For determined business owners, keeping things afloat can be a challenge a lot of the time. Cash needs to be on hand for open orders that need a fast turnaround — but this may be affected by ongoing order fulfillment, or late payments on another job leaving a firm with depleted capital.
At times like these, many businesses seek out support from traditional bank loans to inject cash into their business. However, once debt starts to accumulate, they might feel as if they’re back at square one. Thankfully, in the innovative world of modern business, there are a variety of solutions out there to help small to medium-sized businesses seize back momentum.
In this article, we’ll examine two popular solutions used by a range of companies — invoice factoring and purchase order (PO) financing. Although these financing options can help businesses, too many owners and professionals do not fully understand how they influence their existing capital stack, the ability to meet demand, and support them in achieving crucial growth. Without further ado, let’s dive into key differences between these funding options, and which one will be the right choice for your business.
Purchase Order Financing vs. Factoring
Business owners are often unfamiliar with alternative financing options available to them. In fact, many confuse the following solutions and ask providers about ‘purchase order factoring’, when in reality there is no such thing. Let’s dive in to the difference between Purchase Order Financing and Factoring.
What is Purchase Order Financing?
Purchase order financing (also known as ‘PO finance’ or ‘PO funding’) is a funding solution businesses use to pay suppliers to fill open customer orders. When customers submit a purchase order, that means they have agreed to buy a product from you.
However, fulfilling this order through your supplier typically requires liquid cash for the manufacturing and shipping, and often a company of any size — from startups to large enterprises — may simply not have sufficient cash to do so.
That said, we know that no one will want to turn away a large purchase order. Instead, a third-party funder can support them in meeting existing consumer demand. The business is then able to focus its efforts on other areas to generate growth.
What is Factoring?
Otherwise known as ‘invoice factoring’, this is where the company sells unpaid invoices to a third-party (a.k.a the ‘factor’). at a discounted rate. The seller uses this transaction to reduce the customer terms and obtain working capital in an expedient manner. The benefit of this funding tool is that it allows the supplier to agree to the end-buyer payment terms, while accelerating the cash flow by selling the receivable upon invoicing. It is important to note that an invoice factor cannot come into play until the end-buyer has actually been invoiced for the goods.
Let’s take an apparel business as an example. Imagine a small t-shirt business wants to increase sales by offering credit terms to its customers. It allows buyers to pay for purchases within a 30 day period with the aim that, by making it easier for customers to make a purchase with these flexible terms, it can increase revenue and customer loyalty, while remaining competitive with larger businesses that also offer flexible payments. In this case, there is no issue with fulfilling the purchase orders, but rather than waiting the full period for payment, the businesses instead decides to sell these outstanding invoices to a factor. The factor then pays the business an amount of the invoice up front, providing them with immediate cash payment. When the invoice is due, the factor takes on the job of collecting payment, and sends it back to the business after deducting a fee.
When a purchase order comes in, it may be the case that a business has reservations about its capacity to deliver quickly enough,the order will take too large an amount from cash flow, or they may simply not have enough capital to fulfill the order. At this point, the company can request PO finance in these steps:
- Business applies for PO funding
- If approved, the provider pays the supplier to complete the order
- Manufacturer ships the product to the customer
- Funding partner invoices customers
- Customer sends payment directly to the funding provider
- Funding provider deducts the fee from payment, before sending the remaining balance back to the client
With factoring, the ‘factor’ (funder) typically advances a portion (around 70-90% of total value) of the invoice amount to the business upfront. The amount that remains is paid back to the business once the invoice is settled, only minus the factor’s fee. This fee is determined by how credit-worthy the company’s customers are, the total volume of invoice factoring requests, and how long the customer typically takes to pay the invoice. The process usually follows these steps:
- Business issues an invoice to a customer
- Business contacts a factor
- Factor typically requires all invoices for business and customer relationships to flow through the factor.
- Business goes through an underwriting and onboarding process.
- The customer pays the invoice to the factor.
- Factor deducts their advance, their fee, and then sends the remaining reserve to the business.
The Pros and Cons of PO Financing
1) Fast capital access
Purchase order funding has become a suitable option for many businesses who do not want the hassle of applying for a conventional bank loan, which can be a lengthy process. Applying to PO finance may result in a quick turnaround — for instance, Setscale aims to provide funds to a business within 24 hours of a successful application.
2) Flexible financing
Once you’ve established a strong relationship with your purchase order financing company, you can expect a long and fruitful relationship. As a PO funder, Setscale accounts for more than just your credit score, exploring ongoing opportunities to support you in growing your business. At Setscale, we believe in empowering firms who are on the cusp of growth.
3) Enhanced credit score
As long as the business repays the lender on time, it will positively affect the company’s credit score over the long run. This will be advantageous for securing better loan terms in the future, improving a business’s access to other forms of financing and even help to secure lower interest rates.
