In the past decade, cash-strapped small business owners have been turning to lenders who offer to finance their purchase orders. Image Credit: Gulf News archives

Dubai: It's a small-business owner's nightmare when your company lands a major merchandise order but runs short of funds to pay for manufacturing and delivery.

If you fail to furnish the required funds quick enough, your company stands to lose the order and possibly a valued relationship with the client too.

Many small business owners stuck in this situation are turning to lenders who offer to finance their purchase order. This where ‘Purchase Order Finance’ or ‘PO Finance’ helps.

‘Purchase Order Financing’, also commonly referred to as trade or invoice financing, has become more popular this past decade.

In such finance deals, the lender evaluates the credit rating of your customer, not your company. If the customer has a track record as a reliable, prompt payer, the lender may be willing to finance your transaction.

A step by step guide to how a purchase-order finance deal works:
• Your business receives a large order from an established, creditworthy customer. This is in your company is a product re-seller or distributor, not a direct manufacturer.

• Your lender checks your customer's credit history and approves the deal. The lender then sets up a letter of credit or bank draft to pay the manufacturer of your goods. This usually takes a week or two.

• Besides forwarding payment to the manufacturer, the lender also pays the costs of shipping the merchandise. Your firm may be asked to pay inspection, insurance or shipping-duty costs incurred.

• The goods are shipped directly to your customer or to a bonded, third-party warehouse, never to your business. Once the customer takes delivery of the merchandise, your company invoices the customer.

• If the customer pays immediately, the lender collects the money, takes its cut, and gives your company the remaining profits from the sale.

• If the customer pays on terms, the lender may buy the invoice from you at a discount off the full invoice amount and pay your company the remaining profit immediately.

• The lender then waits to collect the full amount from the customer and keeps the difference as its profit. This process of buying invoices at a discount is also known as factor lending.
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It's a small-business owner's nightmare when your company lands a major merchandise order but runs short of funds to pay for manufacturing and delivery.

How much does such financing cost?

Fees for factoring your invoice are usually modest. ‘Purchase order’ finance costs will be much higher, as the risk the lender is taking on is much greater.

In a factor loan, the goods have already been delivered and the customer invoiced. The deal's essentially done, so there's less risk in simply waiting to collect on the invoice. In such a finance, the lender is advancing money based only on a written commitment for a purchase.

If the customer refuses the shipment, is otherwise dissatisfied, goes broke during the transaction or for any other reason doesn't pay up, the lender loses their money. There are many more snags that can arise in such a lending deal, so costs are higher.

Though in most cases you don't need a great credit rating to get a purchase order finance loan, there are some other criteria used by most lenders in this sector.

For instance, some lenders offer limited loans to small businesses, and many will likely lend on the strength of a major purchase order or confirmed government contract.

Perks and risks to taking on alternative financing

One advantage of seeking purchase order or trade financing from a lender is that it will likely cost less than it would using an alternative, for-profit lender.

Most institutions charge market rates for their loans, so your cost will be similar to what it would have been if you'd been able to get a traditional bank loan.

Where a lender will get involved in your deal and pay your supplier directly, other alternative financiers won't take on that role. Instead, you'll get a straight loan and repay it by making monthly payments.

You'll use the loan money to pay your manufacturer and all shipping costs, and be responsible for invoicing and collecting the customer's payment.

Although getting such financing isn't ideal, as the costs will eat into your profits, if it's a choice between purchase order or trade financing and losing a big sale, it can keep your business growing.

A short-term loan is an instalment loan, meaning you borrow money from a lender and then pay back the money over three to 18 months, in weekly or daily instalments.

Is this better than a short-term loan or a business credit card?

Short-term loans and purchase order finance have a lot of similarities. They both can cover temporary gaps in cash flow, the cost is similar, and both are relatively easy to qualify for. However, short-term loans and purchase order financing are structured very differently.

A short-term loan is an instalment loan, meaning you borrow money from a lender and then pay back the money over three to 18 months, in weekly or daily instalments.

The lender gives you the funds directly and you can then use them to pay for whatever business expenses you need to cover: working capital, paying staff, paying for marketing, or for other business activities.

If the primary reason you’re using purchase order financing is to cover temporary gaps in cash flow, consider using a business credit card instead. You can use a business credit card to borrow small amounts of money when you can’t afford to buy supplies for an order.

And then you can pay off the amount you borrowed when your customer pays for the goods. Business credit cards are often a relatively affordable type of financing.

The average interest rate on a business credit card is around 14 per cent, compared to the minimum 20 per cent rate range on purchase order financing. The drawback to business credit cards is that your credit limit might not be high enough to purchase supplies for several orders (or even for a large order).

Bottom line?

Purchase order financing is an alternative way to access working capital, especially for small business owners, giving them access to funds that can help pay the suppliers before invoicing the buyers. This is because cash flow problems are most common for small business owners.

For example, a borrowing company receives a significant order from a buyer. At this time, the borrowing company does not have enough liquidity to pay the supplier upfront. So, the borrowing company uses such avenues to access liquidity by applying for funding to a financial institution.

The actual rate for purchase order financing depends on many factors. For example, the size of the purchasing order and the agreed time of repayment. Other factors are the business relationship between the parties and their financial stability.

However, purchase order financing may not be the solution to every company. For example, low-margin businesses may need to access other funding alternatives. This is because high fees can eat into your profit margins. Moreover, purchase order loans may not very flexible when it comes to your needs.

In most cases, the perks outweigh the downsides as it enables you to buy inventory and grow sales when capital is limited and helps your firm grow without increased bank debt or diluting ownership. This in turn also increases sales opportunities and facilitates cash flow for timely deliveries to customers.