Purchase Order Financing Overview

Purchase order financing is similar to factoring in many ways. The biggest difference is that instead of selling a receivable the company in need of financing sells a purchase order.

Purchase Order Financing and the Steps Involved

The following diagram illustrates the flow of money and actions in the purchase order financing process. Each step is explained in detail below.

Parties Involved

  • Buyer - This is the firm purchasing products. This might be a retailer purchasing products from a distributor, or manufacturer purchasing raw materials.
  • Seller - This is the firm selling the products.
  • Finance Company - The company that will buy the purchase order from the seller and provide the financing.

The Purchase Order Financing Process
The points below correspond to the lettered steps on the diagram below.

  • A - The buyer submits a purchase order to the seller for $20,000 dollars worth of product. The purchase order is basically an order to the seller to produce a given amount of product. Once a purchase order is generated there is some degree of certainty that a sale will be made. This gives the purchase order value.
  • B - The financing company would then buy this purchase order from the seller at a discounted rate. This provides the seller with capital that they can use to finance the order or other operations. This also means that finance company is also responsible for collecting the $20,000 from the buyer when they receive the product from the seller. In this case the finance company offers the seller 90 percent of the value of the invoice and a discount rate of 4 percent. Therefore, the seller receives $18,000. The 10 percent or $2,000 will become the reserve balance which is the financing company's way of hedging their risk. Of that 10 percent, 4 percent is the profit for the finance company and cost to the seller.
  • C - During this period the seller works to fill the $20,000 order for the buyer. This period of time presents risk to the finance company. If the seller where somehow unable to fill the order the finance company would not receive payment from the buyer and would lose $18,000. In this case, the seller does produce the product and deliver it to the seller.
  • D - Now the buyer pays the finance company the full $20,000. Once the factor receives the full payment for the order, they return a portion of the $2,000 reserve balance to the seller since they no longer need to hedge their risk. The finance company keeps $800 (4 percent of $20,000) of the reserve balance and this is the profit for the factoring company. This means the finance company would return $1,200 to the seller.

This is an example of a standard purchase order financing transaction. The process can involve slight deviations depending on the nature of the deal, but most purchase order financing transactions follow this basic pattern.

Benefits of Purchase Order Financing

Purchase order financing can be used to benefit a company in many ways. Several of the common benefits and uses of this method of financing are listed below.

  • Funding Rapid Business Growth - Businesses that are growing rapidly require a lot of capital to boost future production. If banks are not able to provide this additional capital, companies can miss out on orders. In this case, a company can sell purchase orders as a way to finance their fulfillment, and take advantage of these opportunities.
  • Funding Seasonal Businesses - Businesses in seasonal industries run into the same problem rapidly growing businesses do. They may not have the capital on hand to boost production for the busy season. If banks cannot provide this additional capital, purchase order financing can.
  • Take Advantage Of Supplier Discounts - If a supplier offers a 2% discount on invoices that are paid within 10 days, that equates to a 36% annualized return on investment. In some cases, this discount can make purchase order financing much more attractive, since it allows companies to better take advantage of these discounts.