Keeping finances in order is one of the most challenging aspects of running a construction business. There is often a domino effect that takes place when cash is tight. Fortunately, there are a lot of financing options available to contractors, material suppliers, and other construction providers that can help when cashflow suffers–invoice factoring and purchase order financing being two of the most popular choices.
Researching for the best option for your situation? This article will breakdown the differences between invoice factoring and purchase order financing. By the end, you will be able to tell which one fits your situation best and benefits you the most.
Invoice Factoring Vs Purchase Order Financing: A Quick Look
Invoice factoring and purchase order financing could seem very similar but they are very distinct from each other.
Invoice factoring is an option for businesses that want to turn an invoice for a job that’s already been delivered into quick liquid capital. Purchase order financing is for businesses that need help financing the purchase of materials and other resources needed to get started on a job.
Addressing Cash Flow Issues in Construction
The construction industry as a whole is notorious for cash flow issues. Wait times between billing and collections can be long while new projects require significant amounts of money to get started. These facts combined result in the need for steady flow of cash not only to keep growing as a business but also to keep overhead expenses paid and the business running.
Invoice factoring and purchase order financing both address cash flow issues although in different ways.
Let’s look at each one separately to thoroughly understand how contractors, suppliers, and other construction businesses can benefit from them.
Invoice Factoring
One of the chief reasons why cash can get tight is late payments or long payment terms on commercial invoices. It’s not surprising to see NET30, NET60, and even NET90 invoices in construction, meaning invoices are to be paid 30, 60, or 90 days after client receipt. It’s not unusual for some invoices to have terms even longer than that depending on your contract.
In this process, cash is held up during the wait and for many contractors and suppliers, it’s a struggle to start new projects during this period. Even when there’s some capital for emergencies in the bank, using that to fund new projects while invoices haven’t been paid yet can put a company in a very tight spot. Using up contingency funds to tide you over while waiting for payments can seem like a smart idea but smarter entrepreneurs will tell you to reserve those in absolute emergencies.
Whether for stability, growth, or better profitability, invoice factoring can be a good option for your specific situation.
Invoice factoring, also sometimes called invoice financing*, can be a good option in this situation.
*While some use the terms invoice financing and invoice factoring interchangeably, there are those who make the distinction. For invoice financing, you still are in charge of collecting the payment from the client. For invoice factoring, the factor takes the charge in getting the customer’s payment.
How Does Invoice Financing Work?
It’s important to remember that factoring is not a loan. It is essentially a sales-purchase transaction.
Accounts receivable represent money that you’re still owed for projects that you have worked on or have delivered materials for. Because of the terms of payment and other related circumstances, you are not able to access these funds immediately although you do own them and have full rights to them.
Think of A/R like any other asset — property, land, equipment– that you can sell for money. In invoice factoring, you are essentially selling the invoice to the factoring company at a discount. The discount represents the factoring fees. Factoring companies are also called factors or factoring lenders.
So, you take your invoice/s to the factoring company and they will pay up to 90% of the invoice upfront.
Don’t worry–this doesn’t mean that they charge the entire remainder as their fee. The way factors make money is chiefly through the discount/factoring fee. When the invoice is paid, the factor takes the 60%-90% they fronted, and you get the 10% to 40% balance minus the factoring fees. Some factoring companies could also charge you factoring fees upfront by giving you the bulk of the money minus the factoring fees initially, and then give you the remainder in full when the invoice is paid.
How Does Invoice Factoring Help?
The main way invoice factoring helps you is by drastically cutting down the wait time between billing and collections. Instead of waiting for the full 30, 60, or 90 days for the invoice to be paid, you get access to most of the cash right away, in exchange for the factoring fee.
Accelerating the payment process for your accounts receivable give you the opportunity to have cash in hand to use for whatever purpose you please–to fund growth, attain stability, and even establish profitability that you might be struggling to get.
The flexibility of having cash in hand allows you to make payments and financial decisions that you might otherwise not have the ability to. Because you’re selling your invoices, there are no stipulations as to where you use your money. From making payroll to paying taxes, invoice factoring affords you the flexibility to meet your financial obligations without having to go into debt or sell of equity in your company.
Who Can Benefit from Invoice Factoring?
Contractors, material suppliers, equipment lessors, and other business owners in construction can potentially benefit from invoice factoring. Businesses who have long wait periods between billing and actually receiving payment are the usual customers of factoring companies.
While factoring companies do look at the credit standing of the business getting their invoices factored, the primary determinant of getting approved for invoice factoring approved is the financials, reputation, and credit standing of the client the invoice is going to. The quality of the account with the outstanding invoice will be the main thing the lender will look into. This is why invoice factoring, unlike other financing options, is often something that even companies with rocky finances and credit histories can avail.
That said, it’s very important to note that in case the invoice does fall through, you are not entirely off the hook–you will still be responsible for getting the money to the factor. However, this isn’t a favorable case for them either, so most if not all factoring companies are diligent in screening the invoices they discount/factor.
Sample scenario:
Invoice factoring works best when the client with a pending invoice is a reputable one. Arguably, federal offices and other government units are some of the most credible clients.
For example, an HVAC supplier who delivered units for a federal project holding an unpaid invoice with a NET90 term is a perfect candidate for invoice factoring. They can send the invoice in for factoring. Say, the contract is $100,000, and the factoring company they went with fronts 90% for federal projects with a 3% factoring fee, the supplier will get $90,000 deposited to their business account. When the invoice gets paid, the factor will deposit another $7,000 to their account which is the remainder ($10,000) minus the factoring fee ($3,000).
