Combining Factoring and Purchase Order Financing

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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Review: International Trade

Viviane Simond, Express Trade Capital

The international market is in a particularly remarkable state of flux due to a wide range of contributing factors. Between the effects of climate change, political upheaval, and shifting consumer habits, the future of international trade has seldom been so uncertain.

Climate change may prove to be the most pervasive influence on the international market at large. Recent studies predict that climate change will generate violent storms and intense flooding that could damage ports, railways, roads, and harvests in high-traffic areas. Our ever-increasing reliance on global trade routes compounds the difficulties governments face in their attempts to manage the effects of climate change. This combined effect of growing demand and dwindling supply threatens to create raw material shortages and unexpected price hikes.

Climate change causes harvests to be more variable, which threatens the reliability and integrity of the infrastructure on which international trade depends. There are fourteen major choke points around the world (including the US Rail Network, Panama, Suez-Canal, etc.) that are vital to adequate distribution of food supplies. The US, Brazil, and Black Sea collectively account for about 53% of global exports including dietary staples like wheat, rice, maize, and soybeans. Any major obstructions to one or more of these choke points could lead to a supply shortage and price spiking. These issues may risk systemic stability and human security in the world’s most insecure and politically unpredictable regions if governments don’t devote significant resources to solutions. Thirteen choke points have been subject to closure or significant traffic restriction over the past 15 years.

Terrorism, even just one instance in one location, can hinder international trade throughout an entire region. Attacks also affect long term economic activity, since trade is typically condensed for about five years after an attack takes place. Counter-terrorism efforts delay shipments, which hurts vendors, buyers and shippers alike. As a result, transactions take significantly longer. Food products become much more susceptible to shipping delays and supply chains are disrupted due to tighter border regulations. Unfortunately, these delays can be extremely expensive.

In the wake of terrorist attacks, airport security surcharges and insurance premium rates increase, as do shipping and customs requirements, which cause delays and increased trading costs across the board. Unfortunately, non-tariff barriers established in the name of counter-terrorism, like restrictive outsourcing policies, often tend to protect certain industries more effectively than they do individuals. Unrestricted trade enables nations to work together and fuels economic prosperity and development. By reducing trade, counter terrorism policies inadvertently drive a wedge between trading nations and hurt their economies. Consequently, countries that lose money due to trade restrictions are less able to combat terrorism.

Brexit will likely have a massive effect on international trade patterns, depending on how British Parliament implements it. Since immigration concerns were among the primary driving forces behind the Brexit vote, the UK is likely to lose a significant portion of its migrant workforce. This will likely put a damper on productivity, economic growth, and job opportunities. Furthermore Scotland, which voted overwhelmingly to remain in the EU, intends to hold an independence referendum in response to the economic difficulty it will probably suffer as a result of Brexit. This proposed “Scexit” would alter the UK’s political character and potentially increase the rift between the UK and the EU.

During the Brexit proceedings, the UK will have to renegotiate legal framework for their trade relationship with the EU as an outsider. In the process, the EU will probably implement tariffs on UK-produced goods in an attempt to balance the scales. As of now, the UK is still a part of the EU, so British companies can trade with the EU on a tariff and quota free basis. There are rumblings of intimidation tactics between EU countries and the UK, including a possible automotive trade war between the UK and Belgium. Fortunately for the UK, their trade relationship with the US will not be affected. However, when Brexit is fully in place, Europe and the UK’s relationship as well as their trade agreements will probably be quite different.

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Debt Finance vs. Equity Finance

Ross Bienstock, Express Trade Capital

When business owners need cash flow, they have access to a variety of financing resources, most of which fit into one of two categories: debt and equity. Although both are equally useful in different contexts, there are advantages and disadvantages to choosing one funding method over the other.

What is “debt finance”?

Debt finance is simply borrowed money that will be paid back, plus interest. Common examples of debt financing include credit card charges and car and home purchases. There are several advantages to debt financing when compared with equity financing, first of which is that once the borrower pays the lender back, their relationship is over. Debt finance is also advantageous because it is easy for the borrower to predict their expenses since loan payments are consistent in amount and frequency. Since the lender does not have any equity in the business (meaning they don’t own any portion of the business), it does not decrease the owner’s interest in the company. Another advantage is that the company can off write interest paid on debt finance on their tax return, decreasing the effective cost to the company.

There are also drawbacks to using debt financing for your business. Using debt financing indicates that the entity borrowing the funds is extremely confident in their ability to pay them back. While it is obviously advantageous to be confident in one’s ability to repay debts, this arrangement leaves one with little recourse if unexpected difficulties affect their cash flow. The borrowing business may fall on hard times and end up with insufficient cash flow to pay its debts.

