Contract Factoring vs. Purchase Order Financing What’s the Difference?

Large orders are a common challenge for growing businesses. Fortunately, there are a number of financing options available to bridge the gap between a big opportunity and order delivery. Two popular funding solutions are contract factoring and purchase order financing. While both provide working capital to help fulfill specific deals, they operate very differently and are designed for different business models.

Here’s a look at how each financing method works, their pros and cons, and how business owners can decide which is best for their situation.

What Is Contract Factoring?

Contract factoring, also known as invoice factoring or progress billing, helps provide cash flow to businesses that invoice, based on work completed under a service contract. Instead of waiting weeks or months to get paid by customers, companies can receive immediate funds by selling their invoices to a third party, called a factor. Unlike a typical business loan, this type of financing is tied to the contract’s value.

How Contract Factoring Works

Contract work is often tied to a milestone or progress payment schedule. Once work is performed under a service contract, the business can issue an invoice for the portion of work completed. But rather than then waiting for the customer to pay, a company can sell that invoice to a factoring company at a discount, usually between 70% to 90% of the invoice amount.

When you sign an agreement with a contract factoring lender, the financial institution will use your customer’s commercial contract as collateral for the debt. You can ask for an advance — usually limited to a percentage of the contract’s total value — to cover upfront costs for things like labor, materials, and equipment. Your payment schedule is typically structured around specific project milestones or expected customer payments.

After buying the invoice, the factor will collect payment directly from the customer. Once the invoice is paid in full, any remaining balance — minus a contract factoring fee — is sent back to the business.

So, let’s say an engineering firm is working on a multi-month infrastructure project and just completed the first milestone, worth $200,000. Instead of waiting 30, 45, or even 60 days for the client to submit a payment, they sell the invoice to a factoring company and receive $170,000 upfront. The factor collects the full $200,000 from the client and sends the remaining $30,000 to the firm, minus any agreed fees, once the invoice is paid.

Who Uses Contract Factoring?

Contract factoring is commonly used by service-based businesses that work on long-term or milestone-driven projects, especially if they need a regular influx of cash to keep the project moving along. This can include businesses and industries like:

• Construction companies
• Engineering or architectural firms
• IT and software development agencies
• Government contractors

These companies often deal with long billing cycles and need ongoing cash flow to cover labor, materials, and overhead costs as work progresses.

What Is Purchase Order Financing?

On the other hand, we have purchase order (PO) financing. This financing option designed for businesses that manufacture and/or sell physical goods rather than provide services. It helps cover the cost of purchasing or manufacturing products needed to fulfill a confirmed customer purchase order.

Instead of financing a long-term project, PO financing covers the cost of goods your business will need to fulfill a specific customer's purchase order. Unlike factoring, which deals with completed work or invoices, PO financing provides upfront capital to fund production before the goods are ever delivered.

How Purchase Order Financing Works

Once you receive a confirmed purchase order from your customer, a PO financing lender pays your supplier directly to manufacture or supply the goods. You fulfill the order, and when the customer pays their invoice (to the lender), the lender deducts any fees and forwards the remaining balance to you.

So, say a clothing distributor receives a $200,000 order from a major retailer for a time-sensitive holiday restock. They will need about $120,000 upfront to pay their overseas suppliers to get those pieces of clothing manufactured, finished, packaged, and shipped. A PO financing company will step in and cover up to 100% of the contract price, sending payment directly to your supplier so you can get started fulfilling the order.

Once the goods are delivered and the retailer pays, the lender deducts its fees and forwards the rest to the distributor.

Who Uses PO Financing?

Purchase order financing can be a good option for businesses that sell physical goods and receive larger-than-usual or time-sensitive orders, but are limited on liquidity. This might include wholesalers and distributors, import/export companies, or seasonal businesses with large short-term orders but limited liquidity.

Key Differences Between Contract Factoring and PO Financing

Although both solutions improve cash flow and help fulfill large deals, contract factoring and purchase order financing serve different business models and stages in the order lifecycle.

• Business type: Contract factoring is better for businesses that provide a service while purchase order financing is intended for businesses that sell goods.
• Funding: Contract factoring can be funded as you complete milestones while PO financing requires a confirmed purchase order.
• Use: Funds from contract factoring can be used to pay for labor, materials, overhead expenses, and more while PO financing is just intended for supplies or goods necessary to meet a specific order.

• Repayment terms: Contract factoring is repaid at certain progress points or milestones, while PO financing isn’t settled until the customer pays their invoice.
• Payee: Customers pay contract factoring companies and/or PO financing companies directly.
• Collateral: Contract factoring is secured by the value of the signed contract, and PO financing is secured by the goods being ordered.
• Timeline: Contract factoring is meant for longer-term projects and repayment schedules (sometimes lasting months or even years) while PO financing is short-term and meant to be repaid in just weeks (depending on the customer’s invoice agreement).

