How Does Purchase Order Financing Work?

Business Funding - 3 Min Read

A common question we get here at Mulligan Funding is: how does purchase order financing work?

We’ll explain the process, and then we’ll follow-up with a VERY important warning that you aren’t going to hear from companies that offer this kind of financing option.

How Purchase Order Financing Works 

Purchase order financing is when a business essentially sells its open purchase orders to a lender, and receives cash in return which it uses to pay for (typically) short-term expenses.

When the purchase order comes due, the customer (i.e. the party that the purchase order is made out to) doesn’t pay the business anymore: it pays the lender who provided the purchase order financing.

So for example, if ABC Company has a purchase order with XYZ Customer, and then sells that purchase order to 123 Lender in exchange for cash, then XYZ Customer pays 123 Lender – not ABC Company. This is an important aspect to keep in mind, because it’ll come up later when we point out some of the major problems with purchase order financing.

The final step in the process is that when the lender receives payment, it keeps most of it to cover both the principal and interest (usually around 80 percent). The residual is sent to the business that originally owned (but sold) the purchase order.

The Problems with Purchase Order Financing 

For some businesses, purchase order financing may be viable and make sense – and that’s fine. However, we have heard from MANY customers over the years who have gone down this road, that they were unpleasantly surprised by a few things that weren’t explicitly clarified before they applied for funding.

We’re not going as far to say that these customers were deliberately misinformed, but we’ll confidently say that some firms offering purchase order financing basically have a “don’t ask, don’t tell” policy – i.e. if their customer doesn’t ask about a specific consequence or implication, then the firms doesn’t go out of their way to mention it. As you might expect, we’re not fans of that approach, but that’s a topic for another blog post. For now, let’s move forward by highlighting the major problems with purchase order financing.

Potential Damage to the Relationship

The first key problem is that, as noted above, businesses that sell their purchase orders are doing more than just moving a piece of paper around – they’re assigning their customers to a third party. Some customers will be OK with this (or just won’t care or notice). However, other customer may be troubled by this, as it can look like the business is having financial difficulties. What’s more, the lender may use aggressive accounts receivable tactics that could damage the relationship, and result in losing the customer to the competition.

Potential Vicious Cycle of Borrowing

The other major problem, again as noted above, is that lenders take a huge chunk of the payment to cover principal and interest costs – which doesn’t help businesses with their ongoing cash flow needs. Indeed, this is why some businesses get stuck in a vicious cycle with purchase order financing, and start depending on them to stay afloat. It’s similar to how individuals can get trapped in a “pay day loan” spiral.

The Bottom Line

Some businesses do in fact use purchase order financing as an alternative to a traditional bank loan, and as long as it’s in their best interest to do so, we advise them to move ahead.

However, there are many businesses that are far better off applying for a working capital loan or a merchant cash advance. Either of these options gives them rapid access to the cash they need, but without putting their valuable customer relationships at risk, or forcing them to pay back a huge portion of their loan in one fell swoop. Instead, they can automatically pay back a small amount each day (either a fixed fee or as a portion of credit card sales), and so they won’t risk drying up their cash flow.

Call Mulligan Funding at 855-326-3564 to discuss your financing options today!

The information shared is intended to be used for informational purposes only and you should independently research and verify.

Note: Prior to January 23, 2020, Mulligan Funding operated solely as a direct lender, originating all of its own loans and Merchant Cash Advance contracts. From that date onwards, the majority of funding offered by Mulligan Funding will be by Loans originated by FinWise Bank, a Utah-chartered Bank, pursuant to a Loan Program conducted jointly by Mulligan Funding and FinWise Bank.