Purchase Order Funding vs Invoice Discounting

As a SME in South Africa, you’ll be faced with opportunities, challenges, wins and losses along your journey, but it’s important to keep your head up on your path to success. One common challenge faced by SMEs is managing cash flow effectively to meet their operational needs and seize growth opportunities. Another challenge is not understanding the business finance funding types available, and if you qualify or not. Let’s explore essential financing options that can help SMEs overcome cash flow constraints: Purchase Order Funding and Invoice Discounting. By understanding the differences, pros, and cons of these financing options, and identifying the types of businesses that qualify for each, SMEs can make informed decisions to accelerate their growth and success.

What is purchase order funding?  

Purchase Order Funding, also known as PO Funding, is a financing solution designed to help businesses fulfil customer orders when they lack the necessary funds to purchase the required inventory or raw materials. It allows SMEs to secure financing based on the confirmed purchase orders they have received from reputable customers.

How does purchase order funding work?  

When an SME receives a purchase order from a customer, they can use this formal agreement to apply for a loan. The lender will then assess the creditworthiness of the customer and the viability of the purchase order. If approved, the lender will provide the SME with the necessary funds to produce or purchase the goods required to fulfil the order.

For more on purchase order funding read our full guide on FundingHub.

What are the pros of Purchase Order Funding?  

1. Unlock Business Growth: PO Funding enables SMEs to take on larger orders and expand their customer base, leading to increased revenue and market share. ‍
2. Minimise Debt: Purchase Order Funding is not a loan; it is a transaction-based financing option. This means that SMEs can avoid taking on additional debt.
3. ‍Improve Supplier Relationships: With timely access to funds, SMEs can pay their suppliers promptly, strengthening their relationships and possibly negotiating better terms. ‍
4. No Equity Dilution: PO Funding does not require SMEs to give up equity in their company, preserving ownership and control.

What are the cons of Purchase Order Funding?  

1. Limitation of workflow processes / must be direct-to-customer. Companies that are most likely to get purchase order financing are those who directly supply a finished product to a customer. This makes the transaction process of a financing company, who will make the purchase of the stock for your business, a straightforward one. Businesses that are just a single part of a longer production process are unlikely to receive purchase order financing support. ‍
2. On-going dependency. A common problem with purchase order financing is that small businesses see it as a short-term solution for a single order or transaction. The problem is though that this elevates the expectation and future orders to the small company, and with subsequent orders, they will once again require more funding to fulfill those. If profits from the first big order are not managed efficiently, this creates a recurring dependency on a financier to keep the company operating. ‍
3. Minimum gross margin. Most purchase order funding options will only happen if there is a minimum 20% gross margin on the transaction. If the profit on your stock or resource is notably small, this will make it more difficult to incentivise a funder to provide financing to the supplier.

What types of businesses usually apply for Purchas Order Funding?  

• Manufacturing companies fulfilling large product orders.
• Importers and exporters dealing with significant international orders.
• Distributors handling high-volume orders from established retailers or wholesalers.
• Companies experiencing rapid growth and requiring immediate cash to fulfil orders.

What is invoice discounting?  

Invoice Discounting, sometimes referred to as factoring, is another financing option available to SMEs. It allows businesses to access cash tied up in their outstanding invoices before their customers pay them. This solution provides SMEs with a way to bridge the gap between the delivery of goods or services and the receipt of payment.

How does invoice discounting work?  

When an SME delivers goods or services to a customer and issues an invoice, they can apply for financing using these invoices. The lender will evaluate the creditworthiness of the SME's customers and the quality of the outstanding invoices. If approved, the financing company will advance a percentage (typically 70-90%) of the invoice's value to the SME.

What are the pros of invoice discounting?  

1. Improved Cash Flow: SMEs can access funds promptly, helping them meet immediate financial obligations, invest in growth initiatives, or cover operational expenses.
2. No Debt Accumulation: Like Purchase Order Funding, Invoice Discounting is not a loan, so businesses can avoid accumulating debt.
3. Flexibility: SMEs can choose which invoices to discount, allowing them to manage their cash flow according to their specific needs.
4. No Collateral Required: Invoice Discounting is a form of unsecured financing, so businesses don't need to provide collateral to access funds.

