Business loan

Entrepreneurs: is trade finance better than a business loan or a credit card?

Dubai: It’s a small business owner’s nightmare when your company lands a large order of goods but lacks the funds to pay for manufacturing and delivery.

If you fail to provide the necessary funds quickly enough, your business risks losing the order and possibly a valuable customer relationship as well.

Many small business owners stuck in this situation turn to lenders who offer to finance their purchase order. This is where ‘Purchase Order Finance’ or ‘PO Finance’ helps.

“Purchase order financing,” also commonly referred to as transaction or invoice financing, has become more popular over the past decade.

In such financing transactions, the lender assesses your customer’s credit rating, not your company’s. If the customer has a proven track record of being a reliable and prompt payer, the lender may be willing to finance your transaction.

A step-by-step guide to how a purchase order financing transaction works:

• Your company receives a large order from an established and creditworthy customer. It is in your company that it is a reseller or distributor of products, not a direct manufacturer.

• Your lender checks your client’s credit history and approves the transaction. The lender then issues a letter of credit or bank draft to pay the manufacturer of your goods. It usually takes a week or two.

• In addition to transmitting payment to the manufacturer, the lender also pays for shipping the goods. Your company may be asked to pay for any inspection, insurance or shipping costs incurred.

• Goods are shipped directly to your customer or to a third-party bonded warehouse, never to your company. Once the customer has taken delivery of the goods, your company invoices the customer.

• If the customer pays immediately, the lender collects the money, takes their share and gives your business the remaining profits from the sale.

• If the customer pays according to the terms, the lender can buy the invoice from you at a discount on the total amount of the invoice and immediately pay your company the remaining profit.

• The lender then waits to collect the full amount from the customer and keeps the difference as profit. This process of buying discounted bills is also known as factor lending.

It’s a small business owner’s nightmare when your company lands a large order of goods but lacks the funds to pay for manufacturing and delivery.

How much does such financing cost?

The costs of factoring your invoice are usually modest. The financing costs of the “purchase order” will be much higher, because the risk taken by the lender is much higher.

In a factor loan, the goods have already been delivered and the customer invoiced. The transaction is essentially done, so there is less risk in just waiting to collect the invoice. In such financing, the lender advances money solely on the basis of a written commitment to purchase.

If the customer refuses shipment, is otherwise dissatisfied, goes bankrupt during the transaction, or fails to pay for any other reason, the lender loses their money. Many other problems can arise in such a loan agreement, so the costs are higher.

Although in most cases you don’t need a great credit score to get a purchase order finance loan, there are other criteria used by most lenders in this industry.

For example, some lenders offer limited loans to small businesses, and many will likely lend based on a large purchase order or confirmed government contract.

Advantages and risks associated with alternative financing

One of the benefits of seeking purchase order or trade financing from a lender is that it will likely cost less than using another for-profit lender.

Most institutions charge market rates for their loans, so your cost will be similar to what it would have been had you been able to secure a traditional bank loan.

When a lender gets involved in your transaction and pays your supplier directly, other alternative financiers will not take on this role. Instead, you’ll get a direct loan and repay it by making monthly payments.

You will use the loan money to pay your manufacturer and all shipping costs, and be responsible for invoicing and collecting payment from the customer.

Although obtaining such financing is not ideal, as the costs will eat away at your profits, if it comes to choosing between purchase order or trade financing and losing a big sale, it can allow your business to continue to grow.

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A short-term loan is an installment loan, which means you borrow money from a lender and then repay the money over three to 18 months, in weekly or daily installments.

Is it better than a short-term loan or a business credit card?

Short-term loans and purchase order financing have many similarities. They can both cover temporary cash flow gaps, the cost is similar, and both are relatively easy to qualify. However, short-term loans and purchase order financing are structured very differently.

A short-term loan is an installment loan, which means you borrow money from a lender and then repay the money over three to 18 months, in weekly or daily installments.

The lender gives you the funds directly and you can then use them to pay for any business expenses you need to cover: working capital, staff compensation, payment for marketing or other business activities.

If your primary reason for using purchase order financing is to cover temporary cash flow gaps, consider using a business credit card instead. You can use a business credit card to borrow small amounts of money when you can’t afford supplies for an order.

And then you can repay the amount you borrowed when your customer pays for the goods. Business credit cards are often a relatively affordable type of financing.

The average interest rate on a business credit card is around 14%, compared to the minimum rate range of 20% on purchase order financing. The downside to business credit cards is that your credit limit may not be high enough to purchase supplies for multiple orders (or even for a large order).

At the end of the line ?

Purchase order financing is another way to access working capital, especially for small business owners, by giving them access to funds that can help pay suppliers before invoicing buyers. Indeed, cash flow problems are most common among small business owners.

For example, a borrowing company receives a large order from a buyer. Currently, the borrowing company does not have enough cash to pay the supplier upfront. Thus, the borrowing company uses these channels to access liquidity by seeking financing from a financial institution.

The actual purchase order funding rate depends on many factors. For example, the size of the purchase order and the agreed reimbursement period. Other factors are the business relationship between the parties and their financial stability.

However, purchase order financing may not be the solution for all businesses. For example, low-margin businesses may need access to other financing alternatives. Indeed, high fees can reduce your profit margins. Also, purchase order loans may not be very flexible depending on your needs.

In most cases the pros outweigh the cons as it allows you to buy inventory and increase sales when capital is limited and helps your business grow without increasing bank debt or diluting property. It also increases sales opportunities and facilitates cash flow for on-time deliveries to customers.