Recently, I have been writing articles about brokers who want to start factoring companies. As I have mentioned previously, the factoring field is very competitive, so you have to be highly selective when you choose your market niche.
Some new factoring companies have taken this strategy a step further and differentiate themselves by adding niche products such as purchase order (PO) financing.
This article discusses whether this is a good strategy.
A brief purchase order financing tutorial
Basically, purchase order financing helps companies that have a purchase order and need funding to fulfill it. In principle, the product sounds great. However, it has a number of restrictions. Specifically, it can be used only for transactions that meet a narrow set of criteria, such as:
- The order must be non-cancelable
- The product must be verifiable through a third-party service
- The order must have a gross margin of 30% or more
- The order must be for finished goods
On the surface, the transaction is simple. The purchase order funding company pays the supplier directly on behalf of the client. Once paid, the supplier ships the goods to the end customer. The client invoices the customer once they confirm receipt of the goods, and the transaction settles after the customer pays in full.
This invoice is often factored, and most of the proceeds go to close the PO financing line. Factoring benefits the client because it usually lowers total transaction costs.
As you can see, even on the surface, the transaction has a lot of moving parts. Once you get to the details, these transactions are often complex.
Benefits of offering purchase order financing
If you own a small factoring company, there are some benefits to adding purchase order financing to your portfolio of products.
The obvious benefit is that you increase your value to your clients – at least those that can benefit from that particular service. By providing clients with an end-to-end financial solution, you differentiate yourself, thereby limiting the competition and making it easier to book clients.
Lastly, PO financing tends to have higher margins than conventional factoring – an important benefit in an already crowded factoring marketplace.
But, are these benefits worth it?
Risks of adding purchase order funding to your portfolio
The truth is that PO finance transactions are fraught with risk, especially for new entrants that don’t fully understand them.
Aside from knowing the financial aspects of PO financing, you need to develop expertise in a few other areas: logistics, shipping documentation, warehousing, insurance, customs procedures, letters of credit, product inspections, and many other subjects. It can take a couple of years to become well-versed in these matters.
Also, the complexity of these transactions presents many opportunities to make a costly mistake. Unfortunately, it only takes one mistake to derail a transaction. Keep in mind that you will be dealing with small companies that don’t have much (if any) collateral. If a transaction fails, your chances of recovering any principal are close to 0%.
Does it make sense?
Unless you have a background in trade, have years of experience in factoring, understand shipping logistics, and have a solid foundation all the other subjects discussed in this article, avoid directly offering PO financing. In my opinion, the risk for new market entrants is significant and outweighs potential long-term returns.
On the other hand, if you have the necessary knowledge, you should consider enhancing your portfolio with this product. Offering purchase order financing adds a potentially profitable niche to your company.
About Marco Terry
Marco Terry is the managing director of Commercial Capital LLC and Commercial Capital LLC (Canada), a leading factoring and purchase order financing intermediary. He can be reached at (877) 300 3258.