23JulJuly 23, 2022 By Patrick

Purchase Order Financing Or Equity. Which Is Better For The Growth Of My Business?

Purchase order financing is the most frequently requested business loan inquiry we receive. Depending on the size of the orders and opportunities that lie ahead for the company, bringing in an equity investor is also a consideration. There are distinct advantages to both and we will outline the main advantages of each here.

The day has come! The customer you have been chasing for weeks, months or even years gives you the purchase order that you have been hoping for! Now, how do we afford to pay suppliers and other costs associated with the order? Ideally, you would be able to do this with internal cash flow and not have a need for outside financing. However, the truth is, if you are doing a good job on the sales and marketing side, you will quickly outgrow your internal capacity. AND, this is a good thing! Of all the stresses business owners encounter, having a large pipeline of sales if the best!

The conversation quickly turns to, “how do we afford these orders now that we have them?” Is purchase order financing or equity the better option? The answer, it depends.

Purchase Order Financing

By financing the cost of goods for your orders, you are leveraging the growth of your business through outside capital. Let’s go through an example:

You receive a PO for $100,000
Your gross profit is 50%
This makes your cost of good also 50%
You borrow $50,000 to cover the costs to your suppliers, shipping costs, etc.
Your working capital cycle is 90 days from the time you receive the order, to the time you ship, to the time the customer pays
Cost of the financing is 3% every 30 days the money is outstanding

Let’s say a major retailer awarded your company a $100,000 PO as outlined above. You need to borrow $50,000 for 90 days. The cost of the financing will be $4,500 for the 90-day period ($50,000 X 9%). Your adjusted gross margin would be $45,500 ($50,000 – $4,500).

The purchase order finance company is repaid by the customer’s payment. By using this form of financing you are leveraging 100% of the cost of goods and have the capital to grow your business. Additionally, the PO financing allows you the added strength of being a cash buyer. Our clients negotiate discount terms with suppliers to offset a portion of the cost of the financing.

For example, a 2% product discount for early payment in the sample transaction above would equate to $1,000 ($50,000 x 2% = $1,000). This savings in product cost would reduce the adjusted finance cost to $3,500 ($4,500 – $1,000 = $3,500).

The advantage of purchase order financing is that it can grow as your business grows assuming your customers are credit worthy. The PO finance company’s primary source of repayment is the customer. This makes the customer’s financial strength a key factor in underwriting these transactions.

The disadvantage of PO financing is that it only covers variable expenses associated to sales. This is where equity may be a better fit.

Equity Capital

Equity comes in to play when you need more than your cost of goods covered. Examples of when equity may be a better call would include the following:

The equity group brings value outside of the capital being invested such as supplier and customer contacts.
In-roads and introductions of value that the equity group brings to the table
When funding for marketing, salaries, plant expansion, and other fixed expenses are needed to grow and scale the company

The equity group will take a percent of ownership in exchange for their investment. The strategy may or may not include the sale of the company in the future at some multiple.

Equity can be a viable option if there are a lot of fixed expenses to be covered. Prepare to give away a large chunk of your company when exploring equity options. The equity group is seeking a return on their investment and realize that they are in the power position by bringing in the majority of the capital needed to grow the company.

Summary

Both forms of financing can be useful when growing your business. Purchase order funding can be used as a bridge to finance your growth. Once you scale your business to a certain level and can fund operations internally, you don’t need outside financing and can save the finance cost. On the other hand, equity can cover the costs of a much broader list of expenses. The downside is that it’s a “now and forever” proposition. The equity group and your company are joined “until sale do you part.”

We always advise on debt versus equity when you can. It’s the bridge needed to grow your business, but not permanent by definition. If you would like to discuss which form of financing is best for your business, call us at 844-239-2632. We would be happy to lend a hand!

To your success!

Huntington Coast Capital.

14Feb By Patrick

Purchase Order Financing Versus Letters Of Credit

Paying suppliers is a required and continuous expense for business owners whether you’re in retail, own a restaurant or are a manufacturer or distributor. Cost of goods sold is the first deduction against gross revenue on any companies income statement. The lack of ability to pay for the cost of goods expense severely impacts the growth potential of the business. In this article, we are going to look at the difference between purchase order financing and letters of credit and how they are used in business.

