What Is It?
Merchant cash advance (MCA) is a type of financing mostly used by small businesses with high credit card sales which don’t want or can’t get a traditional bank loan.
How it works?
Lender (MCA provider) transfers cash to a business as a lump sum to be paid back as a fixed percentage of future sales or revenue. The repayment period is thus not fixed as MCA lasts until the initial advance plus a margin is repaid in full.
When it comes to MCA’s the most important terms to be mindful of are:
Advance amount – the lump sum a borrower receives upon approval. It depends on the financial strength of the business and projected credit card sales as these are indicative of the capability of repaying the debt over time.
Payback amount – the total amount a borrower must repay. It is calculated as the funded amount multiplied by a factor. If the advance amount is $100,000 CAD and you pay back $120,000 CAD, it means that a 1.2 factor is applied (which is also equivalent to 20%).
Holdback – pre-agreed share (percentage) of the daily credit/debit card receipts which are withheld by the lender to pay back the MCA. It typically ranges between 10% and 20% of borrower’s card sales, but will vary between different MCA providers and will also depend on borrower’s specific circumstances. If holdback percentage is 20%, this means that 20% of your card sales will be withheld by the lender until you repay the full payback amount which is equal to $120,000 CAD.
Pros and Cons of Merchant Cash Advance
MCA offers several advantages compared to traditional financing options, but those advantages come at a higher price, sometimes prohibitively high. Because of this, before applying for an MCA, business owners should gain full understanding of what it entails and what are the potential benefits and potential costs.
The benefits include:
1) Fast access to financing: unlike bank loans, MCAs are usually approved within days with easy application process and no out of pocket costs;
2) Flexibility as there are no fixed monthly repayments: since repayment is calculated as a percentage of your sales, in slow times you pay less and in good times you pay more;
3) Approval rate is much higher compared to bank loans (usually well above 90%) and you can be eligible even with a bad credit;
4) No collateral needed;
5) The amount you owe is fixed and you know it from the start: it is the initial advance plus a margin which is calculated based on a factor;
On the flip side, there are also a few disadvantages to this form of financing which need to be carefully considered in order to make informed decision whether this is the right path for your business. Some of them are:
1) It is one of the most expensive forms of small business financing as margins can be as high as triple–digits;
2) It’s a temporary, quick fix to business problems;
3) Your income stream is reduced daily as the lender automatically collects a fixed percentage of each of your sale;
4) It is a loan without maturity as repayment dynamics is conditional on your sales which varies over time. This means that your ability to make reliable financial plans will be hampered by this uncertainty;
5) Technically, this transaction is not treated as a loan and as such is not subject to regulation; This also means that it won’t help you build your credit.
6) You could fall into deeper debt which may further exacerbate the business problems you were trying to fix with an MCA. If the residual amount left after the lender collected holdback amount doesn’t leave enough cash to run the business, you can find yourself falling into deeper debt to finance the shortfall. This may lead to further problems. Particularly businesses with thin margins should be aware of this risk.
When is a Merchant Cash Advance a Solution?
MCA should be used to finance business expansion rather than to recover or save it.
Indeed, MCA is gaining popularity as an element of a carefully executed growth strategy.
A fast cash injection at the right time allows a business to seize market opportunities which would otherwise be forfeited, thus fuelling the next cycle of growth.
Examples of this would be investments like building inventory to meet rising demand, buying equipment or financing marketing strategy to expand into new markets. The key here is that the borrowed funds are used to generate higher income in the future as that is a prerequisite for the business to thrive on top of just being able to repay debt.
This is why borrowers need to give careful consideration to their businesses’ key metrics as these will provide indication whether this form of financing is sustainable for them.
In case of inventory acquisition, the key indicators to look at would be gross margin and inventory turnover – if the inventory turns over fast enough and the margin is robust enough to sustain the holdback amount, then it makes sense for a business to use MCA to finance inventory.
Alternatives to Merchant Cash Advance
If your business faces opportunity which is conditional on having quick access to working capital to finance the expansion, then it makes sense to use MCA.
Alternatively, you may want to explore other financing options with potentially better terms and additional benefits like building your credit.
These alternatives would include business loans, a business line of credit or a business credit card.