Cash-Strapped Businesses Turn to Purchase-Order Financing

This article is a reprint of Wise Bread's contribution to OPEN Forum from American Express -- where small business owners can get advice from experts and share tips with each other.

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It's a small-business owner's nightmare: Your company lands a major merchandise order from a corporation or government agency, but doesn't have the money to pay for manufacturing and delivery. If you can't find some cash — fast — your company stands to lose the order and possibly the customer relationship, too.

Many business owners stuck in this situation are turning to alternative lenders who offer to finance their purchase order. P.O. finance has become more popular as bank lending slowed in recent months. While some P.O. lenders have been around for decades, many companies in the sector, such as PurchaseOrderFinancing, sprung up during the last downturn.

Even if your business has seen its credit rating cut in recent years, a purchase-order lender might be willing to work with you. That's because in P.O. 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.

Here's how a purchase-order finance deal works:

• Your business receives a large order from an established, creditworthy customer. Your company is a product re-seller or distributor, not a direct manufacturer.
• Your P.O. lender checks your customer's credit history and approves the deal.
• The P.O. lender 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 company may be asked to pay inspection, insurance or shipping-duty costs incurred along the way.
• 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 P.O. 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. Many P.O. lenders also offer factor loans. Fees for factoring your invoice are usually modest.

P.O. 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 P.O. 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 a P.O. lending deal, so costs are higher.

Though you don't need a great credit rating to get a P.O. finance loan, there are some other criteria used by most lenders in this sector. For instance, Miami-based microlenders offer loans up to $35,000 to small businesses, and many will lend on the strength of a major purchase order or confirmed government contract.

One advantage of seeking P.O. financing from a microlender is that it will likely cost less than it would using an alternative, for-profit lender. Most microcredit 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 P.O. lender will get involved in your deal and pay your supplier directly, a microlender 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. You can learn more about microfinance lenders at the Microfinance Gateway.

Getting P.O. financing isn't ideal, as the high costs will eat into your profits. But if it's a choice between P.O. financing and losing a big sale, it can keep your business growing.

This is a guest post by Carol Tice.