In our last article on working capital, we discussed a method of working capital financing focused on the end of a businesses operating cycle; after the business shipped the goods or rendered services to its customers.
In fact, many businesses find themselves overwhelmed with customer orders, yet do not have the capital (cash) on hand to buy the materials or hire the labor needed to complete those jobs.
Let’s look again at a business’s operating cycle. When a company receives an order for their products or a contract for their services, they usually have to go out and purchase supplies or materials and in some cases hire labor to fulfill those orders. The orders then get filled (the job completed) and the goods get shipped or services finished.
But, what happens when a business does not have the money on hand to make those needed purchases or hire that needed labor? The business could either delay the start of the job and hopefully not anger the customer or it has to decline the business – potentially damaging its reputation in the industry as well as giving up that job’s profit potential.
But, as stated, businesses find themselves in this situation all the time.
To combat this, successful businesses, businesses that want to satisfy customers and not lose out on potential profits, will either turn to their bank or lender (if they can) or seek out purchase order financing.
Purchase Order Financing
Purchase order financing, like most alternative (non-traditional) business loan products, are focused on a future cash event for repayment.
In this case, when a customer places an order and agrees to pay (in the future) when the products or services are completed, that creates a future cash event; an event that can be factored today for immediate cash.
This cash advance then gives the business the means to buy the supplies or hire the labor needed to complete the job and realize that future cash event.
A financing company will advance funds based, not on the purchase price of the order (the amount that the customer agrees to pay) but on the cost it will take to complete the job and fulfill the order.
Example: Your business works hard and lands a new customer that wants to buy $10,000 worth of your products. However, to complete that order, your business must buy $5,000 in raw materials and increase the usage of its production space that will further increase other direct costs (direct to this order) such as utilities and labor in the amount of another $2,000 – for a total cost of production of $7,000.
A purchase order factor (the financing company) will advance your company the $7,000 needed to complete the order and ship the goods (usually 100% of what it takes to fulfill that order). Then, once your customer pays, the financing company will collect that payment, retain its initial $7,000 and its financing fee and remit the remaining to your business.
Again, just like most financing activities, purchase order financing can be more expensive than say a traditional bank line of credit. However, very few new or growing business (and very few businesses in general) qualify for bank credit these days.
However, if there is enough margin built into the price of your product or service, the difference (cost of financing) is minimal.
Look at it this way: You receive the above mentioned order for $10,000. It takes your company $7,000 in direct costs to produce and ship those products – leaving your company $3,000 in gross margins to cover other overhead and expenses as well as contribute to the company’s profits. The whole process, from the purchase of materials and labor to the collection of payment, takes 30 days.
Now, if you have the $7,000 working capital on hand, the use of those funds essentially costs the business nothing. However, if you have to finance those purchases, then that financing will eat into the $3,000 margin built into the price. But, the question is how much?
Let’s say you can receive a bank line of credit at 8% for the period the money will be outstanding (30 days). This will cost your company about $50 in interest (ignoring any fees to set up and maintain the line of credit). This still leaves your company $2,950 to cover overhead and other fixed costs.
Or, your purchase order financing company charges you more in interest, say 10% for the period outstanding. This only results in a cost to your company of about $60 – still leaving your company enough from the job to meet other business needs.
The goal is not to look so much at the cost of this or any financing, but to look at the return on the total job.
If your business does not have the cash on hand or refuses to finance the needed working capital, the business then loses that customer (the current jobs and probably all future jobs that customer would have brought) plus the $3,000 in gross margins – money your business could use to cover the next job, meet other expenses or take out in profits.
Further, purchase order financing can offer other benefits to a growing business. Developing a relationship with a purchase order financier will allow your company to bid on larger commercial and government contracts, contracts that may have eluded your business in the past due to a lack of working capital. Thus, you can go after bigger, larger jobs – jobs that you have always dreamed your business could handle but were just unsure of how to pull them off. Purchase order financing provides that chance!
If your business is struggling to meet customer needs then why not use all the resources available. While purchase order financing might not be right for all businesses, it could be the perfect means of providing your company needed working capital as it finds new ways to grow.
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