When businesses are in need of short-term capital, Accounts Receivable (AR; also known as Factoring) and Purchase Order (PO) financing are two options available to them. These options are particularly attractive to businesses that do not have good credit rating.
In AR financing, the business sells its outstanding invoices, or receivables, at a discount to a finance or factoring company. The factoring company then assumes the risk on the receivables and provides quick cash to the business. In contrast, PO financing is an advance to a business, secured by a purchase order or contract, to cover the cost of manufacturing and shipping a product or delivering a service.
AR and PO financing differ in terms of their benefits, the situations where they are appropriate and their terms.
Accounts Receivable vs. Purchase Order
A good way to begin understanding the two types of financing is to understand the terms behind each. Accounts receivable is money owed to a business by its clients and shown on its Balance Sheet as an asset. A purchase order (PO) is a commercial document issued by a buyer to a seller that indicates the type, quantity, and agreed prices for products or services that the buyer has agreed to procure from the seller. So a crucial distinction is that receivables are generally for goods/services that have already been delivered while a PO signifies intent (or a commitment) to buy.
Pros and Cons
Both funding options are attractive to companies that have bad or no credit rating because the credit-worthiness of the borrower is not critical to getting these types of loans. What matters more is the credit-worthiness of the customers of the business. This also results in loans closing quickly because lenders may not need to do detailed due diligence like in other, conventional loan applications.
PO financing lends itself to business models that rely on producing and delivering physical goods rather than services. AR Financing, however, does not have this restriction. It is a tool that can improve the cash flow of any company irrespective of whether they sell products or services. PO financing is ideally suited for businesses that require their customers to pay cash on delivery because the faster they get paid, the faster they can repay the PO loan and the lower their financing charge. For businesses that are unable to negotiate such payment terms with their customers, AR financing could be an option because they can get cash quickly by selling the receivables at a discount.
Profit margins and credit-worthiness
If profit margins of the borrower are slim then PO financing may not be an option because financing companies generally require profit margins of 20% or more. They impose this restriction because they want to lower the risk of getting repaid with interest. Another factor is the credit-worthiness of the buyer/customer that has issued the PO. In AR Financing, on the other hand, lenders don't care about the profit margins of business. They do care about the credit-worthiness of the company's customers, because the financing company now assumes the credit risk on the receivables.
Use of Funds in AR Financing vs. PO Financing
With PO Financing, the lender generally stipulates that funds can't be used for anything other than fulfilling the purchase order against which funding has been obtained. AR Financing mandates no such restrictions on what the advanced capital can be used for; AR Financing can be a used to fund any business need.
Costs of financing
AR financing is considerably cheaper than PO financing because the risk to the lender is much lower when the loan is secured by receivables. The risk is higher for the lender in the case of PO financing because the goods/services have not been delivered yet so things could go awry in the manufacturing process. Interest rates for AR financing range from 1-4% while PO financing rates are 5-10%. In addition to the interest rate, there can also be other charges like service fees, penalties, costs to insure the loan and re-factoring charges for debts over 90 days old.