Merchant cash advance: 5 common errors to avoid
5 mistakes with a merchant cash advance
- Using cash advance to pay revolving expenses
- Not considering a business loan or line of credit
- Failing to calculate APR
- Overlooking repayment processes
- Taking the first cash-advance offer
Cash advances have developed a poor reputation over the years because of a few unscrupulous financing companies. Are cash advances safe? Yes — when handled wisely.
Cash advances are not technically loans but commercial transactions whereby a company purchases at a discount a portion of your future business receipts — credit or debit card sales in the case of merchant cash advances.
Cash advances can be a useful funding tool for your small or fledgling business; however, they are not suitable for everyone. Avoid these mistakes when taking out a merchant cash advance to avoid financial turmoil at your company.
1. Using cash advance to pay revolving expenses
If your company has used up existing business loans or credit lines and is seeking additional capital, a cash advance is likely not the ideal solution. Because of their high cost and rigid repayment parameters, it is easy to fall into further debt when using a cash advance to pay off other loans.
Moreover, it is also unsustainable to use a cash advance to make payroll and satisfy bills from suppliers. For a company with consistent monthly sales income looking to rapidly finance a specific repair, equipment purchase or other stand-alone expenditure, a cash advance may be a prudent option.
2. Not considering a business loan or line of credit
It is possible to obtain a merchant cash advance with bad credit, existing liens on your business or penalties for nonsufficient funds, but it will cost you significantly more than a conventional loan. If your business has a low credit score or insufficient collateral for a conventional loan, you may still be eligible for loans backed by the U.S. Small Business Administration or an unsecured business credit card.
If time to fund is your main concern, a business line of credit is one loan option that can give you access to cash in as little as a few days. Alternatively, if your company is sitting on outstanding invoices, obtaining funds through an invoice-factoring company is another alternative that could make sense for your company.
3. Failing to calculate APR
It can be complicated to understand how a cash advance works compared to other financing vehicles. The cost of a cash advance is not expressed as an annual percentage rate (APR) but rather as a factor rate of between 1 and 2. Factor rates can disguise just how expensive a merchant cash-advance rate really is.
For example, a factor rate of 1.4 on a cash advance of $10,000 would cost you $4,000 ($10,000 x 1.4 = $14,000). While that may not sound too onerous, assuming your future monthly sales revenue will be $5,000 and the cash-advance company is withholding 15 percent per month until the debt is repaid, the effective APR of this $10,000 advance is 46.55 percent. When compared to a conventional business loan or line of credit with a 6 percent APR for example, the difference is staggering.
When shopping around for cash-advance companies, make sure to understand all fees associated with the advance and calculate the APR to better illustrate the cost of the transaction relative to other loan products.
4. Overlooking repayment processes
The three most common ways of repaying a cash advance are through a holdback percentage, automatic clearinghouse payment or via a trust account — also known as a lock box. A percentage of your sales revenue will then be directly withheld periodically until the advance is repaid in full, plus fees.
Each process requires granting either the cash-advance provider or a third party, such as a credit card processor, access to part or all of your sales revenue, so the decision to pursue a merchant cash advance should not be taken lightly. Understand what stakeholders will be involved in repayment, what the payment term and frequency is — typically as often as every week or month — and when the process begins and ends.
While the repayment percentage is tied to the amount of sales your company generates, frequent payment obligations can drain cash flow and become a significant burden on your business.
5. Taking the first cash-advance offer
Once you’ve established that a cash advance is the best financing option for your business, make sure to compare merchant cash-advance companies and find the most cost-effective rate. Compare the repayment obligation to realistic sales projections to ensure you can shoulder the debt burden.
The key question is whether your business can afford to pay back the cash advance plus associated fees. If the answer is not a resounding yes, a different business loan is likely a safer option.