As a business owner, you have plenty of options when it comes to financing your company. If you’re in need of a loan, there are options such as SBA loans, equipment financing loans, startup business loans, and many more. In cases where a business is unable to obtain one of these types of loans, some business owners will choose the option of a merchant cash advance. Although this type of financing has its appeal, it may not be the best financing option for you or your business. In this article, we’ll explain what a merchant cash advance is and why it could be harmful to your business in the long-run.
What is a merchant cash advance?
Contrary to what many people believe, a merchant cash advance is not a loan. A merchant cash advance (also known as an MCA) is a financing option where the provider buys a percentage of a business’s credit card and debit card sales in exchange for a cash advance. Therefore, the cash advance and financing is based on the business’s future sales. The provider will take a fixed percentage from a business’s daily sales until the amount covers the advance. This is also known as a holdback.
In a merchant cash advance, the total amount you pay for your advance, as well as its interest, is calculated by taking the factor rate, which can range anywhere from 1.2 to 1.5, and multiplying it by the advance amount. For example, if you apply for a merchant cash advance and receive $15,000 with a factor rate of 1.3, then the total amount (including interest) you need to pay back for the advance is $19,500. The difference between the two amounts ($4,500) covers the interest and fees for the cash advance.
Why do businesses opt for a merchant cash advance?
Since the advance is based on future sales, merchant cash advances are beneficial options for businesses that don’t have a good business credit score. Applicants do not need any collateral or assets in order to secure the advance, making it an unsecured financing option. As a result, merchant cash advances are more lenient in requirements and are able to offer businesses more flexibility in financing.
Unlike loans which have longer repayment terms and longer funding processes, merchant cash advances can finance applicants within a day or a few days. This makes it easy for struggling businesses to access cash quickly if there is an emergency, whereas a bank would not be able to provide a loan as timely. The money is quickly deposited into your bank account and will be withdrawn from your account for repayment using an automated clearing house payment (ACH).
So why are merchant cash advances dangerous?
On the surface, merchant cash advances seem like they are a great option for a struggling business that needs quick financing. There are plenty of pros for this type of financing: quick access to cash, lenient qualifications, an easy application process, and convenient payment and repayment processes. However, the major drawbacks begin to surface as you dig deeper into the numbers.
Looking at the real numbers
Merchant cash advances are notoriously known for its high APR rates, which can go into the triple digits in certain circumstances. Depending on the provider as well as your terms, when you convert your factor rates and percentage into an annual percentage rate, you’ll see that merchant cash advances have APR rates that can be anywhere from 8% to well over 125%.
As you calculate the daily payment for your holdback, you can also see how the fixed percentage rate can affect your business’s daily revenue. To see the numbers clearly, we can use the previous example of receiving a cash advance of $15,000 at a factor rate of 1.3, which equates to a total repayment of $19,500. Let’s say your provider sets your daily fixed percentage rate at 15%. To calculate your holdback, which is the daily amount paid to your provider, you need to take the total sales of the day and multiply it by the fixed percentage.
For example, if your total credit card and debit card sales for the day is $4,000 and the fixed percentage rate is 15%, then the amount that you will need to pay to the provider for the day is $600. Suppose your average monthly revenue is around $20,000. If you were to calculate the monthly amount for your holdback, it would be $3,000, which would mean you could pay off your total advance of $19,500 in about 6-7 months.
At first, these amounts may seem reasonable. However, when you use an APR calculator to examine the actual annual percentage rate of the example above, it comes out to a rate of 102.46%. This just shows you how tricky the numbers can be when applying for this cash advance. With interest rates so high, merchant cash advances are the most expensive financing option for business owners. On top of this, merchant cash advances are not as heavily regulated as loans, which have interest rate caps. This means that providers can legally charge whatever interest rate they want, which could be unfavorable to business owners.
Getting stuck in debt cycles
Business owners who are struggling to make ends meet may have a large disadvantage when taking a merchant cash advance. Just as a debt cycle could be triggered for a borrower in a payday loan, a debt cycle could be started for a business owner with a cash advance. Because of the large number of payments and the high-interest rate, it can be shaky territory for businesses that are already strapped for cash. Loan stacking is common for borrowers who are struggling to cover their debts, and unfortunately, in dire financial circumstances, some business owners end up taking a secondary merchant cash advance in order to cover the costs of the first, creating a unnecessary cycle of debt.
Find safer alternative options
Although merchant cash advances are quick and dirty solutions for a business in need of emergency cash flow, it can have negative long-term consequences for a struggling business. Instead of risking the cycle of debt, struggling business owners should find an alternative to merchant cash advances by looking for lenders who can provide other financing options. To learn more about alternative loan options, read our articles on business financing.