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An explanation of some of the unique financing issues for government contractors who manufacture products.
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This is a guest post by Richard Lewis, Financial Engineering Counselors, Ltd.

A purchase order finance (PO finance) and/or factoring relationship has several scenarios and nuances. Briefly, PO finance is used primarily where “product,” manufactured-assembled (OEM) and/or distributed, is being sold to a credit worthy customer. The U.S. Government and its agencies are a “credit-worthy” customer.

A manufactured product is more difficult than a distributor type product for PO financing because the overall worthiness and capabilities of the manufacturer/assembler and parts suppliers are also taken into consideration to supply the necessary components on a timely basis. With distributors the end product may be pretty much known, thus entailing less delivery and acceptance risk.

For example, Dell computers are a known quantity and delivery is pretty much assured from Dell. On the other hand, if a company is manufacturing its own computers, the quality and assurance of the parts, drives, chips, etc. must be taken into consideration, as well as the company’s capability of putting them together in the prescribed product; memory, speed, etc. must all satisfy the terms in the RFP or contract.

The PO finance company finances the purchase of parts from the supplier by issuing a letter of credit, guaranty, or cash payment directly to the supplier, as determined by the specific situation. In any event the PO finance company wants to receive its payment/reimbursement as soon as product receipt is acknowledged and the acceptable invoice submitted.

A crucial determinant is the FOB. FOB stands for “free on board,” and is a contracting term that relates to where the product must be delivered. If the product is billable at delivery point, as opposed to when received and properly installed, it’s much easier to factor. For example, if a widget is manufactured for the US Army for use in Afghanistan, the widget will be easier to finance if its FOB is domestic, such as the factory or military base/warehouse, etc. If the FOB is Afghanistan, transportation, delivery, and acceptance becomes more of an uncertainty, risk, and is substantially more difficult to finance.

Before a contract with the U.S. Government is executed, carefully read the contract for details about FOB, invoicing and payment. A little buried clause like FOB could upset the whole apple cart, at least the financing. Once the contract is signed it’s significantly more difficult to get a modification/amendment, even if it’s mutually agreed upon and makes common and business sense. The Government is the Government.

Where does the factor fit in?

PO financing almost always needs a factor on the back end to take them out, but factoring can stand alone as its own form of financing. A factor legally purchases the invoice and advances a percent of the face amount to the company. With the U.S. Government as customer, it is usually “up to” 90%. It may be more or less, more often less, dependent on the specific situation. For example, the company submits an invoice for $100,000 for the widgets that have been delivered and receipt acknowledged by the Army. The factor will then advance the company $90,000 for the company to use as it sees fit.

In the case of PO financing, say the cost of the widgets is $70,000 (paid or otherwise guaranteed by the PO finance company). The factor will pay the $70,000 to the PO finance company and make available the $20,000 difference to the company.

When the Army pays for the widgets, usually within 30 days, it pays directly to the factor as specified under the Assignment of Claims Act of 1941, as amended. The factor reduces the outstanding on that specific invoice, deducts its fees and remits the balance to the company.

A company may factor some or all its contracts and invoices under the specific contract, at its sole discretion. Agreements with a factor may or may not have monthly minimums and length of agreement.

The cost: The fees and charges vary greatly and can vary anywhere from a singles digit annual rate to 30+% annually. Factoring is more expensive than bank lending and PO financing is even more expensive because of the completion risk factors and the financier taking the financial risk.

Richard Lewis is a consultant with Financial Engineering Counselors, Ltd.  FEC is a diverse financial advisory firm that assists government contractors in obtaining their working capital needs. You can contact him at 703-992-8988.

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