What are the cons of invoice discounting?  

1. Customer dependency: The creditworthiness of the SME's customers plays a significant role in determining the funding amount. If customers have poor credit, it could affect the discounting process.
2. Cost of financing: The financing company will charge a fee or discount for advancing the funds, which can sometimes reduce the SME's profit margin.
3. Administrative effort: SMEs need to manage the invoicing process carefully to ensure accuracy and avoid potential disputes with customers. Ensure you are using an invoicing software so that this process is much faster, and effectively managed.  

What type of businesses usually apply for invoice discounting?  

• Service-based companies with a steady stream of invoiced clients.
• Wholesalers or distributors selling goods to creditworthy customers.
• B2B companies with reliable and established customer bases.
• SMEs seeking immediate cash flow relief and growth opportunities.

Which is better for my business purchase order funding or invoice discounting?  

When it comes to choosing between Purchase Order Funding and Invoice Discounting, determining the most suitable option for your SME's needs requires a thorough assessment of your business model, cash flow requirements, and growth objectives

What factors can help you make an informed decision on which funding type to choose?  

Nature of Your Business:

Purchase Order Funding: If your SME is primarily engaged in fulfilling customer orders, especially for manufacturing or distributing goods, Purchase Order Funding can be the ideal choice. It enables you to take on larger orders, expand your customer base, and seize growth opportunities without accumulating additional debt.  

Invoice Discounting: On the other hand, if your SME relies heavily on invoicing clients for services rendered or goods delivered, Invoice Discounting could be more suitable. It provides a consistent source of working capital by unlocking cash tied up in your outstanding invoices, giving you the flexibility to manage your cash flow efficiently.

Cash Flow Requirements:

Purchase Order Funding: If your business frequently faces cash flow challenges due to the need to purchase raw materials or inventory before fulfilling customer orders, Purchase Order Funding can offer a quick injection of funds to address these specific needs.

Invoice Discounting: If your SME experiences delays in receiving payments from customers, Invoice Discounting can be a valuable solution to bridge the gap between delivery and payment. It allows you to access funds promptly, ensuring smooth operations and mitigating the risk of late payments affecting your cash flow.

Customer Base and Creditworthiness:

Purchase Order Funding: The creditworthiness of your customers plays a significant role in securing Purchase Order Funding. If your customers have a strong credit history and are reputable, it increases your chances of approval for this type of financing.

Invoice Discounting: Invoice Discounting focuses on the quality of your outstanding invoices and the reliability of your customer base. If your clients have a track record of timely payments and good creditworthiness, Invoice Discounting could be a viable option for your SME.

Frequency of Funding Needs:

Purchase Order Funding: If your SME often receives large, irregular orders that require significant upfront costs, Purchase Order Funding can provide a one-time solution for fulfilling those specific orders.

Invoice Discounting: For SMEs that require a continuous flow of working capital to cover ongoing expenses, Invoice Discounting offers the advantage of accessing funds regularly as new invoices are generated.

Cost Considerations:

Purchase Order Funding: While Purchase Order Funding allows you to avoid taking on additional debt, it might come with higher fees or interest rates due to the risk associated with financing specific orders.

Invoice Discounting: The cost of Invoice Discounting typically involves a discount on the face value of your outstanding invoices, reducing your profit margin slightly.

How do I know whether I qualify for purchase order funding or invoice discounting?

You’re in luck. At FundingHub we consider all aspects of your business when assisting you on your funding journey. When you apply for a loan, we’ll help you compare live end-to-end offers, but we’ll also help you by matching you with alternative lenders and by looking for other funding types that suit your needs right now.  

The best financing option for your SME depends on various factors, including your business model, cash flow requirements, customer base, and funding frequency. Purchase Order Funding is ideal for SMEs dealing with specific purchase orders, enabling them to take on larger orders and expand their operations without accumulating debt. On the other hand, Invoice Discounting offers continuous access to working capital by unlocking funds from outstanding invoices, making it suitable for SMEs with a steady stream of invoiced clients. Both Purchase Order Funding and Invoice Discounting are valuable tools that can empower your SME to overcome cash flow constraints and accelerate growth on your business journey.

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