Pros and Cons of Contract Factoring

Here are some of the benefits and drawbacks of contract factoring.

Pros

• They offer immediate access to capital after invoicing. Contract factoring unlocks any cash that’s tied up in accounts receivable, reducing the time you have to wait on client payments.
• Can cover more than just materials. Unlike PO financing, contract factoring funds can be used for payroll, rent, and other operational needs.
• No new debt is incurred. Since you’re selling your invoices and not borrowing against them, contract factoring doesn’t add to your total liabilities.
• They’re ideal for long-term or phased projects. Contract factoring fits projects with recurring or milestone payments, giving businesses continuous cash flow throughout the project.

Cons

• It only applies to completed work. You can’t factor a contract until you’ve performed and billed for part of the work. If you need money upfront to even start the work, contract factoring won’t be able to help.
• Fees can add up. Contract factoring fees can range from 1% to 5% per month, which may be more expensive than traditional loans over time.
• There’s a customer payment risk. Since the factor collects payment directly from your client, delays or disputes can impact your cash flow.
• It’s not ideal for all clients. If your customer has poor credit or an unreliable payment history, you may be denied when applying for contract factoring or be limited to a reduced factoring amount.

Pros and Cons of Purchase Order Financing

If you think purchase order financing is the better option for your business, here are the benefits and downsides to consider.

Pros

• Product-based businesses can get approved quickly. If your purchase order financing paperwork is in order and your customer has a strong credit history, approval can happen quickly compared to many business term loans. This makes it an ideal option for urgent or seasonal orders.
• Approval depends primarily on the buyer’s creditworthiness. Unlike traditional loans and business lines of credit, where your company’s credit history plays a major role, PO financing decisions focus on your customer’s ability to pay. This is especially beneficial for small or growing businesses with reputable clients but a limited credit history.
• They enable businesses to take on large or unexpected orders. PO financing opens the door to opportunities that you might otherwise have to turn down simply due to cash flow constraints. By covering supplier payments, PO financing helps you grow quickly without forcing you to rely on long-term debt.

Cons

• It’s a short-term solution. PO financing is tied to individual purchase orders and is not suitable for ongoing operational needs. It won’t help with recurring overhead costs like payroll, rent, or utilities.
• Total costs are higher than traditional loans. The convenience and speed of PO financing come at a price. Interest rates can be much higher than bank loans or lines of credit, mostly because lenders are assuming more risk.
• Funding is limited to covering supplier costs, not overhead or payroll. You can’t just ask for a larger funding amount to cover other expenses, and these funds go directly to your supplier after approval... not your operating account. If you need working capital for production, staffing, or marketing, you’ll need to look into additional financing options.

Final Thoughts

Both contract factoring and purchase order financing offer strategic ways for businesses to improve cash flow and take advantage of growth opportunities without draining reserves. But they serve different purposes.

If you’re a service provider working on large, long-term contracts with milestone billing, contract factoring gets you paid as work is completed... even if your client takes weeks to submit payment. On the other hand, if you’re a goods-based business that receives a large or urgent order, purchase order financing can help you cover necessary supply costs upfront, so you can fulfill the order without delay.

Before choosing a funding solution, evaluate your business model, cash flow cycle, and the structure of the deal in question. Understanding which type of financing aligns best with your needs will help you grow sustainably and avoid unnecessary financial risk.

FAQs on Contract Factoring versus Purchase Order Financing

What is contract factoring, and how is it different from contract financing?

Contract factoring is a type of financing where you sell your invoices or accounts receivable to a lender at a discount to a third-party. In exchange, you’ll get cash as work is completed and your customer will pay the lender directly. Contract financing, on the other hand, provides you with upfront funds using the contract as collateral.

Who typically uses purchase order financing?

PO financing is often used by wholesalers, distributors, import/export companies, and seasonal businesses that have to fulfill large or unexpected product orders. This gives them the funds they need to process orders without tying up their own working capital.

How much can I borrow through contract factoring or PO financing?

The amount you can borrow with either financing option depends on the lender you choose and your client’s creditworthiness.

How fast can I get funding with PO financing versus contract factoring?

PO financing can often be approved in just a few days if your customer is creditworthy. Contract factoring is also relatively quick once you’ve invoiced, but the initial setup process may take slightly longer depending on the complexity of your contract and client.

Can PO financing or contract factoring cover overhead or payroll expenses?

Funds can be used for labor, materials, and overhead with contract factoring but not with PO financing. PO financing funds are paid directly to suppliers and can’t be used for operating expenses.

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