Share Your Expertise: Cameron Adair on Purchase Order Financing

Purchase Order Gap Financing as applies to U. S. Manufacturers sourcing Contract Manufacturing at Facilities in China.
By: Cameron Adair

Many small manufacturing operations in the U. S. have sought “gap” financing from private (non-bank) “factoring” firms and asset-based lending firms in order to complete and ship a contracted order to a customer. Such “gaps” in the working capital necessary to pay for the materials and labor involved in producing the “finished goods” often occur because a small manufacturer has already exhausted existing bank lines and does not have other capital availability, or because it has been “swamped” with more orders than it can handle with its existing credit lines.

When faced with a temporary liquidity “crunch”, the first call such companies make is to traditional factoring firms and asset-based lenders only to be told that, “We can lend against your receivables from your customers, but you must first finish and ship the order, and create the receivable. We can’t help you with the funds you need to complete the manufacturing process; we can only help you after the goods are finished and shipped.”

This is the prevailing “norm” as most factoring firms and similar asset-based lenders can only lend against receivables, and they are looking at the creditworthiness of the customer as their collateral, and not to the manufacturer. They cannot lend against “work in progress” or “purchase orders” for goods that have not been finished and shipped. This, of course, does not help the small manufacturer who still needs temporary cash availability to complete the purchase order and ship the goods to the customer.

There are a number of commercial financing firms that specialize in the high-risk arena of providing “gap” financing to small manufacturing companies to help them fulfill purchase orders. These “purchase order factoring” operations range from a handful of firms with a national footprint, to various regional firms and some finally to some very localized operations. There is no easily-defined industry group of such firms, and most small manufacturing companies have a difficult time finding out who to call, and what few firms there are that may even take a look at their “gap” financing needs in order to complete purchase orders.

Typically, “gap” financing firms will advance funds for raw materials and direct labor to get a set of goods covered under a purchase order completed and shipped. In general, most such lenders will only advance a portion of the funds needed, and the manufacturing company must have as much of its own working capital employed as possible (rarely can 100% of the cost of materials and labor be financed). These lenders will usually disburse directly to the materials suppliers, and wire funds to the payroll account on payday, in order to minimize risk, and will take a lien on the “work in progress” and finished products until the goods are shipped. At the point of “shipment”, when an invoice is sent to the customer and a “receivable” is created, the “gap” lender is typically paid (and the lien released) by an advance from the factoring firm that will “kick in” and lend against the newly-created “receivable” from the manufacturer’s customer.

“Gap” financing is expensive, usually 50% higher (on an annualized APR comparative basis) than the costs imposed by “receivables” factoring firms. It should only be used to the minimum extent necessary to complete and ship an order, and only be “drawn” upon for the least amount of time while the “interest meter” is ticking. A manufacturing company must have sufficient margins in the goods being produced to be able to “afford” such gap financing, and it can only be viewed as a temporary “means to an end”. Nevertheless, purchase order “gap” financing can make the difference between a company completing and shipping an order, and thereby keeping a good customer, as opposed to losing the order entirely. It can also provide temporary “relief” during periods of increased demand by customers when a manufacturer is unexpectedly “swamped” with orders and does not have the bank lines to meet these needs.

The need for purchase order financing gets more complicated for small U. S. manufacturers who, more and more in recent years, wish to contract to have their goods (or components of their finished goods) manufactured for them in China. Chinese manufacturing plants require advance deposits and payment in full prior to shipping. The cost of shipping from China and landing the goods in the U. S. must also be paid “up front”. For a U. S. company that has the capital, this process can tie up funds for a significant period time. But, for the U. S. company that must borrow some of these funds, the interest costs can become very expensive, especially while the meter is “ticking” during the overseas shipping process. Chinese manufacturing firms and shipping lines do not extend credit to smaller, “foreign” companies, and for a U. S. company, final payments are due when the goods are delivered “FOB” at the shipping port.

There is no easy answer to this dilemma. Larger, credit-worthy U. S. companies can arrange bank lines and letters of credit to handle their contract manufacturing and shipping costs in and from China. But for the smaller U. S. manufacturer with a limited capital base and bank credit facilities, the “mission” may be very difficult to achieve if not impossible.

Our affiliated commercial lending firms have provided “gap” financing to some smaller U. S. manufacturers in recent years to help fund contract manufacturing in China. This has been done on a case-by-case basis, and whereas our results have been favorable (i.e., as a lender, we have gotten repaid with the interest due), the costs to the borrower have often exceeded what was originally expected due to unforeseen delays and other “snags” in the process.

To be of help where possible, our affiliated lenders have recently organized a central “clearing house” to “field inquiries” from small U. S. manufacturers who need “gap” financing for contract manufacturing in China in order to “vet” each inquiry and see if we can match the manufacturer with a gap financing source that can meet their needs. To date, our affiliates have been able to work with only about one-third of the companies that have inquired; however, this still provided a source of much needed financial help to some companies who otherwise may not have been able to source such financing elsewhere.

ABOUT THE CONTRIBUTOR

Cameron Adair is Chairman of ADG Group in Atlanta, a merchant banking firm with interests in specialized commercial financing companies and consumer financing companies.

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Sourcejuice is not paid or affiliated with Cameron Adair or the ADG Group, but is assisting readers to navigate the possible necessity of contacting or inquiring such a firm for their respective services.

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Show Me The Money! Searching for Investment For Your Import Venture? Part 1 of 2 : SourceJuice on March 19th, 2008 6:16 pm

[…] a step-by-step run through of how “purchase order” financing works, check out Cameron Addair’s article in the “Share Your Expertise” […]

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