Working capital finance vs purchase order finance – how do they compare?
Businesses struggling with cash flow can get the boost they need by either purchase order finance or working capital finance. We take a look at the pros and cons of each.
Working capital finance
Working capital is a significant indicator of the liquidity and health of a business. Working capital is the sum of the business’s existing assets, minus its current liabilities. The working capital indicates whether a business is able to meet not only its short-term debts, but also its operating costs, like payroll and paying its suppliers.
Once its liabilities are subtracted, a profitable business will have a positive working capital. However, if sales are not good, or the business is hampered by an inefficient collections process, it might very well have a negative working capital.
When this occurs, business owners often tap into personal funds to keep the business afloat. However, trying to find external funding is also a choice and several working capital finance options are available. These include overdrafts, business loans and invoice finance, for example. Let’s take a more detailed look at some of them.
Invoice finance
One of the traditional ways of sourcing working capital is invoice finance. Invoice finance is generally structured as either factoring or invoice discounting. Basically, it uses outstanding customer invoices as security to make payments to the company.
Factoring is a better option for smaller businesses with limited access to bank loans and invoices of lower value. The factor or factoring company will then also take over the company’s credit control functions. Invoice discounting is a better option for larger companies that have more creditworthy customers and their own established and robust financial processes.
Invoice finance supplies the business with working capital against the value of the company’s unpaid customer invoices. In both factoring and invoice discounting, outstanding invoices are in effect sold to a financial provider. Once the invoices are issued, the business is advanced the sum of 90% (although this percentage might vary) of the value of the invoices issued.
The benefit of invoice finance is that it generates short-term working capital by raising funds using the value of unpaid customer invoices as security. Both factoring and invoice discounting “sells” outstanding invoices to a financial provider. When the customer pays the invoice, the business gets the balance the minus fees charged by the provider.
Apart from generating funds to pay the running costs of a business, invoice finance also unlocks capital that can be invested in growth projects, i.e. expanding into a new market, or going after a big contract.
Working capital loans
Loans, both secured and unsecured, are entirely different. Many businesses regard an unsecured loan as a good way to generate working capital without risk to either the owner’s personal assets, or the business itself. Unsecured loans, however, are not easy to get compared to secured loans. Secured loans generally carry longer repayment terms, have lower interest rates and have higher limits. Banks will tend to only consider a small company for an unsecured loan if they come with an excellent credit history.
Business finance in the form of working capital generally ranges between £1,000 and £50,000, with repayment terms that can vary up to 36 months. The amount of the loan will largely be determined by the business’s credit profile and history. Unsecured loans in larger amounts can be obtained, but the business owner will almost certainly have to come up with a personal guarantee to do so.
Overdrafts
Overdrafts have traditionally been a generally quick and easy way to obtain working capital for businesses in all sectors. However, recently overdrafts have become much more difficult to get. In essence they are a form of unsecured lending. So even if the business does manage to have an overdraft approved as a way of generating short-term working capital, the limit is likely to be rather low, unless the business has a really robust credit history. This could be problematic for investing in the future growth of the business.
Purchase order finance
Purchase order capital refers to funds that are utilized to bridge the gap between a supplier placing and paying for an order and the end customer paying for that order. There can be a significant period between the two, especially in industries where a customer’s payment terms can easily be in excess of 60 days.
How does purchase order financing work?
Purchase order financing is basically just a variant of traditional factoring. It means that a business factors receivables to generate funds to meet their short-term cash requirements. Likewise, purchase order financing delivers a quick and effective immediate cash injection. This is generally required so that a business is able to fill a large order for a customer or pay for goods or raw materials up front.
This is particularly relevant if the end customer is unwilling to pay a deposit or insists on generous credit terms. At the same time, the supplier’s terms may include a deposit or even payment in full before shipping or delivery. Even though the business owner may already be using a factoring and invoice discounting facility, he may be unaware of the added benefits of purchase order financing.
Invoice finance and purchase order financing are similar, yet differ in a very important way. Factoring and invoice discounting speeds up payment collection by making the cash that is tied up in unpaid customer invoices available to the business once the invoices have been submitted.
Purchase order financing, however, makes it possible for businesses to get up to a 100% advance against confirmed customer orders before an invoice has been generated.
The benefits of purchasing order funding
Receiving a large order from a company and not having the necessary working capital on hand to pay for the products or the necessary raw materials, is a common problem for businesses. This is particularly the case for new start-ups and businesses that find themselves in higher risk industries, like transportation, manufacturing, distribution and logistics.
These businesses can find themselves in the invidious situation of not being able to fulfil the order as they lack the necessary working capital. Turning down the order, however, is also not a viable option – as it will mean a loss of revenue and potentially harm to its reputation.
It is in this very scenario that purchasing order financing offers a practical solution that is suited to both new and established businesses that are having difficulties with obtaining credit from suppliers. The amount of the purchase order funding required will be determined by the creditworthiness of the company that is placing the order and also, of course, on the size of the order.
Purchasing order financing can also be used in conjunction with existing banking arrangements. It also has the significant added benefit of not incurring added debt that will reflect negatively on the balance sheet of the business.
If purchase order financing is used in conjunction with an existing invoice finance facility, it can also be scheduled to include bad debt protection. This will contribute greatly to the business owner’s peace of mind, all the way through from placing the order to finally receiving payment from the end customer.
It must be noted that the funder does charge a transaction fee, as well as interest on the funds that are advanced. These monies are generally repaid from an invoice finance facility after delivery of the goods and once the invoice has been submitted to and paid by the customer.