The client being the government plays a big role in getting a big upfront % of the invoice. The percentage that the factoring company will advance is dependent on so many factors, but like mentioned above, the reputation and financials of the client with the outstanding invoice will hold the most weight.
If your unpaid invoice is for a client who’s a Fortune 500 company or one that’s known to have good relationships with their suppliers and contractors, you’re likely to get not only a high percentage of advanced cash, you can also likely get better terms like lower factoring fees or longer time before interest kicks in in case of a delayed payment beyond the original invoice terms.
Is Invoice Factoring Worth It?
Like any other financial tool, invoice factoring may or may not be the right fit for your financial situation. However, it’s one of the most powerful financial options available to construction businesses because it addresses the long payment terms which usually is one of the main reasons companies end up in the red.
Invoice factoring also almost always makes sense financially compared to other scenarios. When used wisely, it may cost you practically nothing to accelerate the receipt of payments you’re owed. How? Because factoring fees/discount rates are typically on par with merchant fees for credit card payments and even term business loan interest rates.
Of course, these rates can change depending on many factors like the strength of the invoice you’re looking to sell. But because you are the seller, you have a lot of control over the whole invoice factoring process: you choose when to factor and what specific invoices you want to factor.
This is also why invoice factoring is not only for moments where cash is really tight. The most financially savvy construction companies know how to use invoice factoring to manage their cash flow without cutting into their profits.
Purchase Order Financing
Purchase order financing is one of the financial tools that many contractors, suppliers, and other construction business owners often get confused by. This is brought about by the use of “purchase order” as a term on both the demand side and the supply side. To be clear, let’s define the usage for both sides.
Demand side purchase orders come from your customers. This is usually a description of what they need in terms of services, products, or supplies. Purchase orders of this nature are translated into sales orders once financial information is ironed out and services/products/materials are for delivery to your customer.
Supply side purchase orders come from you. You issue purchase orders to the vendors you deal with for products and other merchandise that you need in order to successfully fulfill customer orders. In construction, purchase orders are sent by contractors to material suppliers for materials they need for a project.
Purchase order financing deals with the latter, supply-side purchase orders. Procuring materials for construction projects often make up for a big chunk of the capital needed for a project to go underway. For this, there are two main challenges that contractors face:
- Vendors often require full cash payments for materials especially if you have no prior established relationship.
- Without the materials, you can’t start the project therefore can’t generate more income.
This is where purchase order financing can be the solution.
How Does Purchase Order Financing Work?
Purchase order financing is usually offered by the same factors that offer invoice factoring. Why? Because invoice factoring is part for the process of purchase order financing.
Let’s dive into what the process of purchase order financing looks like.
You, the contractor, are looking to get purchase order financing to get materials for a project. You know the exact materials you need and how much money is needed to purchase the merchandise.
The first conversation with the factoring company that will finance the purchase order will involve the terms of the transaction. Something called “Letters of Credit” defines the conditions and terms involved in the whole process including mainly what needs to be satisfied in order for them to transfer the money needed for the purchase of materials.
It’s important to understand that they are not lending you money to purchase materials on your discretion. There has to be a project that needs specific materials. The factor will advance the payment for the materials and send the payment directly to the vendor you choose. When the vendor is paid, you can then get access to the materials needed to start or continue working on a project, finish your obligations to your customer, and invoice them for your service.
Now that you have an open invoice awaiting payment, the factor will purchase the invoice from you (invoice factoring step), deducting the money advanced for the purchase order and sending you a PART of the remainder based on what’s been agreed upon on the Letters of Credit. The agreement should outline how much you’ll get immediately for the purchase of the invoice and how much will be held back while waiting for customer payment.
When the factor collects payment from the customer, they take the factoring fees out and send you the remainder.
Is Purchase Order Financing Worth It?
Purchase order financing directly addresses the problem faced by many contractors and subs who lack the working capital or liquidity to start a project but it’s easy to get leery about financing deals because there are a lot of transactions where you cut too deep into profits that you get so little or end up in deficit when all is said and done.
However, factors who offer purchase order financing often bake certain conditions into the requirements that safeguard not only their interests but also the contractors’ or subs’.
How? Many factors require a certain percentage of gross profit for the materials in the purchase order to make sure that you don’t end up in the red at the end of the transaction.
The money advanced for a purchase order also goes directly to the vendor. This particular financial tool can only be used to fund purchases that are earmarked for a definite project.
You can’t use PO financing to beef up your inventory–the materials have to have a set use. To ensure this, the factor will check that you have a demand-side purchase order that corresponds to the purchase order you want to finance. Through the demand-side PO, they can also gauge the profit margin for the materials and decide if it’s worth financing both for you and them, after fees.
Purchase order financing allows you to get a breather while you build up cash reserves to be able to cover future purchase orders without getting financing.
The best outcome of a financed purchase order is that you get to build trust between you and the supplier. This way, you are more likely to get more flexible terms in the future after a couple of transactions where you were able to full, in cash, with the help of PO financing.
Invoice Factoring Versus Purchase Order Financing: Which Is Better?
The answer is that it really depends! Both financial tools have a place in your overall cash flow management strategy.
Each of the two fulfills specific needs under particular circumstances.
That said, invoice factoring can be part of your regular cash flow management protocols. It can work seamlessly with multiple projects to give you better flexibility and fund your growth or strengthen your cash position.
On the other hand, purchase order financing gives you a lifebuoy for situations where your cash is overstretched and you need a little bit of a boost. The good thing is that you often would only need to use PO a couple of times to get to a better cash position.
Managing cash flow in construction is very difficult so it’s in your best interest to take advantage of the tools that make it a little bit easier.
Further reading