Known as production finance or work in process financing, a product is being produced by the company and shipped to the company’s customer. Since purchase order financing provides only direct costs in fulfilling the order, the company must have a proven history of not only producing the product but also the capacity and the cash flow to cover other non-direct costs. Purchase order financing can include the cost of materials, parts and direct labor to fulfill the order.
The company must be profitable or at least cash flow neutral. The basic concept in mitigating the significant risk associated with production finance is that the order being financed is incremental sales to the company. In most cases, the company has maxed out their line or ability to fulfill the order under their borrowing capacity from their current financing source.
In addition, two main items must also be addressed in the initial assessment of the potential for purchase order financing on a production deal: (1) the number of suppliers required to fulfill the order; and (2) the time involved with the production cycle.
The greater the number of suppliers means more work required in due diligence in vetting out the suppliers and ability to control the collateral of raw materials and parts delivered to the company. The fewer the suppliers, the more likely that production is of a low tech nature. The more suppliers, the more involved the production process and more risk associated with the transaction. Ideally the production cycle is in days or weeks and the client can invoice as product is produced and shipped, especially on larger orders. If the production cycle is much more than 60 days, the cost of purchase order financing to the company and the risk with the longer exposure of employed funds by the purchase order finance company, the transaction may not make economic sense for either party.