Purchase Orders Also Have Value as a Source of Cash

Southern California’s adventurous, risk-taking economy has given rise to the use of yet another source of working capital for growing businesses: purchase-order borrowing.

Only a handful of finance companies do this kind of lending, and few business owners even know it exists, much less avail themselves of it. Because purchase-order borrowing is a costly way of raising working capital, it’s not for everyone.

Purchase-order financing works much like asset-based borrowing, discussed in this space in recent weeks. Indeed, the technique takes the idea underlying asset-based borrowing to the beginning of the production line.

Think of the production line as a means by which you turn raw materials into cash. Raw materials undergo change as they move through your production line; as they change, they become more valuable. Eventually they become cash.

Lenders understand this and open their wallets to you as your goods gain value. Thus, in classic asset-based lending, banks and finance companies lend against inventory, or goods still in your plant, and against receivables, or goods on their way to your customers. In both cases, the idea is simple: Lenders advance working capital against the value created by your production line.

In a real sense, lenders speed your production line. They shorten the time it takes you to turn the value created by your production line into cash, in return for part of it--interest.

But if inventory and receivables hold the potential to become cash, so do purchase orders. It takes longer, to be sure, and not every PO becomes cash. For that matter, given the hazards of production and distribution, not every PO yields a profit. Some don’t even yield the costs you incur in fulfilling them, as any business owner who has seen a new product fall flat knows.

So the value of a PO doesn’t equal that of an item in inventory or a receivable, either in reality or in the eyes of a lender. But a PO has value nonetheless. And as business owners scratch for capital, lenders work to accommodate them by looking for value against which they can advance cash.

Thus, purchase-order lending.

“My customers come to me because they suddenly realize a unique opportunity to do new business,” said Dave Pooser, regional managing director of Transcap Trade Finance, one of the country’s biggest sources of PO financing, with offices in Pasadena.

“They need opportunity financing, and they understand that they may not realize their normal gross profit margin on the transaction-- but that the size of the transaction will still yield significant new dollars to the company,” Pooser said.

“Those dollars make PO financing well worth it.”

Pooser said the cost of PO financing varies with the quality of the PO and the time it takes to turn the PO into a receivable. In Pooser’s eyes, for example, a PO from Wal-Mart outshines one from Joe’s Corner Clothing Outlet, and a 30-day manufacturing cycle looks safer than a 60-day cycle.

Given a high-quality PO of $100,000 and 30 days until you ship your goods, Pooser said, you could finance an amount equal to your cost of goods at an effective interest rate of between 2% and 5% of the loan. If you were to borrow, say, $75,000, you would pay between $1,500 and $3,750 to finance the PO for 30 days.

That would reduce your gross profit margin from 25% to between 20% and 23%--a big drop. If you gave up that kind of money year-round, PO financing would prove a costly way to raise capital indeed.

If it were to take 60 days to turn your PO into a receivable, the cost of the financing would double.

Clearly, PO borrowing can quickly eat into your profit. If things get out of hand, the technique can ruin you.

The lesson here is that you should use PO financing only when your ordinary sources of working capital can’t cover an unexpected and potentially profitable upturn in your business, and only when you can control the time it takes to turn a PO into a receivable, according to Tony Anish, regional director in Los Angeles for Utah-based finance company Altres Financial.

Altres Financial does asset-based lending and factoring (an old form of receivables financing to be explored in this space in upcoming weeks). It began experimenting with PO financing in recent months.

“Purchase-order financing gives the business owner more working capital,” Anish said. “If you’ve got 60 or 90 days before you send out an invoice for your goods, PO financing gives you working capital from the point you receive your purchase order until it turns into a receivable.

“It advances capital so you can turn product into a receivable-- and then finance the receivable with an asset-based loan,” he said.

Altres maintains a loan portfolio of some $225 million nationwide, of which 25% to 30% is generated in California. Its book of PO loans totals less than $1 million, from which you can conclude that Altres is testing the waters.

Indeed, Altres lends against purchase orders only when the package includes loans against a company’s receivables as well.

“We do PO loans as an add-on to receivables lending,” Anish said. “So far, purchase-order lending is the smallest part of our business. We’re feeling our way with the program because it’s an area where you can lose money very rapidly.”

Anish sees the risks from his standpoint as a lender, of course, and if they look substantial to him, they should look downright scary to the business owner.

That is not to say, however, that PO financing is never a good idea. Business owners in Southern California differ from their counterparts elsewhere in the country in their willingness to take risks with their businesses as the economy expands, including the ways in which they finance them.

Next: How a Long Beach business owner used purchase-order borrowing to turn a quick $150,000 profit.

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Freelance writer Juan Hovey can be reached at (805) 492-7909 or via e-mail at jhovey@gte.net