Purchase order financing is the practice of a company selling its purchase orders to a third party in return for immediate funding. A company can use the funds to acquire the raw material to fill out the order, while the third party, often a financing company, goes about collecting payment from the buyer. Once payment is received by the third party, they keep the amount that was loaned along with a predetermined fee. The rest of the payment is returned to the original company to close out the purchase order financing agreement.
It is not unusual for a company to find itself in the position of needing cash while lacking the immediate ability to acquire it. When lending options are exhausted and all significant payments due to be received are still some time from arriving, the choices can be limited. In these situations, a company may want to try purchase order financing, which allows the sale of its purchase orders in return for immediate cash.
To understand purchase order financing, imagine a company that needs a quick influx of cash but is still weeks away from receiving any outstanding payments. The company can seek out a financing company that specializes in buying purchase orders. Financing companies that provide these third-party services are often called factors. Once the financing agreement is reached, the factor provides a specified amount of cash, usually a percentage of the purchase order's amount, and takes charge of collecting the payment.
When the purchase order is filled and the company delivers its goods, the factor collects the payment from the buyer. At that point, the factor keeps the amount that was originally fronted to the company in question, along with their specified fee. This fee is usually an interest rate that is based on the duration of the purchase order financing agreement. Whatever amount of money is left over is returned to the company that initiated the agreement.
There are many benefits to purchase order financing agreement for a company that seeks one out. In addition to the immediate cash, the company is absolved of the responsibility for collecting payment, since the financing company takes that job over. Another benefit is that the agreement is not considered debt, so other financing arrangements may be readily available to the company receiving the cash. The big drawback to the arrangement for the company selling purchase orders is the high interest fees that are attached.