Most specialty contractors would agree, on every project, the two most important budget items to manage with the utmost accuracy are labor and material. Unfortunately, these two items are the most constrained in today’s economic environment, and it’s causing lots of challenges for all those in the construction industry, especially specialty contractors. To survive these economic challenges, specialty contractors need the tools and resources to help them not just survive but thrive.
One of the biggest challenges specialty contractors face right now is escalating material costs. Cost hikes are being influenced by a number of factors, and typically specialty contractors can’t get ahead of these costs without a purchase order from the general contractor. In many cases, purchase orders are delayed, causing further setbacks and delays, ultimately leading to more cost escalations.
Ideally, specialty contractors would be able to order materials early, which leads to better lead times and lower costs. However, they may not have the cash available to fund the materials purchase because they’re waiting on payments from other customers and projects. Some specialty contractors use purchase order financing to cover the cost of materials without using their own cash, and here’s how it works:
What is purchase order financing?
Purchase order financing, also called PO financing or material financing, is when a third party provides funds to cover the expenses for a specialty contractor’s purchase order. The third party, or financing company, provides the cash flow the contractor needs to perform the work and covers them until payment arrives. PO funding may fund the whole purchase order or just a portion, depending on the contractor’s or supplier’s need.
Unlike other credit options, PO financing relies on the customer’s credit-worthiness or the project, not the specialty contractor or supplier. For this reason, PO financing is available to a wider variety of specialty contractors and suppliers, like those just starting that don’t have an established credit history.
In today’s environment having access to cash to get materials ordered early can make or break a specialty contractor’s ability to meet or exceed their estimated costs and lead to improved project margins. Not to mention, having materials early on per project schedule allows a specialty contractor to ensure they can meet project deadlines.
Who uses purchase order financing?
Purchase order financing is available to anyone who needs to buy physical goods, like framing lumber or asphalt shingles. (Sometimes, it can be used to cover equipment purchases or rental.) In construction, this includes:
- Material suppliers and distributors – They need to purchase inventory or raw materials for manufacturing.
- Fabricators – They need to purchase raw materials for fabrication.
- Subcontractors – They need to purchase materials or equipment to perform their work.
- Equipment rental companies – They need to purchase used or new equipment to offer to their rental customers.
Purchase order financing isn’t used to cover services like construction labor or mobilization. Other contractor financing options can help fund overhead or additional costs. Instead, PO financing is specifically used to cover the costs of materials or equipment.
How purchase order financing works in construction
Here’s an example of purchase order financing in action on a construction job:
1. A roofing contractor signs a $2 million contract with a GC to install a roof on a new commercial project. They’ll need to buy $750K in materials to complete the job.
2. The roofing company creates an itemized list of the materials they need to complete the job: underlayment, metal roofing panels, flashing, sealant, etc. They send a purchase order to their local roofing material distributor.
3. But the roofing contractor only has a $250K credit line with the distributor, and they don’t have $500K on hand to complete the purchase. So the contractor or supplier applies for purchase order financing from the financing company.
4. The financing company looks at the project details, including the GC’s history of making payments. When approved, the financing company sends a check directly to the supplier, or sometimes a certified letter of credit.
5. The distributor delivers the roofing materials to the jobsite, and the contractor successfully installs the roof.
6. The contractor submits a pay app to the GC for the work and materials and awaits payment.
7. The GC approves the request and sends the roofing contractor a check for $2 million.
8. After the check clears, the contractor pays $500K to the financing company, plus any interest or fees (and $250K to the supplier).
In this example, the roofing contractor used PO financing to complete their biggest job to date and saved their own cash to cover labor costs and overhead during the project.
How much does PO financing cost?
Typically, PO financing costs between 2% to 8% of the order amount. The cost of purchase order financing depends on several factors. For instance, the size of the order, how many POs you’ve financed, the length of time to repayment, or how risky the job is.
Rather than being paid all at once, that cost is typically spread out throughout the project. The contractor may need to pay an origination fee plus a small weekly payment to the financing company for up to four months.
For companies trying to grow a specialty construction business, the cost of financing a material purchase is inconsequential compared to the benefit they get from completing more or bigger jobs.
Another point to consider when determining ROI on financing material is the rate at which materials are currently escalating. While prices for construction materials such as steel, lumber, glass, and aluminum have steadied in 2022, they remain higher than prepandemic levels. We continue to face global uncertainties that could impact future prices.
Purchase order financing vs. other funding options
Credit cards are easy to get for most contractors, but they can be expensive if you don’t have the best credit history. Interest rates are much higher than PO financing––they can be as high as 29%, plus fees and other charges. And to pay for large purchases, you must have good credit or a long-standing relationship with the issuer.
Line of credit
A line of credit is like a safety net on your bank account. You can draw money from the account when you need it and only pay interest on your withdrawal amount. It can also be used to cover overdrafts on an account. It’s not only available from a bank, though. Material suppliers typically provide a line of credit to qualified customers, also known as trade credit.
Getting a line of credit takes time, and you must go through the application process, which includes a financial statement review and a credit check. Financing a purchase order is typically much faster and doesn’t rely on the applicant’s creditworthiness. Like with credit cards, it’s easy to get in trouble with a line of credit if it’s not used wisely.
Bank loans offer a way to get both long-term and short-term financing. If you’re looking to expand your business or purchase a large amount of materials or equipment and have plenty of time to go through the loan process, a bank loan may be a good option. It can take several weeks to close the loan, so you have to be prepared to wait.
Invoice factoring involves selling your current accounts receivable invoices to a financing company. As a result, it is only available after you submit an invoice or pay app to your customer. By that point, you’ve already purchased and installed the materials. So factoring is not a valuable alternative to PO financing.
PO financing can improve cash flow & help businesses grow.
Because construction customers take an average of 83 days to send payment, it can be tough to take on new or bigger projects when you don’t have funds from the old projects yet. Purchase order financing is one tool contractors and suppliers can use to help them improve their cash flow and sustainably grow their business.