What Is A Merchant Cash Advance?

A merchant cash advance (MCA) is a short-term financing option for small businesses. An MCA is an unsecured loan that is repaid through a business’s future credit card and debit card sales.

Merchant cash advances are a popular financing option because they are relatively easy to obtain, and the repayment terms are flexible. MCAs can be used to pay for a variety of expenses, including inventory, marketing, and debt consolidation.

If you’re thinking about applying for a merchant cash advance, read on to learn more about how this financing can affect your business.

The Basics of Merchant Cash Advances

The government does not believe a merchant cash advance constitutes a loan as they are an advance that is paid back from your credit card sales. As a result of this classification, merchant cash advance providers can charge extremely high-interest rates, often in the triple digits. 

Given these high costs, a smart small business owner will tread carefully when considering whether a merchant cash advance makes financial sense for their business. 

Typically, a merchant cash advance provider will give a business a lump sum of cash in exchange for a percentage of the business’s future cash flows. 

Historically, these payments were directly deducted from the business’s merchant processor, but today many MCA providers will simply ask the business to make an automatic, fixed payment via ACH directly from their business checking account. 

To better understand how much a merchant cash advance would typically cost a business, consider the following example:

1. A retailer needs to purchase inventory but does not have the cash on hand to make the purchase. The business has exhausted its other financing options and turns to one of many merchant cash advance companies to quickly purchase inventory to sell its customers. 
2. Even though the retailer in this example has bad credit, the MCA company agrees to provide a lump sum of cash to allow them to make their inventory purchases.
3. The MCA company calculates a total repayment amount based on the amount originally issued to the retailer plus a factoring fee. 
4. The retailer makes the inventory purchases as intended and then enters into a fixed repayment each month until the outstanding merchant cash advance amount dissipates.
5. In some cases, the MCA company may take a fixed portion of the credit card transactions each month as a repayment mechanism. 

The Pros and Cons of Merchant Cash Advances

On the plus side, a merchant cash advance can help a business acquire cash rapidly. The pros of an MCA include:

• Fast application process and speedy access to needed cash for operations.
• Minimal creditworthiness requirements, both personal and business.
• MCAs do not require businesses to pledge collateral or business assets as with secured loan products.
• Ability to negotiate repayment terms to some degree.

Unfortunately, MCAs also have major downsides for businesses desperate for cash. The cons include:

• Extremely high APR (sometimes greater than 300%!).
• Major effects on free cash flow to the firm (FCFF).
• No benefits for building credit on either a personal or business basis.

An MCA can strain a business significantly enough to cause bankruptcy and other financial challenges. The higher interest rates combined with the high factor rate can ultimately force a business into an unfavorable situation. 

A business should only enter a contract like this after exhausting all other financing options, including bank loans, credit cards, factoring services, SBA loans, and friends and family funding sources. 

Comparing Merchant Cash Advances to other Forms of Financing

As stated previously, a merchant cash advance acts as a financial option of last resort. In other words, MCAs function as a kind of “nuclear financial bomb” for a business that can help to fund operations in the short run but have major costs thereafter. 

See below for several more financially-stable alternatives to consider prior to entering into a contract with an MCA provider. 

Bank Loans

A traditional small business loan comes in two varieties: secured and unsecured. Either type of loan, depending on the availability of collateral, can help a business to secure upfront cash with a sane interest rate. 

Lending institutions, including banks and credit unions, will structure their business loan products on the basis of the prime rate plus a spread based on the creditworthiness of the business. Some factors these lenders will consider when underwriting a loan include:

• Availability of free cash flow.
• The debt-to-equity ratio of the business.
• The personal credit score of the owner of the business (for small businesses).
• The availability of collateral such as property, plant, and equipment. 
• Macroeconomic conditions and the demand for business loans. 

Bank loans and other traditional loan products offer far superior terms compared to merchant cash advances. 

Another type of revolver financing known as lines of credit can also act as a sustainable funding source for businesses with working capital problems. 

In some instances, the bank may utilize a loan guarantee from US Small Business Administration (SBA) to help secure the loan. A guarantee from the SBA ensures the bank will get a portion of the debt repaid even if the borrower defaults. 

Credit Cards

Most business owners already have a level of familiarity with traditional credit card products from the major issuers, including banks, American Express, and Discover. 

These products, while not suitable for long-term funding, have far lower interest rates than the typical merchant cash advance and can help bridge the gap to more sustainable funding sources. 

Factoring

Invoice factors function as intermediaries between the business and the present value of the cash tied up in its current unpaid invoices. 

An invoice factoring service can provide a business with upfront cash in exchange for a fee plus the transfer of ownership of those unpaid invoices to the factor. From there, the factor will attempt to collect on the accounts.

This type of service, while often more expensive than more traditional business financing sources, offers yet another avenue that can lead to lower costs compared to an MCA. 

Calculating Fees and Interest

First, take the total amount of the advance promised by the MCA provider. For this example, assume that the principal amount equals $10,000.

The MCA provider will then apply a factoring rate to this amount. For this example, we will assume that the factoring rate equals 1.5. 

The total amount that the business must pay to the MCA provider in this instance equals the original amount granted ($10,000) multiplied by the factoring rate of 1.5. This amount equals $15,000.

The breakdown of costs in this example equals the original amount of $10,000 plus the fees charged by the MCA provider of $5,000 for the total $15,000 repayment. 

The business would repay this amount from their daily credit card sales over a specified period. For instance, if the business agreed to repay the amount over a 10 month period then the total repayment per month would equal $1,500. 

MCA providers can also work with businesses to adjust the fixed payments to suit the current revenue conditions at the firm. 

Determining If a Merchant Cash Advance Makes Sense for Your Business

Businesses that have no choice but to enter into a merchant cash advance agreement should treat the funds as a short-term loan and repay as quickly as possible. Business owners should also consider the alternatives listed previously before committing to one of these contracts.