Almost every small business needs a little extra funding from time-to-time. Maybe you’re just starting out, or maybe sales have been a little slower. Whatever the reason, there are many options to secure extra funding, and a cash advance is one of them.
What Is a Business Cash Advance?
A merchant cash advance (more commonly called a cash advance), is a financial transaction between your business and an alternative financing company. The company purchases your receivables at a discounted rate, essentially “advancing” your future revenue. This advance amount is the total amount of capital the funding company will advance you.
Merchant cash advances act as commercial transactions, not loans. They are unsecured and used a factor rate, which can be similar to a form of interest. This factor rate represents the discount taken by the merchant cash advance provider that is buying your future revenue.
For example, let’s say you expect future receivables of $10,000, are approved for an advance of $8,500 and are required to pay back the merchant cash advance provider a factor rate of 1.1. This means you’ll be paying back the provider $9,350. Factor rates vary, but generally fall between 1.1 and 1.5. Your rate is based on a number of different things, including business history, average monthly revenue, no negative balance days, other debt obligations and credit card sales. Beyond the factor rate, a cash advance does not involve any upfront fees or charge interest.
Is a Cash Advance Right for Your Business?
So how do you know if a cash advance is the right financial move for your business? Let’s go through a list of advantages and disadvantages.
Advantages of Cash Advances:
- Quick access to funding. Often, you can access the advance within 24 hours of approval without having to do heavy paperwork. The application process is easier than a traditional bank loan and approval rates are high because the funding does not rely on your credit score.
- There’s no collateral requirement. Because merchant cash advances are unsecured, you don’t need to put up any collateral. This means you won’t have to forfeit any personal or business assets if your sales sink and you’re unable to make your payments.
- Payments fluctuate based on sales. Your payment schedule is based on a fixed percentage of your credit card sales. Payments will adjust based on how well your business is doing, as opposed to a traditional bank loan with a payment that never changes no matter how strongly (or not) your business is performing.
- Automatic payments. Payments are automatic as a percentage of your daily sales for a predetermined amount of time.
Disadvantages of Cash Advances:
- It’s expensive. Your effective annual percentage rate could be in the triple digits. The total annual cost for a merchant cash advance typically ranges from about 40 percent to 350 percent of your advanced amount depending on the provider, size of the advance, additional fees, strength of your credit card sales and time taken to pay the advance in full. Compared to traditional bank loans with APRs ranging from 7 percent to 14 percent, this is far more expensive.
- No benefit to paying early. You do not get interest savings from early payment since you owe a fixed amount no matter what. This is different from a traditional small business loan, in which early repayment would result in less interest paid over time.
- No federal regulation. Merchant cash advances are structured as commercial transactions, so they are not subject to federal regulation. They are regulated by the Uniform Commercial Code in each respective state versus traditional banking laws such as the Truth in Lending Act. This could mean that merchant cash advances differ from one another significantly in terms of costs and payment structure. Contracts can also include many unfamiliar terms, making it confusing for the consumer and difficult to compare against other financing products.
- Higher sales results in higher APR. In a cash advance, your “APR” depends on how fast you pay the total advanced amount. If your sales are lower, your payments will be spread out over a longer period of time and your APR will drop. However, if your sales increase, you will inevitably pay your balance faster and in turn will increase your APR.
Alternatives to Merchant Cash Advances
Based on the above pros and cons, if you decide a merchant cash advance isn’t right for your business, there are other options to find financing.
- Short-term loans are a great option if your business needs fast cash to take care of any unexpected expenses, emergencies or a business opportunity. Terms and rates will differ based on your credit score and revenue.
- Equipment leasing allows you to replace business equipment at a much more affordable rate. The terms are longer and involve fixed monthly payments.
- Business credit cards are another alternative to merchant cash advances. There are credit cards for every type of small business and credit score, as well as some business credit cards with rewards programs that can benefit your business beyond just financing.
- Small Business Administration (SBA) loans offer financing for small businesses seeking low rates, longer terms, and smaller fees. An SBA loan is offered by conventional lenders and backed by the government if the borrower fails to repay it.
As a small business, having the cash available to sustain growth is a common challenge. While merchant cash advances are an option, it’s important to know that they’re not your only alternative. There are many ways to get the financing you need to push your business forward — whether that’s to get out of debt, free up cash flow or take on another business opportunity.
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