For startups, medium-size businesses or large enterprises alike, greater demand does not always turn into business growth. While more customer orders are a positive at first glance, this often involves buying more inventory, paying manufacturers to fill orders, as well as hiring the right people to do the job.
In situations like these, businesses often use funding solutions to improve their cash flow. While some pursue traditional bank loans, these are known to have lengthy approvals processes, and are often unavailable to borrowers with low credit ratings. As debt interest piles up, a conventional loan might simply return a company back to square one.
There are more flexible financing options available to modern businesses, however. This article focuses on two potential solutions: purchase order financing and working capital loans. While both are viable tools, their unique applications are not always fully understood. Here we will examine how they work, the key advantages and disadvantages, and which one a company should consider depending on its needs.
What is Purchase Order Financing?
Purchase order financing (otherwise called ‘PO finance’ or ‘PO funding’) is a solution businesses use to cover the cost of fulfilling open purchase orders. As we explore in detail in our explainer article, when a customer submits an order with a business, they commit to buying a product which has to be manufactured and shipped through a supplier.
This isn’t the end of the story, however. It often requires liquid cash to make and deliver goods, no matter the size of the businesses receiving the order. Startups through to large enterprises encounter similar challenges of finding sufficient capital to make this happen. This makes business growth especially hard, as the majority of time and energy is spent on filling open purchase orders — especially the larger ones which could otherwise be the opportunity for the business to scale up.
How it works
With PO financing, a third-party funder helps a business meet consumer demand, directly covering supply chain costs (rather than lending capital straight to the business). That way, the business can concentrate on generating growth through sales, marketing, product development and other areas.
Fast capital access
Purchase order funding is 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 for PO finance can be a quick turnaround — for instance, Setscale aims to provide funds to a business within 24 hours of a successful application.
With a strong relationship with a funding provider, you benefit from a long-term, flexible partnership. PO financing takes into account more than just a business owner’s credit score — the provider considers ongoing opportunities, structuring the finance solution to meet the bespoke needs of the business.
PO finance supports businesses in managing your supply chain and cash flow. That way, you can focus your mind on the big picture and bring in more revenue through product development, sales and marketing.
PO financing lets businesses manage their cash flow and supply chain, but this does not apply to all expenditures. While a viable tool for those companies with larger buyers that outsource supply, it will not be able to cover any given ongoing expenditure like a working capital loan. Instead, it applies to only specific transactions.
PO financing typically has a higher APR than a traditional loan. As a result, some argue this option is mainly effective when used for big transactions with high margins.
What is a Working Capital Loan?
Working capital is a measure for a business’s total liquidity and efficiency. This is done by calculating a company’s current assets and subtracting its total liabilities (financial obligations i.e. loans or debts). The leftover total — the working capital — is what the business has available to meet these short-term obligations and pay for everyday operations. A working capital loan is a funding solution for small or medium-sized businesses to settle debts, finance day-to-day operations and keep things running.
How it works
Usually, the size of the loan depends on a company’s credit history and often the personal credit of the business owner. The purpose of a working capital loan is not for long-term investments or purchases, but to handle wages and other expenses that make sure the business stays afloat.
Working capital loans are what are known as unsecured loans. These are unprotected debts, with no collateral to put down in case of bankruptcy or a failure to repay the lender. The companies that tend to use working capital loans are those with cyclical or seasonal sales patterns, and use a range of financing options — term loans, lines of credit, invoice financing — when production is quieter and the revenue stream is consequently lower.
Easy to obtain
Like purchase order financing, the approval process for working capital loans tend to be shorter than traditional loans, as lenders are more willing to approve loans covering short-term expenses. However, the lender will also assess the creditworthiness of the applicant, as well as the business plan and history.
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.
Improved cash flow
Working capital loans help sustain a healthy cash flow by covering short-term business expenses. Specific loans like equipment financing allow businesses to promote further growth and revenue. By managing seasonal fluctuations, they also help a company maintain cash flow for periods of lower demand and activity.
Some working capital loans are unsecured, meaning that they do not require collateral, but these are only available to businesses with a strong credit rating. If a company has limited credit, it will need to draw on asset collateral, where the borrower pledges security assets (inventory, accounts receivable, investment portfolios etc) to the lender in order to secure the loan.
Working capital loans are usually designed for borrowers that quickly need funding, and often have shorter repayment terms. They are also often unsecured, making them riskier for lenders. As a result, these loans typically incur higher interest rates for borrowers.
How to apply
Open purchase orders can give a business reservations about whether it can fill the order with its existing capital stack. At this point, the company can request PO finance in these steps:
- Business applies for PO funding
- If approved, the provider pays the manufacturer to complete the order
- Manufacturer ships the product to the customer
- Business 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 business
Working Capital Loans
As previously mentioned, there is no single ‘working capital’ loan. It could be a line of credit, invoice financing, merchant cash advances or equipment financing. This means there is consequently no one defined process of applying for working capital loans. Before applying for any of these solutions, there are a few steps a business should do:
- Determine its financial needs, e.g. the amount needed and its specific use.
- Conduct research into potential lenders and establish whether to pursue a bank loan, a credit union or alternatives.
- Collate relevant documents such as legal and financial information, and submit them online or via the lender’s preferred means.
Which option is right for my business?
Both purchase order financing and working capital loans are instrumental for businesses trying to scale up. While overcoming cash flow problems appears as the common denominator, that does not mean their applications are the same.
Purchase Order Financing
Purchase order financing is viable when tied to a specific purchase order: let’s say a small apparel company receives a large order for t-shirts, and these cannot be covered by a company’s existing capital stack due to lack of revenue or consistent demand.
In order to fulfill the order quickly, PO financing directly pays the manufacturer to produce and ship the batch of t-shirts directly to the consumer. The customer pays the PO funder directly upon receipt of the good. The funding provider then deducts fee from payment, before sending the remaining balance back to the client.
Working Capital Loans
Working capital loans, on the other hand, cover a more diverse range of ongoing expenditures. If your business is undergoing a quiet period that makes it harder to both complete payroll and acquire inventory, a working capital loan allows you to do so. This solution should therefore be used for a more general purpose of keeping the business running when demand is lower or the total cost of doing business has increased unexpectedly.