Are you a commercial contractor, subcontractor, or owner of a commercial construction company? Do you want to expand your business but don’t have the funds to cover material costs upfront for lucrative projects? Then, it’s worthwhile to pursue financing to help you scale operations.
There are many options to help scale your business, but not all are viable. Purchase order financing is a common choice amongst contractors.
What is Purchase Order Financing in Construction?
According to FundBox, “purchase order financing is an arrangement where a third party agrees to give a supplier enough money to fund a customer’s purchase order.” Contractors can use purchasing order financing to help manage construction costs on several projects. Whether you’re new to the industry or have experience – but turn projects away due to cash flow issues – purchase order financing may be worth considering.
How Does PO Financing Work?
Materials for construction projects can add up rather quickly, mainly if you’re working on several at once. There are also instances where contractors spend weeks or months waiting on a payment, which causes cash flow issues in their business.
Fortunately, purchase order financing is available to cover the cost of materials so you can focus on what you do best and pay back what you owe over time.
Typically, these parties are involved in a purchase order financing transaction:
- The borrower or commercial construction contractor (or subcontractor) seeking financing to fulfill a purchase order for the materials needed to complete the project
- The purchase order financing company or lender providing the financing for the purchase order.
- The supplier or provider of the materials needed to complete the construction project
- The customer or company/individual who hired the commercial construction contractor for the project
Here’s a breakdown of how purchase order financing works:
- The commercial construction contractor gets hired for a construction job.
- The commercial construction contractor gets an estimate of material costs from the supplier and creates a purchase order.
- The commercial construction contractor applies for financing with a purchase order financing company.
- If the application is approved, the purchase order financing company pays the supplier directly.
- Once payment is received, the supplier delivers the materials listed in the purchase order to the commercial construction contractor.
- The commercial construction contractor begins (or resumes) work on the project and invoices the customer.
- The purchase order financing company purchases the invoice from the commercial construction contractor. This practice is known as invoice factoring.
- The purchase order financing company collects payment for the invoice from the customer, deducts what’s known as a factoring fee, and disburses the remaining amount to the commercial construction contractor.
Generally, you will have received payment in full for the project before the repayment period ends. It’s also important to know that you may not get approved for 100 percent purchase order financing – it depends on your cash flow, creditworthiness, and the supplier’s reputation. So, be prepared for your company to fork over some of the material costs.
Advantages and Disadvantages of Purchase Order Financing
Before applying for purchase order financing, conduct a cost-benefit analysis to determine if it’s a good fit. Here are some key benefits to consider:
- Easier qualification criteria. If you’re having trouble getting approved for a loan because of past credit issues, you may have luck with purchase order financing as lenders are more lenient.
- The lender assumes the risk of default. You likely won’t be on the hook if the customer fails to pay the invoice. Check the lender’s policies to confirm.
Unfortunately, there are also a few drawbacks of purchase order financing to keep in mind:
- Limited capital. You may not get approved for 100 percent purchase order financing. In fact, most companies only approve 80 to 90 percent of the purchase order. This means your company will be stuck footing the remainder of the bill right away.
- Steep fees. You may find that the fees for purchase order lending are a bit higher than other financing options.
Construction Purchase Order Financing Alternatives
Not quite sold on the idea of purchase order financing or wanting to explore other alternatives? These options are also viable for commercial construction contractors.
Business Credit Cards
Some business credit cards come with generous spending limits that can assist with cash flow gaps, and the interest rates are sometimes lower than what you’ll get with purchase order financing. But here’s the catch, you may need a higher limit to cover the material costs for several projects.
You can ask the credit card issuer for a credit limit increase to close the gap. Another viable option is to open a 0% introductory APR credit card, as you’ll save a bundle in interest if it’s paid off before the promotional interest period ends.
Lines of Credit
A line of credit is a set amount of capital provided by a lender that you can tap into during a draw period. Once this period ends, you will no longer have access to the funds and must begin making principal and interest payments.
The major benefit of a line of credit is that it helps curb overspending if you only withdraw what’s needed. Plus, interest rates tend to be lower than what you’d find with other debt products as lines of credit cater to those with a steady source of income and good or excellent credit.
Short-Term Loans
Short-term loans are more flexible than purchase order financing. You’ll need good or excellent credit and a consistent revenue stream to qualify for a competitive loan product. If approved, you’ll receive a sum of cash that’s payable over up to 18 or 24 months. Payments are typically due weekly or monthly, and you’re free to use the funds however you see fit to keep your business up and running.
Invoice Financing
Contrary to popular belief, invoice financing (or factoring) and purchase order financing aren’t the same. Invoice financing lenders pay you for outstanding invoices already sent to the customer. The expectation is you’ll pay the lender once the customer pays you.
Unfortunately, you’re on the hook for repayment whether the customer pays you or not.
But with purchase order financing, the lender purchases the invoice from you (the contractor) and collects payment from the customer. If the customer doesn’t pay, you don’t take a financial hit. Consequently, purchase order financing is more costly because the lender assumes the greater risk.
