Introduction
Merchant cash advances more commonly known as MCAs are a type of funding that enables companies especially small and medium businesses to access money quickly This source of funding has become increasingly popular with business owners who do not qualify for conventional bank loans or require money immediately to meet short term expenditures Even though merchant cash advances provide a safety net to strapped companies they have serious financial implications that should be known prior to engaging in such arrangements
Essentially a merchant cash advance is not a loan but a cash advance on the future earnings of a business Generally a financing firm advances a lump sum to the business in return for a percentage of daily credit card sales or total revenue until the advance is paid back plus a fixed fee This structure makes MCAs especially appealing to businesses with consistent sales volumes and those that have high credit card transaction rates such as restaurants retail shops and service providers
How Merchant Cash Advances Work
The procedure of obtaining a merchant cash advance is normally quick and involves little documentation relative to other forms of financing After submitting an application and basic financial data such as daily sales volumes the lender assesses the business’s suitability If accepted the business receives a sum of money in the form of cash within days at times even within 24 hours
Repayment starts almost immediately and is usually made through automatic payment from day-to-day credit or debit card transactions The number deducted each day varies with the negotiated percentage referred to as the holdback rate which varies between five percent and twenty percent This goes on until the entire advance and the fees of the lender are reimbursed
The repayment arrangement is also linked to the performance of the business such that on high sales days the amount to be repaid is high and on low sales days the amount is low This flexible repayment arrangement is one of the aspects that invite many businesses to MCAs particularly those with variable revenue bases
The Attraction of Quick and Convenient Funding
For many small business owners particularly those who have been rejected by conventional lenders because of poor credit records or inadequate collateral merchant cash advances provide an immediate solution The application for MCAs does not significantly depend on credit scores or a lot of financial information Rather the focus is laid on the capability of the business to make daily or monthly sales making it open to a wider scope of applicants
In addition the rate at which money is made available is another significant advantage With some lenders providing same day or next day funding businesses with emergency costs or surprise opportunities can maintain operations without significant disruption This feature of merchant cash advances has been especially useful in periods of economic uncertainty or when cash flow is low
The True Cost of Merchant Cash Advances
Though the advantages of merchant cash advances are evident the real expense of this financing can be buried within sophisticated fee schemes and stiff payback terms While conventional loans have annual percentage rates that interest charges are computed by MCAs apply a factor rate usually in a range between one point one to one point five As an example a business that takes out a ten thousand dollar loan using a factor rate of one point four will repay fourteen thousand dollars independent of the duration it takes to do so
This arrangement can have a corresponding equivalent annual percentage rate that is far higher than what most conventional lenders charge Occasionally the effective APR of a merchant cash advance can rise above one hundred percent particularly when the advance is paid back in a few months This makes merchant cash advances among the most costly types of business financing out there
The transparency of fee disclosure can also be an issue for business owners
Many lenders fail to give a clear breakdown of charges or the equivalent APR making it hard for businesses to compare funding options or know the long term implications of the advance
Risks Associated with Merchant Cash Advances
The most risk that comes with merchant cash advances is the financial strain that they can cause a business particularly a struggling one with cash flow challenges Since they are repaid daily or weekly depending on their sales businesses can find themselves stuck in a situation where much of their earnings is used to pay back the advance with little left to cover other operational expenses
This repeated siphoning of cash flow can stifle growth prevent reinvestment in the business and even result in default If a company cannot make the daily payments it could be sued or have to shut its doors forever
Also since MCAs are not technically loans they are not subject to the same laws that cover traditional lending This lack of regulation means lenders do not have to follow fair lending practices and can employ aggressive methods to get payments This can place undue pressure on business owners and create a stressful financial climate
The Debt Cycle Trap
One of the most concerning aspects of merchant cash advances is the potential for businesses to fall into a cycle of debt Due to the high cost of repayment some business owners take out additional MCAs to cover the payments of the first advance This practice often referred to as stacking can quickly spiral out of control
With each new advance the repayment burden increases and businesses may find themselves using a growing portion of their revenue just to stay afloat As the number of advances grows so does the difficulty in managing repayments and maintaining healthy operations
At times companies are compelled to invest more in returning advances than paying workers suppliers or rent This isn’t a long-term sustainable habit and can finally end in company bankruptcy The cycle of debt which merchant cash advances creates is an enormous risk factor which should be considered prior to considering this sort of funding
Limited Long Term Benefits
Whereas merchant cash advances may offer temporary relief they have limited long term benefits In contrast to standard loans with typical lower interest rates and fixed repayment periods MCAs do not help to build business credit or enhance financial stability Since MCAs are derived from sales rather than standard credit calculation they do not assist businesses in developing a good credit history with banks and other lenders
In addition the lack of formal repayment terms hinders business owners from budgeting for future financial requirements The uncertainty of daily deductions can make budgeting and long term strategic planning challenging
Companies looking to expand or expand further might find that using merchant cash advances generates more problems than solutions The fact that traditional funding has been denied because of previous MCA contracts can even restrict future prospects and make it more difficult to obtain cheaper forms of financing
Who Should Consider Merchant Cash Advances
Regardless of the numerous hazards merchant cash advances can be an option for some businesses In fact those with strong daily sales and fluctuating revenues by season might appreciate the ease of repayment Another category of companies that might prefer MCAs would be those which require immediate financing to take advantage of time sensitive opportunities or address unexpected expenses
But it is important that companies do extensive research and are completely aware of the terms and conditions of the advance prior to signing up for it Taking advice from a financial consultant or legal expert can ensure that the company is not signing a deal that might compromise its future financially
Merchant cash advances must be considered a last option and not an initial source of capital They are best applied to short term requirements where the expense can be justified by the possible return on investment
Finding Alternative Financing Sources
With the risks involved with merchant cash advances business owners should consider alternative options for financing that might be more sustainable and affordable Some of the alternatives are bank or credit union small business loans that have typically lower interest rates and a more structured repayment schedule
Other alternatives include lines of credit that offer revolving access to money when needed and equipment financing which enables companies to buy required equipment while paying the cost over time Invoice factoring is another alternative where companies sell outstanding invoices to a third party in return for cash upfront
Crowdfunding and peer to peer lending sites have also become viable sources of funding providing business owners with access to funds without the excessive fees of MCAs These sites tend to have more open terms and may be more accommodating to businesses with less than stellar credit
Government backed loans, such as those provided by the Small Business Administration, can also be a valuable resource, offering low-interest financing and assistance to expanding businesses
Conclusion
Merchant cash advances represent an attractive remedy for those firms requiring immediate capital particularly those businesses that experience troubles securing traditional financing Their convenience streamlined documentation and swift funding cycle have made them accessible to most small business owners
But high cost lack of oversight and opportunity to create a cycle of debt render merchant cash advances a dangerous choice Companies need to very carefully consider whether the advantage is worth the disadvantage and whether short term profit is worth long term cost
Prior to seeking a merchant cash advance it is recommended that other financing alternatives be investigated that offer greater transparency and reduced costs Knowing the real implications of this form of funding is essential to making sound financial decisions that benefit the long term health and development of a business
