Merchant Cash Advances vs. Business Loans – What’s the Difference?

September 13, 2023 | Tools & Tips

There are several significant differences between a merchant cash advance (MCA) – also referred to as revenue-based financing or sales-based financing – 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 provider (the party offering the cash advance) is merely providing you today with the money they expect you will earn in the future (your “future receivables”). In exchange for advancing you the money today – let’s say $100 – the provider is purchasing a fixed amount of future receivables – let’s say $120. As your business realizes revenue, it will pay a fixed percentage of each dollar earned until the provider has been paid the entirety of the receivables it has purchased.

So, How is this Different Than a Loan?

There are several differences between an MCA and a loan. Some key differences include total payment amount and payment term. Loans have a fixed repayment schedule over a finite period of time, without any fluctuation. The payment schedule in an MCA can only be an estimate, because it has the potential to be variable due to fluctuations in revenue. Payment amounts in an MCA are tied directly to your 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 decreases, your estimated payment term becomes longer, and vice versa. However, with an MCA, you pay a fixed total amount, as agreed upon upfront, no matter how long the payment period may last.

Do I Owe Interest?

While there is a cost to an MCA, it doesn’t come in the form of interest. Instead, when the provider 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, your payments can be adjusted too. Everyone is better off if your business survives – and, ultimately, thrives.

An MCA Sounds Great – Is it Hard to Get One?

MCAs were designed specifically to make it easier and faster 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 simple. 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 providers 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 providers do require a minimum FICO, it is often lower than what a bank loan would require; MCA providers are primarily concerned with the strength of your business cash flow.
  • Basic Documentation vs. Complete Financial Package: The other main attribute of an MCA that appeals to small business owners is speed. Where traditional business loans require a lengthy list of documents, MCA providers only review financial information with a direct bearing on your ability to pay. 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 provider could already have deposited money into your account.

Let’s Review a Comparison

With an MCA, your payment – whether daily, weekly, or monthly – always remains a constant percentage of your revenue. 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 your balance quicker when business picks up.

So, Which Product is Better for Me?

As with most things in business, it depends. Typically, a traditional business loan – usually from a bank or a credit union – will be less costly than an MCA and allows you a longer period of time to repay your borrowing. However, if payments are missed, the term would get longer, and interest would continue to build. Obtaining one can also be difficult, time and labor intensive, and complex. To qualify, you’ll likely need a long track record of profitability, excellent personal credit, and lots of documentation. If you need working capital quickly, have less-than-perfect credit, or want a straightforward process, a MCA may be right for you.

With either form of financing, making sure you have a clear use of funds and an established plan for remitting payments is crucial for success. Once you have those in place, both an MCA or a traditional business loan could be great for:

  • Reducing inventory costs by purchasing in bulk
  • Bridging cash flow gaps until you receive payment from clients
  • Capitalizing on growth or cost-saving opportunities
  • Maintaining unexpected challenges

Still Not Sure

The good news is we are here to guide you! Our goal is to help find the right financing options for your business. Whether it’s explaining the differences between various types of capital solutions or providing more detail on the benefits of revenue-based financing – give us a call at 888-244-9099 to speak with a Forward Financing funding specialist today or apply now!