Sadie Keljikian, Express Trade Capital
The tools of trade finance are frequently misunderstood individually, but even people who are familiar with the inner-workings of factoring, purchase order financing, or letters of credit are often unaware of how they work together. Without a full understanding of how these tools combine, one may not realize the full range of options and solutions available to them.
Many businesses combine different financing methods to maintain and improve their working capital and liquidity. Although banks have characteristically risk averse and rigid collateral requirements, many trade financiers have a more expansive view of collateral, which allows them to take on clients and transactions most banks would reject outright. Receivables factoring, for example, involves small, usually recurring advances, provided against existing invoices. Unlike a bank loan, the lender, or “factor” will collect payment from retail customers. With this method, the borrower doesn’t have to pay back the advance unless a customer defaults or returns the order on the corresponding invoice. Even in those cases, non-recourse factors insure the receivables against payment default by the customer, so the borrower still usually doesn’t have to pay back the factor if the invoice is not paid.
While some banks will lend against receivables, no bank will categorize purchase orders as assets. This means POs cannot be used as collateral to obtain or secure bank loans. Thus, banks will not finance the cost of fulfilling purchase orders based solely on the merit of the purchase orders alone. Purchase order funders will.
Purchase order financing (or “PO funding”) is a form of lending in which clients with confirmed purchase orders receive funding to bolster or, in some cases, fully cover manufacturing and shipping costs. PO funding is ideal for creating enough cash flow to take on more sales, especially for vendors who sell to customers on open payment terms. Without PO funding, the lag between paying for production and receiving payment from customers can take months and drastically deplete a business’s operational funds. By employing purchase order funding, companies can obtain sufficient cash flow to pay for shipping and production and take on more orders, while deploying any remaining operational funds elsewhere.
What’s truly remarkable, however, is how much cash flow a company can accrue when they combine purchase order financing with factoring. In these cases, the client typically receives both funding varieties from the same institution. The money initially advanced against the purchase orders then translates to an advance against associated invoices and the lender collects repayment from the client’s customers. This means that clients receive funds more quickly and don’t have to pay their lender back.
The result is a simple, continuous system. Here’s an example:
Let’s say a wholesaler, we’ll call her “Jane,” receives purchase order for $1 million from a big box retailer. Her customers’ payment terms are net 30. The manufacture of her goods costs $500,000 and shipping is another $100,000. A purchase order funder will typically pay Jane’s supplier the total amount owed or a substantial portion of it, and Jane will supply any remaining balance. Purchase order funders prefer to pay suppliers directly to ensure that funds are used to purchase the goods specified in the customer’s PO. Payments are commonly wired directly or else paid under a letter of credit or document payment facility.
In this case, the PO funder can open a letter of credit for $500,000 and then pay the supplier and shipper the full amount when the goods are ready. In this case, the PO funder laid out $600,000 ($500,000 to the supplier and $100,000 for shipping costs).
Once Jane receives and ships the goods to her customer according to the terms of the PO, she has fulfilled her obligations and can proceed to bill her customer for $1 million. Jane can assign the resulting invoices to her factor who can typically advance up to 80% of the $1 million invoice value. However, the factor must first pay off the purchase order funder who already advanced 60% of the $1 million when it was still just a purchase order.
In this case, the factor should send $600,000 (plus interest) to the PO funder and another $200,000 to Jane, adding up to a total of $800,000 ($600,000 to pay off the PO funder and $200,000 to Jane, which adds up to 80% of the $1 million invoice). Unlike PO funding advances which are earmarked for cost of goods and shipping, Jane can use the $200,000 she received from the factor however she wants.
If Jane’s factor and purchase order funder are the same entity, the process is simpler, less costly, and altogether more efficient. In such instances, the factor/PO funder will collect payment on Jane’s invoice and pay themselves back for funds advanced at both the PO funding stage and the factoring portion.
When a vendor combines their factoring and PO funding services, they receive all their financing under one roof which means fewer calls and less hassle and complex coordination. The vendor also gets a resource of enhanced expertise – a competent factor/PO funder will be highly experienced in all aspects of trade and supply chain finance. A factor/PO funder is optimally positioned to help clients navigate the rough and choppy waters of commercial transactions, from advising on transaction structure and mitigating risk, to controlling the flow of goods and collecting payment on accounts receivable.
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