Merchant Cash Advances Vs. Business Loans – What’s the Difference?
February 2, 2019 | Tools & Tips
There are several significant differences between a merchant cash advance (MCA) and a traditional business loan. In fact, the MCA was developed as an alternative to a traditional business loan to enable smaller merchants in industries often overlooked by banks – such as restaurants and retailers – to obtain fast access to short-term working capital. This article will analyze a few of the key distinctions between an MCA and a business loan to help you determine which is right for you.
It’s an Advance, Not a Loan
As the name implies, a merchant cash advance is, well, an advance! This means that the funder (the party making the cash advance) is merely providing you today with money that they expect you will earn in the future (your “future receivables”). In exchange for advancing you cash today – let’s say $100 – the funder is purchasing a fixed amount of future receivables – let’s say $110. As your business realizes revenue, it will pay a fixed percentage of each dollar earned until the funder has been paid the entirety of the receivables it purchased.
So, How is this Different Than a Loan?
There are several differences between an MCA and a loan. Some key differences include repayment amounts and repayment terms. Loans have a fixed repayment schedule over a finite period, without any fluctuation. The repayment schedule in an MCA has the potential to be variable because of fluctuations in revenue. Payment amounts in an MCA are tied directly to your revenue. At the outset, your MCA contract will define your payment amount, which is based on the funder’s best estimate of your projected monthly revenue. Since your payment amount is a percentage of your receipts, it can fluctuate due to an increase or decrease in receivables. Thus, if your payment amount increases, your repayment term becomes shorter, and vice versa. Indeed, if your business were to experience a downturn in receivables, you should contact your funder to adjust your payment amounts accordingly.
Do I Owe Interest?
While there is a cost to a merchant cash advance, it doesn’t come in the form of interest. Instead, when the funder makes an offer they will specify the amount of future receivables they are purchasing. The ratio of receivables purchased to the amount advanced is known as the “factor rate.” For instance, a funder advancing $100 in exchange for $120 of future receivables is said to be offering you a 1.2 factor rate. All else equal, a higher factor rate is more expensive than a lower one.
What if My Revenue Declines?
Though no one likes to find themselves in a situation of being unable to meet their financial obligations, it is sometimes unavoidable, often for reasons outside of one’s control. If your company hits a rough patch and business slows down dramatically, funders will work with you to align your repayments according to your receivables and revenue. Everyone is better off if your business survives – and, ultimately, thrives – so be sure to communicate proactively with your funder about any hardships you are facing so they can be part of the solution.
An MCA Sounds Great – Is it Hard to Get One?
MCAs were designed specifically to make it easy and fast for small business owners to access the cash they need to keep their businesses running smoothly. So, compared to a traditional business loan, getting an MCA is a piece of cake. Here are a few reasons why:
- Real-time Performance vs. Historical Track Record: While traditional business loans typically require a lengthy track record of profitability (two-to-three years), MCA funders focus almost exclusively on the trajectory of your revenue over the most recent three-to-six-month period. If you exhibit stable or growing sales volume spread across a diversified number of individual transactions, you’ll likely qualify for some amount of funding.
- Business Cash Flow vs. Personal Credit Score: Most banks and traditional lenders underwrite business loans using your FICO score as a preliminary screen. As a result, business loans are often inaccessible to small business owners, many of whom have sacrificed their personal credit to invest in their business. While most MCA funders do require a minimum FICO, they are primarily concerned with the strength of your business cash flow.
- Basic Documentation vs. Complete Financial Package: Aside from its more lenient underwriting criteria, the other main attribute of an MCA that appeals to small business owners is speed. Whereas traditional business loans require a lengthy list of documents, MCA funders only review financial information with a direct bearing on your ability to repay. This usually amounts to a credit application and a few months of bank statements. So, in the time it takes to assemble all the documentation required for a complete business loan application, an MCA funder could already have deposited cash into your account.
Let’s Review a ComparisonAs the table above illustrates, with an MCA, your payment – whether daily, weekly, or monthly – always remains a constant percentage of your revenue (the “Holdback Percentage”), whereas with a term loan, your payment always remains a fixed dollar amount. By scaling your payment up and down based on revenue, an MCA allows you to retain more cash when business slows down and pay off your advance quicker when business picks up.
So, Which Product is Better for Me?
As with most things in business, it depends. In most cases, a traditional business loan – usually from a bank or a credit union – will be less costly than an MCA and allow you a longer period of time to repay your borrowing. However, obtaining one can be difficult, time and labor intensive, and complex. To qualify, you’ll likely need a long track record of profitability, excellent personal credit, and reams of documentation. If you need cash quickly, have less-than-perfect credit, or want a straightforward process, a merchant cash advance may be right for you.
With either form of financing, making sure you have a clear use of funds and established plan for repayment is critical to success. Once you have those in place, a merchant cash advance or a traditional business loan is great for:
- Reducing inventory costs by purchasing in bulk
- Bridging cash flow gaps until you receive payment from clients
- Capitalizing on unanticipated growth or cost-saving opportunities
- Maintaining cash buffer to manage working capital swings
For more information on financing options for your small business, give us a call at 888-244-9099 to speak with a Forward Financing funding specialist today.