Introduction
Merchant cash advances (MCAs) are rapidly becoming more prevalent as a business financing tool among small business owners who are in need of money quickly. MCAs present an alternative option in contrast to conventional bank lending that is less involved and speedier. While they are attractive, merchant cash advances do carry substantial risks that business owners might find themselves neglecting. This piece of writing plans to dissect what exactly a merchant cash advance is, how one operates, and why it may not always be the optimal financial solution for businesses, particularly in the long term.
What is a Merchant Cash Advance?
A merchant cash advance is a form of financing in which a lender advances a lump sum of money to a business in return for a percentage of its future sales. Unlike fixed monthly payments on traditional loans, MCAs are paid back based on daily or weekly credit card sales or total revenue. Essentially, an MCA is not a loan but, instead, a purchase of future sales that will be reimbursed by the lender through daily deductions off the business’s credit card revenues.
It is a relatively simple process to get an MCA. Business owners would usually be asked to submit some general information regarding their sales volume and cash flow. Approval in most instances can be obtained in a matter of days, and the funds can be transferred into the business account almost instantaneously. This ease and swiftness contribute to why MCAs are so appealing to small business owners who require immediate capital.
How Does a Merchant Cash Advance Work?
The operation of a merchant cash advance differs significantly from other loans. If a business obtains an MCA, it is not actually borrowing money in the same way as for a traditional loan. Rather, the lender is buying some of the company’s future earnings, and this will be paid back as the company makes sales. The company undertakes to repay the MCA by deducting daily or weekly, normally depending on the business’s credit card sales, although certain contracts may be based on overall gross.
For example, when a company is given a cash advance of $50,000 and undertakes to reimburse the lender with 10 percent of its credit card sales made daily, the lender will make the 10 percent of the daily sales daily until the full payment is realized along with extra fees. Such withdrawals go on until the amount as agreed has been reimbursed by the business. If the company has an unusually good day of sales, it can repay the advance earlier, but when there is slow sales, the repayment will be lower, so it takes longer for repayment.
The Attraction of Quick Funding
One of the primary attractions of merchant cash advances is how quickly businesses can receive funding. In an age where cash flow problems can come out of nowhere, business owners will need funds quickly to pay bills, buy inventory, or capitalize on a growth opportunity. Traditional loans take weeks or even months to obtain, while MCAs can be approved and funded within days.
For small companies that lack good credit or collateral to provide, an MCA might appear to be a great alternative. Since the lender is basing their decision on future business sales, the approval process will typically be less complicated than with traditional loans. The lender is less interested in the credit score of the business than it would be in a bank loan, and most lenders only need simple documentation like bank statements and sales records.
For companies that experience uneven cash flow or fluctuating sales cycles, an MCA can be a lifeline to continue operations in an uninterrupted manner. Since the repayment is directly linked to sales, those companies that are going through ups and downs in their income can enjoy the advantage of flexible repayment terms, which will fluctuate on the basis of how much business is coming in.
The Risky Nature of Merchant Cash Advances
In spite of the convenience and velocity of merchant cash advances, they are subject to risks inherent in them that business owners must be aware of prior to seeking out this option. The most critical of these risks is the high cost and risk of debt cycles that keep companies in operation but unable to keep up.
High Costs and Fees
Perhaps the most detrimental aspect of a merchant cash advance is the cost. As opposed to the fixed interest rates on conventional loans, MCAs carry what amounts to an implied rate of interest, which tends to be considerably greater than that of a standard business loan. Indeed, based on the lender and the advance terms, the MCA can cost anywhere between 40 percent and 350 percent per annum, much greater than what the majority of companies would be saddled with in a traditional loan.
This is a high cost, in part, because of the risk that the lenders take by providing advances to companies with potentially unstable cash flow. Because the lender is counting on future sales, there is always a risk that the company will not be able to generate sufficient revenue to fulfill the repayment terms. In this event, the lender will still demand repayment, which can result in increasing fees and extra charges.
Complex Repayment Terms
Another disadvantage of merchant cash advances is the payment terms. Because MCAs are connected with daily or weekly sales, companies with variable income may not be able to tell exactly how much they owe in a given time period. In slow months for sales, companies can find themselves having to struggle to maintain the repayment, which can result in their gaining even more debt. The fact that repayments are daily or weekly provides less flexibility to the business to manage its cash flow, and this may deter it from being able to invest elsewhere in the business.
Also, since repayment terms are in relation to percentage of daily sales, businesses that have good sales months might repay the MCA sooner than expected. While this might sound like a positive, it can have the unintended effect of causing the business to sacrifice good cash flow that otherwise could be reinvested within the business. Conversely, businesses that see a decline in sales will still be required to make monthly payments, even if they lack the revenue to support them.
Risk of Falling into a Debt Cycle
One of the most critical dangers involved with merchant cash advances is that businesses can become trapped in a cycle of debt. Since the MCA is based on a business’s future sales, if the business finds it difficult to meet its sales targets, it will find it hard to pay back the advance. This causes the business to look for another MCA to fill the gap, which only serves to add to the debt. This borrowing and repayment cycle can rapidly become unviable, particularly if the company is already facing cash flow issues.
This borrow-and-repay cycle frequently has the effect of business owners borrowing more money than they can afford, and this can cause severe financial hardship. The expense of the advance, combined with the reality that businesses are frequently in need of taking out new advances in order to fulfill their outstanding obligations, can cause a situation in which the business cannot create sufficient revenue to pay back its debts and is eventually driven to bankruptcy.
Absence of Consumer Protection
Merchant cash advances are usually not regulated as traditional loans are. Therefore, business owners might not enjoy the same degree of consumer protection or legal recourse that they would with a typical business loan. Most MCA lenders are not obligated to reveal the entire terms and fees of the advance before the agreement, so business owners may not fully know what they are signing up for. In other instances, businesses may be charged hidden charges and fees that make the total amount paid for the advance considerably more than initially thought.
Also, some MCA lenders might use aggressive collection practices if the company becomes delinquent in payments. These can range from harassing phone calls and lawsuits to the taking of business assets. Because MCA contracts are frequently not under the same regulatory guidelines as standard loans, companies might have few alternatives when they become financially troubled.
The Effect on Long-Term Business Well-being
Although a merchant cash advance can be a source of quick relief for a business short on funds, the long-term effect of this type of financing can negatively affect the health of the business. The costs, complex repayment schedules, and potential for falling into a debt trap can all negatively affect the profitability and growth potential of a business.
Many companies that utilize merchant cash advances to address short-term liquidity problems could find that they cannot reinvest in their business or invest in expanding their product or service. This can hamstring growth and get the business trapped in a pattern of borrowing to pay for continuing expenses. Eventually, this can keep the business from realizing long-term stability or scaling appropriately.
Conclusion
Merchant cash advances provide a quick and simple means for small business owners to obtain capital. But the risks involved in this type of financing must not be overlooked. The exorbitant fees, complex repayment schedules, and possibility of debt cycles render MCAs a risky choice for businesses that already have cash flow problems. Prior to making a decision to obtain a merchant cash advance, business owners need to carefully evaluate all of their financing alternatives and consider the long-term effect on their financial well-being. Although an MCA can provide a short-term solution, it may not be the ideal choice for guaranteeing the long-term viability of the business. Looking into other funding sources, including traditional loans or lines of credit, can offer a more stable financial alternative.
