Purchase order financing guide

While most companies hope and pray for a large contract to come in, the truth is it can put a company under financial stress. Once a supplier or contractor receives a purchase order from their customer, they need to purchase materials to start production or work on the project. But they may not have the cash available to fund the materials purchase because they’re waiting on payments from other customers and projects. Some construction companies use purchase order financing to cover the cost of materials without using their own cash. Here’s how it works.

What is purchase order financing?

Purchase order financing is a cash advance to pay a supplier for production costs of an approved order. The third-party financing company provides the cash the supplier needs to manufacture or assemble the products. 

“‘Traditional’ PO financing is when a company is financing finished goods only,” says Mobilization Funding CEO Scott Peper, “meaning they are buying a finished good from a supplier and delivering that finished good to their end customer.”

However, Scott notes that people now use the term “purchase order financing” to refer to a wide variety of activities. For example, in construction “PO financing” is sometimes used to refer to materials financing, in which a financing company pays the building material supplier directly for a contractor’s project needs.

To evaluate their financial risk, traditional purchase order financing companies primarily evaluate the supplier, rather than the purchaser. “The PO company relies heavily on the supplier’s ability to produce the product and their track record,” says Scott. This puts performance risk on the supplier making the product, rather than their customer, who is typically just responsible for installation.

When used in construction, PO financing companies often rely on the creditworthiness of the final customer or the project overall, rather than the contractor or even the supplier. For this reason, PO financing is available to a wider variety of contractors and suppliers, like those who are just starting out and don’t have an established credit history.

Who uses purchase order financing?

Purchase order financing is available to anyone who needs to buy physical goods, like framing lumber or asphalt shingles. (Sometimes it can be used to cover equipment purchases or rental as well.) In construction, this includes:

  • Material suppliers and distributors – They need to purchase inventory or raw materials for manufacturing.
  • Fabricators – They need to purchase raw materials for fabrication.
  • Subcontractors – They need to purchase materials or equipment to perform their work.
  • Equipment rental companies – They need to purchase used or new equipment to offer to their rental customers.

Purchase order financing isn’t used to cover services, like construction labor or mobilization. Other contractor financing options can help fund overhead or other costs. Instead, PO financing is specifically used to cover the costs of materials or equipment.

How purchase order financing works in construction

Here’s an example of purchase order financing in action on a construction job:

1. A roofing contractor signs a $2 million contract with a GC to install a roof on a new commercial project. To complete the job, they’ll need to buy $750K in materials.

2. The roofing company creates an itemized list of the materials they need to complete the job: underlayment, metal roofing panels, flashing, sealant, etc. They send a purchase order to their local roofing material distributor.

3. But the roofing contractor only has a $250K credit line with the distributor, and they don’t have $500K on hand to complete the purchase. So the contractor or supplier applies for purchase order financing from the financing company.

4. The financing company looks at the project details, including the GC’s history of making payments. When approved, the financing company sends a check, or sometimes a certified letter of credit, directly to the supplier.

5. The distributor delivers the roofing materials to the jobsite, and the contractor successfully installs the roof.

6. The contractor submits a pay app to the GC for the work and materials, and waits for payment.

7. The GC approves the request, and sends the roofing contractor a check for $2 million.

8. After the check clears, the contractor pays $500K to the financing company (and $250K to the supplier).

In this example, the roofing contractor used PO financing to complete their biggest job to date, and were able to save their own cash to cover labor costs and overhead during the project.

How much does PO financing cost?

Typically, PO financing costs between 2-8% of the order amount. The cost of purchase order financing depends on a number of factors, like the size of the order, how many POs you’ve financed, the length of time to repayment, or how risky the job is.

Rather than being paid all at once, that cost is typically spread out over the course of the project. The contractor may need to pay an origination fee, plus a small weekly payment to the financing company for up to 4 months.

For companies trying to grow a construction business, the cost of financing a material purchase is inconsequential compared to the benefit they get from completing more or bigger jobs.

Purchase order financing vs other funding options

Credit cards

Credit cards are easy to get for most contractors, but if you don’t have the best credit history, they can be expensive. Interest rates are much higher than PO financing — they can be as high as 29%, plus fees and other charges. They are easy to use and are accepted by most companies, but you can get into trouble with them. And in order to pay for large purchases, you must have good credit or a long-standing relationship with the issuer.

Line of credit

A line of credit is like a safety net on your bank account. You can draw money from the account when you need it, and only pay interest on the amount you withdraw. It can also be used to cover overdrafts on an account. It’s not only available from a bank, though. Material suppliers typically provide a line of credit to qualified customers, also known as trade credit.

Getting a line of credit takes time and you must go through the application process, which includes a financial statement review and a credit check. Financing a purchase order is typically much faster, and doesn’t rely on the applicant’s creditworthiness. Like with credit cards, it’s easy to get in trouble with a line of credit if it’s not used wisely.

Bank loans

Bank loans offer a way to get both long-term and short-term financing. If you’re looking to expand your business or purchase a large amount of materials or equipment and have plenty of time to go through the loan process, a bank loan may be a good option. It can take several weeks to close on the loan, so you have to be prepared to wait.

Invoice factoring

Invoice factoring involves selling your current accounts receivable invoices to a financing company. As a result, it is only available after you submit an invoice or pay app to your customer. By that point, you’ve already purchased and installed the materials! So factoring is not a useful alternative to PO financing.

PO financing can improve cash flow & help businesses grow

Because construction customers take an average of 83 days to send payment, it can be tough to take on new or bigger projects when you don’t have funds from the old projects yet. Purchase order financing is one tool contractors and suppliers can use to help them improve their cash flow and grow their business in a sustainable way.

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