Purchase order financing occurs when funds are advanced from a lender against a purchase order received from a customer of the borrower. This is a high-cost, short-term form of debt, where the borrower is typically expected to pay back the loan within one or two months. The actual payment flow is that the customer of the borrower is instructed to send its payment directly to the lender. The lender then extracts the loan amount and its fees and interest charges, and forwards the residual amount of the payment to the borrower.
A business will usually only resort to purchase order financing when it does not have the cash to fulfill a customer order, and does not have access to other, less expensive forms of financing. In this situation, the alternative is to turn down the customer order, which will likely lose that customer’s business forever and may also initiate rumors in the marketplace that the firm is running short of cash.
The lender is most likely to issue funds when the customer of the borrower is considered to be very creditworthy, since the lender is relying on the customer to pay back the debt.