Summary: A merchant cash advance (MCA) is a form of financing that allows a company to sell a portion of its future sales in exchange for an immediate payment. This financing provides your company with funds to pay operational expenses and support growth. There are a few ways to repay the advance, depending on your type of business.
Initially, merchant cash advances were used solely to finance future credit card sales. Therefore, most clients were retailers and restaurants. The product has evolved to the point where cash advance companies can finance any future sales, regardless of how they are paid for. In this article, we cover the following:
- How do merchant cash advances work?
- Advantages of an MCA
- Disadvantages of an MCA
- Alternatives to MCAs
1. How do Merchant Cash Advances Work?
Most merchant cash advance companies consider their transactions to be purchases of future sales rather than loans. To determine how much funding to provide, the provider reviews your credit card sales, commercial sales, bank statements, and other information. These reports provide it with sales performance information, which gives it an idea of your future sales potential.
a) Determining the advance
The amount of funding your company gets, called the advance, is determined by a combination of your sales and the perceived risk of your account. Most cash advance companies advance anywhere from 80% to 150% of your average monthly revenue based on these parameters.
The amount you must repay is determined by multiplying your advance by a “factor rate.” The factor rate can range from 1.09 to 1.50. For example, a $100,000 transaction with a factor rate of 1.09 would require repayment of $109,000 over a period of time. Usually, the repayment period ranges from 3 months to 15 months.
The actual funding part of the transaction is relatively simple. The funds are deposited into your account once the financing is approved.
b) Paying back the advance
Your company can repay the advance to the finance company in a number of ways. If the advance is based on credit card sales, your company pays the finance company back through a percentage of its daily sales. This percentage, known as the “retrieval rate,” can range from 8% to 13% of your daily sales. It’s paid back by implementing split processing with your credit card processor.
If the advance is not based on credit card sales, repayment occurs by allowing the provider to deduct funds from your bank account via the ACH system (direct withdrawal). For this reason, some merchant cash advances are also referred to as ACH loans (or simply ‘business cash advances’). Although most finance companies debit your account every business day, some do so weekly.
2. Advantages of an MCA
The main advantages of a cash advance are speed and convenience. Most cash advances can usually be obtained within a few days. Additionally, qualifying for a merchant cash advance is much easier than qualifying for a business loan.
These advantages can make an MCA an attractive solution if your company has an urgent need for funding. However, cash advances have some important drawbacks that should be considered.
3. Disadvantages of an MCA
The main disadvantage of a cash advance is the cost of financing. As discussed in the previous section, this solution is expensive. As a result, companies should use this product only after careful consideration – and only if they are able to grow the business while repaying the provider.
Companies can run into serious problems if they aren’t able to repay the cash advance. If this happens, small businesses often resort to obtaining a second cash advance. They hope to use the new cash advance to meet the payment obligations of the first advance and continue running the business. Unfortunately, doing this only pushes the problem to the near future.
This situation often repeats itself. This causes the business owner to get a new advance to pay off the previous one. This cycle quickly becomes unsustainable.
Having multiple cash advances is called ‘stacking’ and is very risky. It often leads to serious financial problems or business failure. The best solution to this problem is to pay off the open cash advances either by consolidating them through a better facility or by some other means.
Another disadvantage of cash advances is that they provide funding as a single lump-sum payment, similar to a term loan. A fixed-amount product is usually not the best solution to solve ongoing cash flow problems. An MCA may provide a short-term solution, but you will probably need to refinance the advance a few times. Generally, recurring cash flow problems are best solved using revolving financing, such as a line of credit.
4. Alternatives to MCAs
There are some alternative solutions that can provide funding to small and growing businesses. Consider evaluating these and other options before making a final decision. Two popular options include:
a) SBA-backed Financing
Companies looking for a loan should consider SBA-backed financing. SBA-backed options, such as its 7(a) loan program, are competitively priced and are easier to qualify for than conventional loans.
The SBA also supports a Microloan program that provides up to $50,000 to small business owners. Microloans are easier to get than conventional bank financing and do not require good credit. Microloans often come bundled with financial consulting and management workshops, which can be ideal for small business owners. Microloans are available to companies that sell to retail and/or commercial customers. This alternative is highly recommended.
b) Invoice Factoring
Invoice factoring is a type of financing that can be used by companies that sell products and services to other companies. Commercial sales are often done on net-30 to net-60 day terms, which can create cash flow problems. Factoring your invoices provides you with an immediate advance that can be used to pay for business expenses.
Most factoring programs operate like revolving lines of financing. They are tied to your sales and can increase as your sales grow. Learn more about factoring vs. business cash advances.
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Note: We do not offer business cash advances.
Marco Terry is the Managing Director of Commercial Capital LLC and has over two decades of experience in asset-based finance. He has worked with small and mid-sized companies across the United States, Canada, and Australia. Marco holds a Master of Science in Finance.