Purchase Order Financing and Manufacturing (Debunking Myths)

One of the disappointing aspects of purchase order financing is that it can't be used by most manufacturing companies. This saddens me a bit because I am a big believer that manufacturing should be play a big role in our economy and would like to help with that.

Most people believe that purchase order financing works as follows: a finance company advances funds against the po, which enables the client to buy supplies, manufacture goods and fulfill the order. Unfortunately, this concept is not 100% accurate. Not even close.

First, let's debunk some myths:

1. The PO finance company will advance me a % of the po: Not true. The po finance company will only pay your product supplier directly.

2. I can use PO financing to cover payroll and other manufacturing costs: Not true. See #1.

3. I can use PO financing to buy supplies - then use to make a product: Not likely. See #2.

So, if a po financing company will not do #1, #2 and #3 - what DO they do?

The Typical PO Financing Client
Let's start with the typical client. A PO financing company will only work with a product re-seller or a manufacturing company that sources their product out to a 3rd party. The common denominator is that the only companies that qualify are those that buy the product from someone else. This is done to eliminate so called "manufacturing risk" and will be clear in the next section.

Common Transaction Structure
The structure of a transaction is relatively simple. It works as follows:

1. You get an order from a client
2. You then place an order with your supplier
3. The funding company pays your supplier. But payment is either done:
    a) By letter of credit payable once goods are verified to meet requirements
    b) Cash against shipping documents with verification - a variant of a)
    c) Prepaid, if the supplier is a large reputable company (i.e. a member of the S&P 500)
4. Supplier ships goods
5. Goods are delivered to end customer
6. End customer pays for goods - transaction is settled

Manufacturing risk is reduced drastically by making sure that the company only pays for goods that conform to what the customer needs - and verified by a 3rd party. Obviously if something goes wrong in the manufacturing or production process, the supplier can't collect and the risk is minimized.

Why is manufacturing risk so scary?
Imagine a scenario where the finance company pays your vendors, who then ship supplies to your company. Your company then begins the manufacturing process - but for some reason - something goes wrong the the product you make does not meet your customers requirements. Your customer refuses to take the goods and the transaction falls through. Now what....? Remember that the financing company has already paid your suppliers and you needed that sale to be able to pay the financing company back. Suddenly you have a big mess and unfortunately it becomes your problem to solve. Not a good situation to be in...for either party. Let's keep in mind that most companies that look for purchase order financing don't have substantial assets - otherwise hey'd go to a bank.

I get it! So purchase order financing is risk free for the finance company (at my expense!)?
Not even close. It's easy to think that, but even without manufacturing risk, things do go wrong.... more often that you'd think. There is substantial risk in the transaction.  However, by reducing/eliminating manufacturing risk, the purchase order financing company can make the risk manageable to them.

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 Looking for information on purchase order financing? Read the purchase order finance blog