Introduction
In the high-speed business financing world, business owners tend to look for quick means of getting the capital they require to keep their business up and running. One such financing solution is a Merchant Cash Advance (MCA) that provides quick access to cash in return for a percentage of a business’s future earnings. Though getting an MCA may appear easy and desirable, particularly for those businesses that may not be eligible for conventional loans, it is fraught with dire risks that could ultimately prove disastrous.
A grasp of the Merchant Cash Advance structure is the key to evaluating their likelihood of risks and returns. In this article, we will dive deep into what an MCA is, how it works, the benefits it offers, and the pitfalls that come with this form of funding. When we’re done here, you’ll clearly understand how MCAs work and why they may not always be the best way for your business to spend its money.
What is a Merchant Cash Advance?
A Merchant Cash Advance is an alternative financial service that gives businesses immediate access to capital in exchange for a fee of their daily credit card sales or total revenue. Traditional loans, where businesses make fixed monthly payments over an agreed period, differ from an MCA, which is paid back through the deduction of daily sales from the business, usually through credit or debit card transactions. This implies the amount to be repaid varies based on the daily sales, with greater sales translating into greater payments and lesser sales translating into lesser payments.
The process of funding an MCA is fairly quick and easy as opposed to conventional lending procedures. Companies can apply for an MCA and obtain the funds within a couple of days, making it a desirable option for companies that need cash flow instantly. In most instances, MCAs are utilized by small companies that do not have good enough credit to secure a conventional bank loan, perhaps because of their short history in operation, poor credit, or an inability to use assets to back the loan.
How Does a Merchant Cash Advance Work?
The merchant cash advance structure is centered around the business’s future earnings. The lender in most situations will advance the business a sum of money in lump, and repayment is commonly tied to future sales of the business. As already noted, repayment is generally a percentage of the business’s credit card daily sales or revenue in general.
The repayment process is ongoing until the amount agreed on, including principal and fees or interest, has been paid off. But in contrast to normal loans, there is no repayment term. Instead, the amount of repayment directly correlates with how well the business is doing. When sales are good, the business will pay back the MCA faster. When sales are bad, the repayment amounts will be lower as well.
The MCA is most often set up with a factor rate, and it is akin to an interest rate. The factor rate is calculated on the cash advance amount borrowed by the business, and the factor rate determines the overall repayment. For instance, if a business acquires a cash advance of $10,000 and the factor rate is 1.3, then the business will end up paying $13,000. The factor rate depends on the lender and the risk profile of the business.
Benefits of Merchant Cash Advances
There are a number of reasons why a Merchant Cash Advance can appear to be a good choice for entrepreneurs seeking quick funding. The following are some of the benefits that companies may welcome when seeking an MCA.
Fast Access to Funds
One of the major benefits of an MCA is the quickness with which companies are able to gain access to capital. In contrast to traditional bank loans that can take months or even weeks to go through, an MCA can frequently be approved and funded in a matter of days. This makes it a perfect option for companies that require cash flow quickly to pay for purchases such as inventory, payroll, or unexpected needs.
No Collateral Needed
Another advantage of an MCA is that it usually does not involve the need for collateral. In other types of lending deals, companies are usually requested to provide property or equipment as collateral to support the loan. In an MCA, companies are not obligated to provide any assets, and so it is a safer bet for companies who might not have something valuable to use as security.
Adjustable Repayments Based on Sales
Unlike the fixed monthly repayments required for traditional loans, the repayment model of an MCA is more adjustable. Since repayments are made as a percentage of daily sales, businesses are not weighed down by a fixed sum that they need to repay every month. When there are slow sales periods, the repayments come down, which is relief for businesses with poor cash flow.
Less Rigorous Qualification Requirements
Traditional loans frequently require stringent qualification standards, such as high credit scores and a long history of business operations. These standards can prove to be challenging for most small businesses to meet. Compared to traditional loans, Merchant Cash Advances are relatively more convenient to qualify for, particularly those with good credit card sales. Lenders usually look at the business’s daily sales volume and cash flow more than anything else.
Risks of Merchant Cash Advances
While an MCA can be a very tempting proposition for those businesses requiring capital on short notice, it does pose several risks that need to be thoroughly considered by business owners before taking advantage of this type of financing. Following are some of the biggest risks involved in Merchant Cash Advances.
High Cost of Borrowing
One of the most significant disadvantages of an MCA is the expense of borrowing. The factor rates charged on MCAs are usually much higher than the interest rates on conventional loans. In some instances, the expense of borrowing is several times more than that of a standard bank loan. This is due to the fact that MCAs are high-risk loans, and lenders charge more for that risk.
For example, whereas a conventional bank loan may carry an interest rate of 5-10 percent, the factor rate on an MCA can be anywhere from 1.2 to 1.5 or even more. This translates to the fact that companies could end up paying much more for the borrowed capital than they would under a conventional loan.
Daily Payments Can Be Burdensome
The daily repayment system of an MCA, although flexible, can also be a heavy load on businesses with variable or seasonal sales. While the repayment is calculated on the daily revenue of the business, small or irregularly selling businesses might struggle to maintain the frequent withdrawals. Daily payments might be daunting in some cases, especially if the business is already in financial difficulties.
Risk of Debt Cycle
Because the repayments are calculated as a percentage of daily sales, companies that are not doing enough business will struggle to repay the MCA on time. Consequently, the company might have to borrow more money to finance the repayments, creating a debt cycle which is more and more hard to stop. This can be especially risky for small companies with little cash flow or those with seasonal sales patterns.
No Limit on Overall Repayment Amount
As opposed to conventional loans, which carry a fixed period of repayment and a fixed amount of total repayment, an MCA does not have a limit on the amount the business will end up paying. The amount repaid in total is subject to the factor rate and the time it will take for the business to pay back the advance. If the business has sluggish sales, repayment of the MCA will take longer, which results in higher total costs.
Effect on Cash Flow
While the adjustable repayment schedule of an MCA may be beneficial under certain circumstances, it may also have a detrimental effect on the cash flow of a business. Ongoing deductions from sales can reduce the availability of money to meet operational costs, like payroll, rent, and utilities. This may place the business in a situation where it is in a continuous battle to meet its cash flow requirements, ultimately causing financial instability.
Possibility of Predatory Lending
A few of the lenders who provide Merchant Cash Advances are predatory lenders who charge very high interest rates and fees, making it almost impossible for businesses to repay the advance. These lenders tend to target small businesses that might be in dire need of instant cash and do not have a complete understanding of the terms and charges of the MCA. Consequently, a few businesses become stuck in a debt cycle that they cannot break.
Conclusion: Is a Merchant Cash Advance Right for Your Business?
Although Merchant Cash Advances can give immediate access to funds and may be a desirable option for businesses with bad credit or those needing cash flow in a hurry, they are associated with high risks that need to be weighed thoroughly. The steep cost of borrowing, daily payback format, and risk of debt cycles make MCAs a high-risk option for most business owners.
Before determining whether to get an MCA, business owners need to examine their financial profile and ascertain if they can handle the repayment period comfortably. They also need to explore other finance options, such as bank loans, lines of credit, or small business grants, which have better terms and lower fees.
In summary, although Merchant Cash Advances can appear to be a convenient solution to short-term financial requirements, they should not be undertaken lightly. By knowing the risks and taking the time to consider the long-term effect, business owners can make better decisions regarding whether or not this form of funding is appropriate for them.
