A common question we receive is, “what is the cost of purchase order financing?” Purchase order financing has been widely used to assist distributors, wholesalers, manufacturers and retailers in growing their business. Purchase order financing specifically covers the cost of goods required from suppliers. Examples are numerous but for example, if you own a spice business, you would need to pay suppliers that harvest and manufacture the spices along with the bottlers and shipping companies to get the finished product to your end customer.
Most businesses can self-fund the cost of their company’s capital needs internally when first starting out. However, if they are successful in their marketing efforts, they will eventually experience orders that outstrip their available cash flow. The goal of any company is to grow and become well-known in their space. More often than not, financing is required to make this happen.
What is the Cost of Purchase Order Financing?
In short, the cost of purchase order financing ranges from 2-3% for every 30-day period the loan remains outstanding. Some PO finance companies will cover 100% of the cost of goods including shipping costs and some will require a 20-30% cash contribution from the client company.
How do I know if the cost of purchase order financing is something I can afford without giving away all my profit?
The analysis required in assessing whether purchase order financing is right for you is different than the loans most people are used to applying for and have past experience with. Most of us have applied for or have a mortgage and/or an auto loan. These types of loans are largely commodity based financing whereby 100% of the focus is on the annual interest rate and monthly payment. These are the most widely used forms of installment loans.
Purchase order financing is a much different analysis. In reviewing this form of financing, we are looking at the opportunity cost of taking on outside financing to fund the growth of our business. We want to maintain our margins as much as we can while growing the business and scaling our products or services.
How to measure the cost of purchase order financing.
To keep the math simple, let’s say your company’s product has a 30% gross margin. You receive an order from a big customer that you have been pursuing for many months and the hard work has finally paid off with a sizeable order!
You need to pay your supplier $100,000 for which you will receive $130,000 from the customer once delivered. The total time from the customer order to receipt of the product is 60 days. The cost of the purchase order financing is 3% per 30 days.
A breakdown of the transaction would be as follows:
- $100,000 borrowed
- 6% effective cost for 60 days (3% every 30 days)
- $6,000 total financing cost ($100,000 multiplied by .06)
- Customer pays $130,000 for the product
- Total gross profit is $24,000 ($130,000 minus $106,000 which is the money borrower plus the fee for the capital)
The $24,000 profit would not be realized without financing the cost of the order. You are leveraging the cost 100% and earning profit with “other people’s money” as they say. This ratio would be the same whether there was just $10,000 or $1,000,000 borrowed.
So the question isn’t “what is the interest rate” but rather an opportunity cost analysis. Would you spend $6,000 to earn $24,000? Similarly, would you spend $600 to make $2,400 or $60,000 to make $240,000? Of course you would!
How does my company qualify for purchase order financing?
There are a couple of points the credit manager will consider before issuing an approval on a purchase order financing facility. In summary the areas of focus are:
- The financial strength of the customer placing the order (i.e. if they are the requesting $130,000 worth of product be delivered before payment, are they financially strong enough to warrant the credit risk?).
- The financial strength of your company as the borrower (can your company survive a delay in payment or complete loss on the order? Are there other customers you can sell the same product to in an emergency situation such as an order cancellation?)
- Past track record of successful delivery to the customers and verification of the supplier efficiency in fulfilling the orders correctly with minimal disputes.
- Your company’s time in business. While is not impossible to receive PO financing on your company’s very first orders, both the customers financial strength and your company’s starting capital would need to be strong.
These are just the four initial considerations underwriters take when reviewing a purchase order financing requests. Variables exist depending on the industry your company is in, typical payment terms in your industry, where your suppliers are located, among others.
How do I apply for purchase order financing?
If your company could benefit from this form of financing, we would like to speak with you. You can reach us at 844-239-2632. A brief 5-10 minute phone consultation can determine whether or not purchase order financing is a good fit for your business.