client has bad commercial credit

Usually, items 1 through 3 can be addressed by re-negotiating a contract with a supplier or client, provided you have enough time to do it and provided your client/supplier is flexible. However, if you wait until the last minute and try to negotiate this AFTER the contracts have been signed and you are getting ready to start the transaction your chances of success will be minimal.

Being an entrepreneur is not easy - many times it means that you have to handle have to multitask and do many things - of equal importance - at the same time.