Introduction
Merchant Cash Advance, or MCA, is an advanced financial offering to help organizations avail funds within short notice quickly. It is an attractive alternative for businesses that are not likely to qualify for standard loans based on bad credit history or other fiscal limitations. The demand for MCAs has increased in the last few years as businesses seek alternate sources of financing. Though they provide quick financing and adaptability, there are a number of hidden risks involved that render them a risky alternative for certain entrepreneurs. In this article, we will be looking at what a Merchant Cash Advance is, how it functions, and why it may be dangerous even with its guarantee of quick funding.
Understanding Merchant Cash Advances
A Merchant Cash Advance is truly a sum of money advanced to a business against a percentage of its future sales on credit cards. Rather than a set schedule of repayment, businesses pay off the MCA through a day or weekly pull from their sales. This method of repayment comes in the form of the level of sales, so the greater a business sells, the higher it will pay back.
MCAs are usually considered to be a fast fix for companies that urgently require funds. MCAs are usually simpler to secure compared to bank loans, which makes them a popular option for entrepreneurs who do not have an excellent credit rating or have already been rejected for a traditional loan. The approval process is normally much quicker compared to traditional loans, with some MCAs being approved and funded in just a matter of days.
How a Merchant Cash Advance Works
When a company applies for an MCA, the lender will review its credit card sales over a time period, typically six months to one year, to establish how much money the company can repay. Once approved, the lender gives a lump sum of cash that is usually a multiple of the company’s monthly credit card sales.
The repayment of the MCA is usually made through a fixed percentage of the business’s daily credit card sales. This percentage is agreed upon when the advance is provided. The more the business sells, the greater the repayment, and if less is sold, the repayment amount will be less. This repayment plan can give businesses leeway because they only pay back a fraction of their sales, and the payments can vary based on business performance.
Apart from the percentage of sales, the factor rate will also be charged by the MCA lender. The factor rate is a multiplier that decides how much in total the business will pay back. For instance, if a company is funded an MCA of $100,000 with a factor rate of 1.3, the company will have to repay $130,000 in the long run. The factor rate is different from an interest rate, but both play the same role in finding out how much the company has to repay altogether.
Why Merchant Cash Advances Are Appealing
Among the primary reasons why companies opt for Merchant Cash Advances is the rapid access to funds that MCAs provide. Conventional loans take weeks or sometimes months to process, while MCAs can be funded and approved within days. This can be greatly helpful for companies that require immediate access to funds to settle expenses, buy inventory, or invest in expansion opportunities.
Aside from speed, the simplicity of qualification is also a plus. Whereas conventional loans demand that businesses qualify on strict criteria, including a minimum credit score, profitability history, and solid balance sheet, Merchant Cash Advances are far more accommodating. The lender’s only concern is the business’s future credit card sales, so businesses with poor credit scores or bad financial history can still qualify.
MCAs also allow some repayment flexibility. Because repayment is based on sales, business entities with revenue that varies need not be burdened with having to make the same amount each month. With this, the business entity does not have to face cash flow issues during less active months. When the sales of the business are low, the amount paid back will likewise be lower, and this helps the business at least somewhat at difficult times.
Risks of Merchant Cash Advances
While MCAs are appealing, they do come with major risks that many business owners are unaware of. The factor rate is the biggest risk, and this is how it works: although MCAs provide immediate access to money, the factor rate can make MCAs a very costly source of funds. While traditional loans provide interest, MCAs employ a factor rate, meaning the entire amount repaid can be several times higher than the lump sum received upfront.
For instance, if a company obtains a $100,000 MCA with a factor rate of 1.5, the company will end up paying $150,000, irrespective of how fast the loan is paid back. This can get MCAs to be substantially more costly than other forms of financing, particularly if the company has a significant amount of debt. Sometimes, companies end up paying twice or even thrice the money they borrowed in the first place.
Another danger of MCAs is the repayment schedule. Because repayments are based on credit card volume, companies experiencing low sales for a slow time of year could struggle to meet the payments needed. Even when the company isn’t making enough sales to be able to repay the daily or weekly payment, the lender still expects to get paid. This can create a debt cycle, wherein companies cannot repay the MCA and are compelled to obtain further advances to pay for their liabilities.
In addition, the daily or weekly deductions from credit card sales can put a strain on a business’s cash flow. This constant outflow of funds can make it difficult for businesses to manage other expenses, such as payroll, rent, and utilities. In some cases, businesses may find themselves in a position where they are unable to pay for necessary expenses due to the large portion of their revenue being automatically deducted for MCA repayment.
The Insufficiency of Regulation in the Merchant Cash Advance Market
The largest issue with Merchant Cash Advances is that there is insufficient regulation in the sector. Traditional loans are regulated to a great degree and overseen by strict requirements, whereas MCAs are fairly unregulated. This implies that lenders have freedom to charge the fees they like, and firms might not actually know the total cost of their advances.
In other instances, lenders might charge hidden charges, like origination fees, processing fees, or prepayment penalties, that can add to the overall cost of the advance. These charges are not necessarily disclosed in advance, and it becomes challenging for businesses to have a complete grasp of the financial implications of obtaining an MCA.
The absence of regulation also implies that there is minimal control to safeguard businesses against predatory lending. Predatory lenders might exploit businesses in precarious situations by providing MCAs with extremely high factor rates, onerous terms that are hard to fulfill, or unjust repayment terms. Since MCAs tend to be offered as a simple and fast method of obtaining funds, business owners might not completely understand the risks until it is too late.
Alternatives to Merchant Cash Advances
Although MCAs might appear to be a good choice for businesses that need immediate funding, there are alternative financing options that can be less expensive and less risky. Conventional small business loans, lines of credit, and peer-to-peer lending websites are all alternatives that have lower interest rates and more stable repayment terms. These alternatives can be longer to arrange than an MCA, but they can give businesses a more stable financial base in the long term.
Another option is invoice financing, through which companies can borrow against outstanding invoices. It is a good choice for companies with long payment terms but instant need for cash flow. With invoice financing, companies can tap into a portion of the value of unpaid invoices without sacrificing a percentage of future sales.
Lastly, the owners of businesses must also look into equity financing, wherein they trade company ownership for capital. Although this involves relinquishing some control of the business, it is a viable means of raising funds without going into debt or assuming a repayment timetable.
Conclusion
Merchant Cash Advances provide a fast and easy method of financing for companies when they require the funds the most. Still, they pose huge risks that can bring about financial ruin if not carefully dealt with. The expensive borrowing costs, the ambiguous repayment scheme, and the industry’s lack of regulation all combine to make MCAs a highly risky financing tool for companies.
Prior to choosing an MCA, entrepreneurs need to take a close look at their financial condition and seek other forms of financing that can be more cost-effective and less risky. Although an MCA can appear to be an easy fix in the short term, the long-term effects of incurring high-cost debt may not be worth the advantages. As with any financial choice, one must understand the terms and risks involved thoroughly before entering into a Merchant Cash Advance.