1) Business type
PO financing is an effective way for businesses to manage their cash flow and supply chain, this does not apply to all types of industry. It is generally seen as a helpful tool for those companies with large buyers relying on suppliers to outsource products, but less so for a service-based business (e.g. consultants, IT, events and entertainment).
Similar to a commercial loan, PO financing costs dollars and cents. The borrower has to pay a fee in exchange for the financial support. This is what has led some to consider PO funding as mainly effective when used for large, high margin transactions.
The Pros and Cons of Factoring
If a business has a short cash flow cycle, needs to access funds fast, and/or has long payment terms with clients, invoice factoring can be a useful tool. This financing option lets a company quickly receive cash, and maintain operations without the delay of the end-buyer’s payment terms. As a result, they save time and energy with reduced hassle. Here’s a more comprehensive list of the pros and cons of factoring:
It can often be a long wait for a customer to pay an invoice. Factoring offers businesses a workaround to this problem by providing a fast cash injection.
2) Zero debt
Factoring is not a conventional loan, and using it does not incur the business any debt. Rather, the factor takes on the credit risk and collects payment directly from the invoiced customer.
Invoice factoring often entails flexible terms that can be customized to fit the bespoke needs of a business. For example, the business can select which invoices they want to factor, by how much, and how often.
During the factoring process, the funding partner will carry out their due diligence, including credit checks on the business’s customers. Not only does this help for transparency, since the factor takes on the credit risk of the customer, but the business is also protected from bad debts e.g. non-payments or defaulted payments.
Invoice factoring can be expensive. Fees can range from between 1-5% of the invoice total, but they may also be much higher — along with interest. The cost is also determined by how credit-worthy the customers are, and the length of time to collect payment. The more urgent cases of particularly unreliable customers with a bad credit rating are more costly as a result.
When a business requests invoice factoring, they are required to sign a contract with the factor. The terms may often include: non-recourse provisions, termination fees and minimum contractual agreements, among other potential stipulations.
Qualifying for Funding
When filing an invoice factoring request, a business is required to send the invoice to the factor. Since these invoices are typically sold to a third-party factoring company, this makes the requesting business subject to a UCC-1. The terms of this legal notice can vary depending on the factoring company. The customer will also be subject to a payment history check — to make sure the business-funder partnership is sustainable, the custom in question should still have a record of on-time payments, no significant litigations, or declaration of bankruptcy in the recent past. Other criteria can include:
- The business should offer credit terms that meet industry standards
- A minimum/maximum amount of invoices per month
- The debtor must not have a history of significant litigation i.e. malpractice, employment disputes, personal injury, etc.
The required documents for a factoring application typically include:
- Outstanding invoice to be funded
- Customer list
- Financial records
- Sales ledger
When it comes to PO finance on the other hand, the approval criteria for purchase order finance can depend on the financing company. Most are reluctant to provide funding unless the applicant has an immaculate credit score — whereas Setscale takes a more rounded, holistic approach. If you have a proven track record, we believe we can help you identify opportunities across your value chain.
That said, it’s important to always include enough detail in your application — this makes the process smoother for everyone involved. Here’s a list of the information you are encouraged to provide when applying for PO finance, in order to assess risk and viability for the loan.
- Company information
- Supplier information
- Buyer’s purchase order
- Manufacturer order
- Payment terms
- Financial statements
- Company and client credit information
- Tax documents
Which option is right for my business?
Invoice factoring and PO finance are not unrelated. Although not every business will use both, their key uses can stem from the same universal needs of those firms trying to loosen cash-flow, save time and reduce hassle in order to achieve critical growth. However, the key difference is the point in the journey of delivering on a customer’s order in which they are used.
Taking the same example as earlier of a small, custom t-shirt business: let us say that a large, unexpected purchase order of 2,500 shirts has come in that needs to be delivered in 30 days. This is new territory for the company — they don’t have the necessary funds available to pay suppliers upfront to produce the t-shirts. In this scenario, the problem is not having enough cash up front, rather than outstanding unpaid invoices. Purchase order finance would come in much earlier, allowing the supplier to make and ship the product for the business to then fill the order. Once the business gets paid, they repay the funding partner.
On the contrary, the situation is different if the product has already been made and shipped to the customer, but the business is still waiting for payment. PO funding is redundant in this case, as the purchase order is technically closed and fulfilled. Instead, the factoring company pursues payment from the customer, taking a fee out of the remaining balance once payment has been completed. What the supplier is avoiding in this scenario is simply the end-buyer payment terms, as they can use factoring to receive cash immediately upon invoicing.
How Setscale helps you grow with confidence
Factoring and PO financing address similar problems, with their own unique benefits. If you are on the cusp of real growth but your main obstacle is fulfilling existing orders at the manufacturing and production stage, PO finance may be the right solution for your business, especially if you need an option that does not require you to sell off assets and compromise on your liquidity. Find out more about Setscale’s zero-interest solution, or get started by filling in a request form today. We look forward to helping you scale.