Purchase Order Finance, the tough Nut to Crack

Most of the innovation and initiatives around early payment focus on Post Shipment finance, that is, when the seller has shipped and invoiced the Buyer.  There are so many tools and techniques to finance “approved” invoices today – from auctions, to pcards, to dynamic discounting and reverse factoring.  But when you look at purchase order financing, all of sudden you find few real tangible sources of funding.

Purchase order finance is a form of transactional finance and as such is a short term facility to satisfy an interim need.  The client needs to fulfill an order.  On the risk continuum, financing purchase orders increase risk substantially compared to approved invoices.  See –Eight Risks to manage when Buying Trade Receivables.

Let’s take a step back.  From an international perspective, when the Letter of Credit (L/C) was a more popular settlement instrument for international trade, it made it quite simple for a local vendor that was the beneficiary to the L/C to get financing.  With open account trade based just on Purchase orders, that is no longer the case.  Now varying levels of purchase orders and commitments have replaced the L/C, anywhere from a Non Cancelable PO which is almost as good as an L/C (but not quite because an LC the credit is the issuing bank, not the end buyer) to a forecast, and you have to trust the buyer on what they say they will buy.

Even with domestic suppliers, Banks lack information on supplier performance – how will they get reliable information on credit and performance risk?  Corporations are unwilling to share scorecard data like on time deliveries, cycle time for orders, % loss / damage / short / not saleable, etc. with funding providers.  This data is a strong indicator of proven vendor history on performance, ie, the ability to produce the product, at quality, and on time.

Then you must understand the production cycle – how long does it take to produce the goods, how many suppliers and sub contractors are involved, what is the labor component of production, etc.  The longer the production cycle is, the greater the risks.

 Purchase Order Transaction Risk

There is a reason PO financing is expensive – there is more risk to manage.  Some examples include:

  •  Can you verify the order (is it non Cancelable, a forecast) and also evaluate cancelation risk?  Purchase Orders may be amended multiple times based on industry and good type.  The changeable nature, lack of guarantee features and control elements like time for shipment make this a fluid document.  Goods at this point have not been manufactured, matched to specification or quality inspected.
  • How to verify the production cycle and control for quality?
  • If the buyer does cancel, are there other outlets for the goods?
  • Is there sufficient gross margin in the order?
  • How to prevent the borrower from using the funds for other means (like that fancy Tesla the owner would like to buy)

So without data to control for those risks, what can be done?  Few firms actively provide PO Financing (eg. King Trade Capital, Cross Road Financial are examples).  Doing so involves trying to control for the above risks.  Lenders may use a combination of buyer references and also third parties to do physical inspections.  The cost of PO Financing will be significantly higher given these various risks to control.  In addition, structuring these transactions can be complicated by having to work with other creditors.  In short, there are reasons why this space is not filled with a plethora of lenders, it’s hard work and can be risky too!

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Voices (3)

  1. Andrés Abumohor:

    The industry has done little to understand companies better. Financial statements are still the cornerstone of financial risk analysis.

    The whole thesis of our work at OmniBnk has been trying to understand a company through their electronic invoicing and e-tax reporting. Data contained in these platforms reflects more clearly the status of a company, not only financially but operationally as well. We are now able to do the underwriting and approve/reject PO financing in under 5 minutes since the client first contacts out platform!

    This is a real game changer for our clients. Even when we decline their credit applications, they have a quick answer.

  2. Tat Yeen Yap:

    PO finance ought not be approached as a standalone or specific type of financing. It is essentially financing the performance of a supplier based on an identified source of repayment (the purchase order). The PO as a repayment source is only as good as the creditworthiness of the buyer, the trustworthiness of the buyer, and the credibility of the supplier, combined.

  3. Mendi Mzamane:

    It seems the industry has not actively gone out of their way to have a risk management platform in place.
    A good starting point is always where cancellation is not an option. This is usually the case with federal contracts whose objectives are to support small business.
    Suppliers with trade references and or international certification such as ISO by an international reputable body such as SGS. These can be the types of programs supported as risk is minimal.

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