Imagine you’ve started a company that buys electronic devices overseas and resells them to retailers based in the United States. One morning, you wake up to an exciting email: a new customer wants to place a huge order.
Great news, right? One issue: you don’t have enough cash in the bank to finance this order out of your pocket. This is a problem since the last thing you want is to turn the customer away.
This is a situation that happens frequently, and it’s a bit of a catch-22. You have a big order with the potential to create a good profit for your business, but you don’t have enough money to finance it.
What should you do in this situation?
Some small business owners in this predicament turn to purchase order financing. This is one way to get the funds they need to get the materials or products they need to fulfill large orders.
What is Purchase Order Financing?
Purchase order financing is a business funding vehicle that enables suppliers and merchants to borrow money to finance large orders. Lenders that offer this kind of financing are willing to fund businesses that have lower credit scores as long as their customers have solid ones. This makes sense because customers pay purchase order financing companies directly once they receive their goods.
Here’s how the typical process works:
- A customer sends in a large purchase order
- After realizing your company can’t finance the order, you reach out to a purchase order financing lender, passing along the purchase order and your supplier’s estimate for how much the order will cost
- Once approved, the PO financing company pays your supplier directly
- The supplier ships the products to your customer
- You invoice your customer
- The customer pays the PO financing lender directly
- The lender deducts their fees and sends you the rest
While purchase order financing can certainly help businesses fund their orders and grow their operations, this type of financing is not without its downsides.
For example, imagine there’s a big blizzard and your supplier ends up needing a few extra weeks to send out an order. Will your customers agree to wait that long?
In this example, let’s say they do. That’s great, but the longer it takes to fill your order, the more interest you might owe to the lender. Depending on your financing agreement, you may be responsible for paying some hefty fees, as high as 6% each month.
What’s more, since customers have to pay PO financing lenders directly, there’s a good chance they’ll wonder if your company is financially sound and whether they should do business with you again.
Even if things work out perfectly, you can only use this type of financing to fund purchase orders. In this light, it’s a rather inflexible form of small business financing. If you are short on cash, you may be better off looking for financial instruments that are a bit more versatile.
What are Some Alternatives to Purchase Order Financing?
There are a number of other funding options that small business owners looking to avoid the disadvantages of purchase order financing can turn to instead.
Let’s take a brief look at five of the more common small business financing options.
1. Invoice financing
Does your business have lots of unpaid invoices piling up? If so, an invoice financing solution may be the perfect fit for your company. Invoice financing lenders advance the full amount of outstanding invoices you want to get paid on. You then have a specific amount of time—let’s say 12 weeks—to repay the advance, plus a small fee.
2. Invoice factoring
Invoice factoring is like invoice financing except the factoring company buys your unpaid invoices at a discount. Typically, factoring companies give businesses something like 80%–90% of the face value of the invoices they buy. Unlike invoice financing, businesses that use factoring may give off the impression that their companies aren’t doing too well because their customers have to pay the factoring firm directly. This may be a red flag for some customers that are wary of doing business with cash-strapped companies. Once the factoring company gets paid, they return the remainder of the balance to the business, minus their fees.
3. Business lines of credit
A business line of credit provides small business owners with access to a specific amount of capital (e.g., $100,000). Unlike the term loans, you don’t get funds from a line of credit in one lump sum. Instead, you have access to the money on an as-needed basis, and interest only accrues when you draw funds from the credit line.
Business lines of credit are a popular choice in part because they’re so flexible. You can use a business line of credit to fund purchase orders, purchase new equipment, buy extra inventory ahead of a busy season, and even hire new employees, among other things. Be sure to repay your credit line as quickly as you can to avoid high interest charges.
4. Bank loans and loans from the SBA
Traditionally, small business owners in search of financing would look for bank loans or loans guaranteed by the Small Business Administration (SBA). Yet following the global financial crisis of 2007– 2008, both entities funded fewer and fewer small businesses. Though today banks are lending to more small businesses, they still only approved 27% of small business loans in January 2019.
Similarly, SBA loans are known for being quite hard to get. The process can take months—and the recent government shutdown didn’t speed things up, either. Unless you’re willing to endure a long process and are confident your financials are strong enough for approval, you may be better off looking elsewhere for financing.
5. Business credit cards
In a pinch, you can always use a business credit card to finance your purchase orders—assuming you have a high enough credit limit. But if you go this route, be sure that you can repay your balance off in full each month. Otherwise, you’ll be on the hook for the interest fees.
The Easiest Way to Finance Purchase Orders
When you’re considering purchasing order financing, it’s safe to say your cash situation is less than ideal. If you’re struggling to fill orders, how are you going to afford to cover all of your other expenses?
Since purchase order financing can be expensive and inflexible (since you can only use funds from PO financing to buy goods to fill orders), it’s not very helpful for many business needs.
If you find yourself in a similar situation, a business line of credit may provide the flexible and fast funding you need to fill large orders quickly. You can also tap into your credit line to cover other business-related expenses—like remodeling an office, storefront, or workspace, launching a new marketing campaign, or opening a second warehouse, to name a few.
Applying for a business line of credit is a quick and painless process, especially if you work with a fintech firm that offers online applications. To apply for Fundbox, for example, you just need a business checking account and need to be willing to show a few months’ worth of banking activity. If approved, you may be able to secure a credit line in minutes, without lengthy paperwork.
With money always at your fingertips, you’ll be able to stop worrying about what you need to do to fund purchase orders and start focusing on what you can do to grow your business.
The SmallBizRising Blog is designed to be an educational content hub pulling information, best practices and practical advice for the small business owner and features topics including accounting, marketing, technology and more. Be sure to subscribe to stay up to date with new content as it is posted. The blog was created by The Neat Company and receives contributed content from a group of contributing companies that provide technology, services and solutions to small businesses.