It is also important to be aware that the greater a business’s debt-equity ratio is, the riskier the company is going to be. Meaning if the amount of funds a business has borrowed approaches or surpasses the value of that business’s assets, it becomes harder for that business to seek out funding. This is a red flag to lenders and often means they won’t get involved with the business in question. As a result, debt finance can hinder the business’s progress and stunt growth.

What is “equity finance”?

If you have ever watched Shark Tank on TV, you have some idea of what equity is. The premise of the show is angel investors deciding whether or not to purchase equity in someone else’s business idea. Equity refers to ownership of shares of a company. Equity financing is different from debt financing because the funds come from investors, rather than lenders. As mentioned, once the borrowing business pays the lender back in a debt financing transaction, their relationship is over. With equity financing, however, the investor remains involved as part-owner of the business.

The biggest advantage to using equity financing is probably that if the business fails, the primary business owner doesn’t need to repay the investor. That may sound insignificant, but the fear of lingering debts after the business dissolves is all too prevalent for many small business owners. This method also leaves more cash flow available since it doesn’t create expenses.

The major disadvantage is also the most obvious. To acquire the equity funding, the business owner must relinquish a percentage of the business to the investor. Any time the business makes a profit or the owner needs to make a crucial business decision, they will have to consult the other partner(s).

Which is best for you?

Does debt financing or equity financing better suit your situation?  It all depends on where your business currently stands and who you know. If you and your business are quite new to the market, you may want to borrow traditionally to avoid giving up equity. If you have a close friend or trusted family member who might be willing to invest, you may be more interested in sharing equity with them to avoid accruing debt. No matter how you choose to finance your business, make sure you know the benefits and drawbacks of each option and carefully plan to avoid unforeseen difficulty.

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Negotiating Payment Terms

Sadie Keljikian, Express Trade Capital

As a wholesaler, negotiating payment terms with your retail customers can be complex and lead to friction. Fortunately, most retailers are reasonable and will work with their vendors to find a compromise. Furthermore, there are ways to work around an insistent customer who refuses to yield to their vendors’ needs.

Where do I begin?

Depending on the customer, a variety of factors can affect the agreed payment terms. First and foremost, it’s important to understand the power you have as a wholesaler and the power your customer has as a retailer. Since retailers are the customers in this arrangement, they usually get the most consideration. Big-box retailers are particularly aware of how much value they hold as customers, since they typically have good credit and place the largest orders their vendors receive. Thus, large scale retailers often seek the best, or longest, payment terms (N90 or more), since most of their vendors are willing to accommodate them.

As a wholesaler, you too have power in the equation, particularly if your product sells well. The more unique and/or popular your product, the more retailers will want it in their stores and thus the more willing they will be to meet your needs.

It is important to bear in mind that, although payment terms are negotiated at the onset of the wholesaler-retailer relationship, larger scale retailers usually don’t use long-term contracts. Instead, individual purchase orders serve as contracts.

What if my customer or I need to adjust terms?

Typically, if either a customer or a wholesaler needs to alter the agreed upon payment terms, it prompts another round of negotiations. If a long-term contract is in place, unilateral adjustments of payment terms are legally prohibited and can result in a lawsuit, so a new agreement must be reached between the two parties.

Sometimes, big retailers (who, as mentioned, typically do not enter long-term contracts with their vendors) will change their policy and formally announce that all future purchase orders will be under new payment terms. If you find yourself unable to agree to those terms due to cash flow concerns, you have a few options.

What are my options when my customer wants better payment terms than I can reasonably offer?

  • Negotiate again. – Although big retailers typically prioritize their own business interests, they will sometimes make exceptions for valued vendors. This is where your worth and power as a vendor comes in, because if your customers care enough about keeping your products in their stores, they may be willing to come to an agreement.
  • Turn down the order. – If your customer is asking too much and won’t negotiate to meet your needs, you can always turn down that customer’s purchase orders. This may hurt your revenues, since the customers who typically ask for extensive payment terms are the ones who will place consistent, large orders. But again, if you aren’t under a long-term contract, you are under no obligation to fulfill every purchase order.
  • Factor your receivables. – If you can’t wait as long for payment as your customers want you to, but don’t want to lose business, you can factor your receivables. In a factoring agreement, a lender will advance you most of the value of your fulfilled invoices, then collect on the invoices from your customers. In other words, in exchange for a small percentage of your invoice values, you will receive payment immediately and no longer need to worry about collecting from your customers.
  • Finance the purchase orders. – purchase order financing, or “PO funding.” PO funding is an arrangement whereby a financial institution pays manufacturing and shipping costs for wholesalers against confirmed purchase orders. It’s a nearly perfect system for situations like this, since the customers with the most leverage (i.e. the ones that request better payment terms) are usually credit worthy.

Although the lack of an overarching agreement can make payment terms seem a bit murky, the longer your relationship with your customers and the more customers you have, the more you will be able to gain leverage and do business the way you want to. Know your rights and options and you will be prepared to manage any customer, regardless of their preferred terms.

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