Letters of Credit

Letters of Credit (abbreviated “LC’s”) are bank instruments drafted to secure international and domestic purchases. They provide assurances for both the buyer and the seller of the goods. The seller is assured payment as long as the terms within the LC are met. These can include satisfactory inspection and acceptance of the goods at the port, factory or upon arrival to their destination. When the goods are paid for under the LC is negotiated between the parties.

Letters of Credit essentially assure two things: 1) the buyer has the financial wherewithal to make the payment for the goods, and 2) the supplier will deliver the goods as ordered on time. LC’s are opened with both the buyer’s bank and the seller’s bank and work together to assure the performance of each.

Requirements are a bit more strict with Letters of Credit than they are with purchase order financing. The LC has to have underlying collateral that is typically in the form of cash or accounts receivable.

When a company applies for a Letter of Credit from a bank the company must have an equal or greater amount of cash or accounts receivable available once the LC is drawn on. The buying entity needs to demonstrate that they have the financial wherewithal to cover the cost of goods once conditions have been met. The buying entities funds are typically held in a control account (similar to an escrow account) until needed. This control of the funds is necessary to assure the supplier that funds will remain available for payment from the time ordered to delivery and payment.

In this respect, LC’s really are not a financing tool as no monies are actually borrowed but rather set aside for a particular transaction. This form of international trade “finance” is a protection against financial loss on available capital versus new money used to cover the cost of goods.

This form of financing is set aside for more established companies with enough liquid collateral available to cover the expense. Consider LC’s as an insurance against loss of principle versus true outside financing. For more granular details on Letters of Credit click here.

Purchase Order Financing

Conversely, purchase order programs offer financing to cover the cost of goods to suppliers beyond cash and accounts receivable collateral. Startups, companies experiencing high growth and even the majority of established companies often need additional capital. In the majority of cases, the capital needs are larger than the accounts receivable balance or internal cash reserves.

In these scenarios, Letters of Credit would fall short of the financing needs required to cover the cost of goods.

Purchase order financing pays suppliers for materials required for the buying entity’s growth. Clients utilizing purchase order financing sign contracts with the finance partner. There is typically a personal guaranty for the facility that acts as a backstop should the transaction not offer enough support to pay back the line in a downside scenario.

Purchase order finance underwriters focus on three main areas when assessing new funding requests:

Financial strength of the customer(s) for which the PO’s are being generated: when purchase order financing is being requested the fund will want to thoroughly understand the credit strength of the underlying customer. For example, if the underlying customer is a nationally known retailer odds of approval are greater. Conversely, if the PO’s are being generated for a “mom and pop shop” with limited to no financial information available, approval is much more difficult.

Financing strength of the supplier: the source of where the goods are coming from whether international or domestic must also be fully understood. Suppliers are typically larger and more established. Usually, but not always, financial information is available on these companies and information can be verified to give the purchase order finance company comfort in wiring them money for the transaction.

Transaction history between the parties: It is important to know how long the client has been dealing with a particular supplier. Approval is much easier if there is a long history that can be documented through shipping documents, invoices and bank transactions supporting successful delivery of past orders. Purchase order financing works best when taking a company’s current business cycle from Point A to Point B versus financing orders for an entirely new supplier relationship that has zero past transaction history. This is because there are a number of inherent risks that go with financing first time orders; lack of past, successful delivery of orders, fraudulent supplier claims, capital at risk before performance, to name a few.

Purchase order financing is a line of credit used specifically to cover the cost of goods when capital needs are larger than available internal cash or accounts receivable.

In Summary

If you are an established company with no need to borrow outside capital, a Letter of Credit would be adequate for your needs. LC’s provide assurance against loss of principle by providing a check and balance prior to releasing funds.

Purchase order financing comes in to play when cash needs are higher than internal capabilities.

Both mechanisms facilitate trade financing and move business forward. Which program is best for your company depends on where you fall on the spectrum. To learn more about how Huntington Coast Capital’s purchase order financing solutions can work for you, watch this short video that explains the process.

We provide consultation and secure funds for a broad base of business financing needs. Call 714-719-8966 to learn how these programs can work with you to grow your business!