Sometimes even the savviest small business owners find themselves with money tied up and unable to cover operational expenses. Merchant cash advances and working capital loans are financing options that can tide small business owners over with liquid capital delivered directly to their bank accounts. If, like many business owners, you need more cash on hand, you may be considering one of these types of financing. When handled properly, these financing tools can keep a cash-hungry business running, but beware – if misused, they may lead you into a vicious cycle of debt.
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|Criteria||Merchant cash advance||Working capital loan|
|Loan vs. non-loan||Technically not a loan||A loan by definition|
|APR||Often exceedingly high||Often reasonable|
|Risk||Potentially high||Low to modest|
|Approval||Highly likely, even if you have a poor borrowing history||Unlikely if you have a poor borrowing history|
|Use allowances||No limits||Typically no limits, except with equipment loans|
A merchant cash advance is a form of financing that isn’t truly a loan. Instead, it is a financing option that provides immediate cash in exchange for a business’s future credit card sales receipts. In essence, when a business accepts a merchant cash advance, it sells the revenue of its future credit card sales for immediate payment.
Merchant cash advances are often used by seasonal businesses or those with cyclical sales to keep up cash flow during slow times of the year. Business owners can pay operating expenses and wages when sales are slow, then repay the merchant cash advance when their sales volume picks up and generate a profit. Since merchant cash advances are backed by projected sales, businesses with subpar credit scores also often rely on them for an injection of short-term working capital.
Besides operating expenses and wages, businesses use merchant cash advances for financing equipment, running marketing campaigns, hiring new employees, expanding inventory, buying materials or acquiring property.
A merchant cash advance traditionally offers an influx of capital based on a business’s expected credit card transactions over the course of a specified term. For example, if your business receives a $100,000 merchant cash advance with a 52-week term and a factor rate of 1.25, you would have to pay back $125,000 in credit card sales over the course of the next year.
Merchant cash advance repayment generally breaks down into weekly payments, said Randall Richards, director of business development at RFR Capital. According to Richards, cash advance companies often draw the payment directly from a business’s bank account rather than its merchant account associated with credit card transactions.
“Weekly payments would be based on sales and a multitude of factors,” Richards told business.com. “Someone who is only doing $20,000 per month in sales won’t qualify for a $100,000 [advance]. The sales have to support the payment, or else the lender is at risk of losing money.”
Since merchant cash advances are based on sales, borrowers with poor credit can usually access them even when they can’t obtain a traditional loan. Of course, this flexibility means that merchant cash advances are more expensive than bank loans.
“Merchant cash advances are one of the alternatives today for people as they move down and become less and less creditworthy,” said James Cassel, co-founder and chairman of Cassel Salpeter & Co. “Merchant cash advances could carry the equivalent of 40% interest rates.”
Cassel clarified that merchant cash advances don’t carry an interest rate of their own, but the cost of a cash advance can be measured against the interest rates associated with a traditional loan. For example, in Richards’ hypothetical of a $100,000 merchant cash advance that costs a business $125,000 over a 52-week term, the interest rate equivalent would be 25%. That is much higher than the interest rates on many bank loans, which might cost a business with great credit 2% to 5% of the loan’s principal value, Cassel said. Understanding your factor rate and whether you can negotiate it is useful in reducing the cost of a merchant cash advance.
The first requirement for most merchant cash advance lenders is that you accept credit card payments, since these transactions will be used to repay the loan. Not only do you need to accept credit card payments, you need to show that you garner enough credit card sales to pay back the loan in a timely manner.
This is some other information you should have readily available:
Your proof of citizenship and a copy of your business’s lease will also help you to qualify.
Lenders will look at how long you have been in business, your monthly revenue and your credit score. Their goal is to assess whether you have a healthy, thriving business that will be able to pay them back. The approval depends on these documents showing that your company is profitable and capable of repaying its debt.
“You can qualify for a merchant cash advance by first applying through a reputable company,” said Xavier Epps, financial expert and CEO of XNE Financial Advising LLC. “Do your research first. Each company will have different requirements, but overall, these companies require less paperwork than traditional banks. The important thing is to make sure you can provide documentation for your business.”
Merchant cash advances can be useful tools for many businesses. Whether you are a seasonal business weathering the slow season or a business with cyclical sales, such as a manufacturer that makes most of its sales in Q4, merchant cash advances can offer support. However, for struggling businesses, relying on a merchant cash advance to stay afloat could be the beginning of a death spiral.
“Sometimes it’s a business that’s so excited and thinks it can’t lose but does,” Cassel said. “Other times, it’s a business that’s in deep trouble and just trying to stay afloat, waiting for the one more sale … just trying to survive, because then they believe they will thrive. Sometimes you have to question the viability of the business.”
Like all forms of financing, merchant cash advances have both pros and cons. If you plan accordingly, they could be an effective tool for maintaining healthy cash flow and operating your business profitably. When used improperly, they can expedite the demise of a failing business. Managing a merchant cash advance to the benefit of your business means understanding the pros and cons and how to navigate them.
The term “working capital loan” refers to a small business loan or alternative financing option designed to cover near-term costs with a short repayment date. Businesses use working capital loans to cover a wide range of operational costs. These are some types of financing that could be considered working capital loans:
Borrowers who require a working capital loan might need it for the same reasons a company seeks out a merchant cash advance, such as to pay employee wages, purchase equipment, acquire new properties or expand inventory. They are also commonly used by seasonal businesses or those with cyclical sales. [Read related article: How to Decide Which Type of Business Loan Is Right for You]
Before you apply for a working capital loan, you should understand how much it costs to cover your day-to-day expenses so you’ll know how much capital to ask for.
Epps said some lenders will ask for an overview of your business’s sales, so it’s important to collect several months’ worth of bank statements, balance sheets and tax returns. You will also need to provide your Employer Identification Number, your business mortgage or lease documentation, and your business credit score.
It also helps to be prepared to answer questions like these:
“Thanks to fintech, many working capital providers have online applications where you can securely provide information on yourself, your business, and some type of verification, like bank statements, credit card processing statements, connecting your accounting software or connecting your selling platforms,” said Alex Sklar, head of business development and strategic partnerships at Payability. “Depending on your business and the partner you chose, funding can happen as fast as 24 hours.”
Working capital loans tend to be less risky than merchant cash advances while serving similar purposes. However, it’s not uncommon for the qualifying requirements to be stricter, since working capital loans are often based on creditworthiness or a form of collateral more tangible than projected future sales. Here’s a closer look at the pros and cons of working capital loans.
If you need fast cash, consider a merchant cash advance or working capital loan.
Many businesses need help to support their cash flow. After all, cash flow is oxygen to a business: Without it, it won’t be long before the business chokes and operations stall. Merchant cash advances, lines of credit and working capital loans are financing options that can buoy up your business while you await future sales. However, without a clear plan in place, these forms of lending can spell disaster for a business.
To make the most of any type of financing, you should have a clear road map to repayment and the ability to execute that plan successfully. Good recordkeeping and a strong understanding of your business are critical.
Accepting a loan in hopes that you might generate future sales to cover it is a major risk. When in doubt, consult an accounting professional before accepting money from a lender of any kind. With a bit of planning, merchant cash advances and working capital loans could be precisely the support you need until you’re back on track to profitability.
Simone Johnson and Adam Uzialko contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.