Purchase Order financing, as well as inventory financing is two relatively new alternative financing solutions in the Canadian business environment. These two solutions provide additional flexibility when combined with traditional financing sources provided by your Canadian chartered bank or independent finance firm.
Traditional business financing in the context of working capital and cash flow revolves of course around the traditional current assets of receivable and inventory. Even if your firm is well financed and has a traditional bank line of operating credit you may have challenges in fulfilling large orders and contracts. This challenge becomes equally daunting when you don’t have traditional financing, so the ability to generate cash to fulfill larger orders and contracts becomes seemingly impossible.
Purchase order financing can provide you with the capital to fill those large orders and contracts, and, if properly put in place; can be very complimentary to your current financing.
As we have noted the concept of purchase order financing, aka ‘P.O. Financing ‘is a relatively speaking, new phenomenon in Canada.
So how does it work? Simply speaking financing is put in place to cover your material costs and direct labor costs, which are of course a significant part of your order or contract. We can safely say in many businesses that is 60-70% of the total order or contract based on most gross margins in any industry.
Your firm therefore has the working capital to finance your production.What’s left of course is essentially the profit on your P.O. or contract.
While it sounds relatively simply and easy we would point out some key critical issues that will allow the Canadian business owner and financial manager to determine if his or her firm qualifies for such financing. We can first of all say there has to be sufficient proof that your purchase order or contract is with a valid, credit worthy party. Naturally if there is any doubt that your order might not get paid, or that the customer is not credit worthy that precludes successful completion of any purchase order financing.
You should also not view the purchase order financing as a long term financing solution, it is not that. The funds are generally repaid immediately when you have completed your order / contract.
There are also some technical issues that need to be addressed if you have secured financing arrangements in place already. For example, if your firm has a bank line of credit they would be required to acknowledge the security that is taken in the Purchase order and resulting receivables that you create out of that order.
In our own experience Purchase order financing frankly works best when there is not a secured lender in place already, but that’s just our firm’s observation. Additionally on occasion certain other collateral or personal guarantees might be required. We would hasten to add that if you have already provided guarantees to the bank or other firms it would seem logical that you would provide them on the purchase order financing, which is somewhat of a riskier transaction for the lender.
Another very critical point is the whole issue of gross margin. The issues are that you need good gross margins to complete purchase order financing! A firm that is in low margin very commodity oriented business is not a strong candidate for P.O. Financing, because the combination of cost of goods, labor, overhead costs, and financing costs of the financing leave very little for the business owner. So categorically good gross margins make a much better P.O. Financing deal.
So why has this type of financing become popular – that’s fairly easy to understand. First of all the current Canadian business financing environment is challenging – therefore any alternative financing vehicle has a strong chance of being embraced and becoming more popular. After that it simply makes sense that p.o. financing can be very successful for your firm if it gives your company working capital you didn’t have,, it allows you to grow and profit at greater levels, and overall improves your competitive positioning within your industry.
We strongly recommend that if you consider Purchase order financing that you enlist the services of a credible experience business financing advisor who can maximize your cash flow and working capital with this unique innovative type of financing.