Scaling businesses are no strangers to the complicated process of getting financial support. Traditional banks and financial institutions are particularly cautious when it comes to lending to small businesses, with a loan approval rate of just 13.5% in the U.S.
Accessibility is also an issue. For example, if customer demand exceeds supply or cash flow, it can be very costly for a business to have to wait to see if an already time-consuming bank application will be successful.
However, businesses can use alternative financing solutions to help improve cash flow and boost growth. This article focuses on two potential solutions: purchase order financing and inventory financing, and how these different tools can be used depending on a business’s goals.
What is Purchase Order Financing?
For a small business to build revenue and grow, they need to be able to deliver on customer orders without fail. But it’s not always simple to execute this.
Often, the cost of paying suppliers to fill customer orders involves sacrificing other opportunities for growth—for example, through product development, sales and marketing. Or a new customer order could come in that is simply too big and will deplete the business’s cash flow.
Purchase order (PO) financing solves this problem by directly financing the costs of supply for individual customer purchase orders. It can cover the expense of buying new materials, inventory or manufacturing.
How PO Financing Works
Since PO financing covers the immediate cost of supply, businesses can maintain momentum instead of losing it by spending time and money on simply meeting demand. The process follows these steps:
- Business applies for PO financing
- If approved, the PO financer pays the supplier to complete the order
- Supplier makes/sends the product to the customer
- Business invoices customer
- Customer sends payment directly to the PO financer
- PO financer deducts fee from payment, before sending remaining balance back to business
Fast capital access
Loan applications from traditional banks can take a long time, and filling customer orders requires urgent capital. PO financing gives businesses the option to quickly cover the cost of supply.
Emerging businesses often have a limited credit history, which is undesirable for traditional lenders. PO financing looks at more than just a business’s credit. The provider identifies ongoing opportunities, structuring the finance solution according to that business’s needs.
To keep things moving, many companies sell equity so that they can take on every single purchase order. By directly financing suppliers, PO financing eliminates this need. Businesses can then look to the big picture and focus on other revenue streams to boost growth.
PO financing helps businesses better manage their cash flow and supply chain, but it is limited to specific transactions. A business cannot, for example, use it to cover ongoing capital expenditure in the way other loans do. It is strictly used to pay suppliers to fill an open customer order.
PO financing typically has a higher APR than a traditional loan. As a result, some argue this option is mainly effective when used for transactions with higher margins.
What is Inventory Financing?
Businesses that experience seasonal demand often find that keeping products or materials in a warehouse that can be used later on helps their cash flow.
While this is a sensible, forward-thinking strategy, it’s often the case that businesses do not have enough working capital to pay for a large inventory order. That’s where they can use inventory financing as a short-term loan to purchase more supplies or materials.
Types of Inventory Financing
The process for obtaining inventory financing depends on the option used. There are three distinct types of business loans for inventory: lines of credit, term loans, and inventory loans.
Lines of credit
An inventory line of credit is recurring financial support that can be used according to need, as opposed to one lump sum. Businesses only pay interest on the funding they actually use, but they must repay each time before they can receive another payment.
A term loan is where a business receives an upfront payment to be repaid in fixed daily, weekly or monthly installments. Like the majority of loans, these have a fixed or variable rate of interest that must be paid alongside the upfront payment. Repayment terms are also short, so the inventory that business purchases need to be quickly sold or used in order to pay back the loan.
Alternatively, businesses can use asset-based loans, where their inventory becomes collateral against a small loan. Inventory lending gives the lender the right to claim the value of existing inventory as the guarantee.
Advantages of Inventory Financing
Seasonal demand often results in businesses finding it hard to predict inventory levels, and the last thing a business needs is to lose customers because items are out of stock. To maintain revenue, inventory financing gives businesses the option to purchase inventory in advance to avoid this exact problem, and guard against disappointing customers.
Fast capital access
Unlike traditional bank loans, obtaining inventory financing is an easier and less time-consuming process. In some cases, loan applications are approved in a matter of weeks and require less documentation.
Inventory lines of credit give businesses more control of their finances, since they only need to withdraw the amount they need at a given time. With inventory loans, unlike traditional bank loans, business owners are less subject to their credit score or history, since the finance providers have the inventory as collateral.
Disadvantages of Inventory Financing
Inventory financing often involves a great deal of due diligence. With PO financing, it can take a matter of days from the initial request to the release of funds. Inventory financing lenders, on the other hand, require businesses to undergo an initial review, followed by a field exam and an inventory assessment. All of these often entail charges.
In many cases, inventory finance lenders will not fund the entire amount that a business needs to purchase more inventory. Some lenders may also have a minimum loan requirement, which is unhelpful for those small businesses just starting out, or others in need of flexible financing. Interest rates on inventory loans are high, and can range from 9% to 97% or more.
Purchase Order Financing vs. Inventory Financing
In theory, any businesses (perhaps small businesses in particular) can leverage either, or indeed both PO financing and inventory financing. They are two financial instruments used throughout a business’s supply chain, targeting specific functions.
As we’ve explored, PO financing is not suitable for businesses purely attempting to increase inventory stock. It can only be used to cover specific purchase orders that have already been sold. Inventory financing, on the other hand, is used to buy supplies for future orders.
Both provide a solution to cash flow problems, but for different business objectives. The solutions are not interchangeable, but inventory financing tends to be more expensive as a result of the extensive due diligence process required, and the fact that more stock will be purchased planning for numerous orders.
Maintain momentum with Setscale
With PO financing, businesses can better manage supply chains to deliver on customer demand. Our non-dilutive solution takes into account more than just a businesses’ credit score, and we don’t get paid until you do.