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What is Purchase Order Financing?
Purchase order financing occurs when a business sells its purchase orders to a factor or lender for access to cash. Institutions who engage in purchase order financing are called "factors". These institutions agree to lend your company a nominal amount based on the value of your purchase orders at a fee.
For instance, if your business was short on cash, but it got an order for a large amount of its finished product, the factor would agree to lend you the money on condition that they get to take over the purchase orders. In essence, your company would get the funding to complete the order, you would deliver the goods and then the factor would take it's fee plus the capital repayment and issue the remainder of the funds to your business. The purchaser therefore pays the factor directly instead of paying the money owed to you.
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Pros and Cons of Purchase Order Financing
From the explanation above the meaning of purchase order financing is now clear. However, there are both pros and cons to this arrangement.
Pros of Purchase Order Financing
- The entrepreneur passes on the collections risk and responsibility. Most factors actually accept the risk of non-payment as part of their service, so not only does the business get access to cash, it also gets to offload its collection responsibilities.
- Factoring provides ready access to cash. This type of financing is convenient and it is usually granted within a short space of time, usually within 24 hours. It also avoids the embarrassment of having to turn to family to pick up the slack in your business loans.
- Factoring is cost effective. Purchase order financing is cheaper than using your credit card to fill in the blanks, so although there is an upfront fee for using this type of service, it can be balanced off by comparing it to alternative financing options.
- There are no installments. Since factoring is not a loan the total is repaid when your customer or customers pay for their goods. You are not saddled with a monthly installment so there may be no payments if your financing arrangement spans several months.
Cons of Purchase Order Financing
- Factors don't release the total amount of the cash. Since the factor accepts the credit risk, they usually withhold a percentage of the funds they agree to lend until your customers pay up and honor your purchase order. This means you may be able to get approximately 80 percent of the value of your invoices with the balance paid out to you upon receipt of funds from your customers.
- Customers don't deal directly with you. The factoring company accepts payment from your customers so there may be some issues with disclosure you need to discuss with your customers before you go this route.
- Payment is taken upfront. Unlike traditional loans which are repaid by mixed portions of principal and interest the fee for a factoring arrangement is taken upfront before any money is made.
- This is a short-term solution only. Purchase order financing cannot make up for long-term financing for contracts because they are designed to take care of short term capital needs.
There are several benefits to purchase order financing but there are also quite a few drawbacks which makes it necessary to properly evaluate your options before jumping in.
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