As business firms seek to expand, the need to hire more staff or acquire more equipment may arise. In theory, this shouldn’t pose much of a problem. Practice, however, tells us that the financial resources required for such changes to take place are not always readily available. Since this is the case, firms have to find ways of getting small loans to finance their objectives.
Of course, there are quite a number of options when it comes to business loans, and each one has a drawback of its own. Of the many options, there is one that has often appealed to lots of business owners over the years, and that is merchant cash advance. And unlike other alternatives to direct small loans from commercial banks, merchant funding is unique in that it is not exactly a loan—at least from the technical perspective.
At first, it might be quite a challenge to understand the basics of merchant cash advance. But a little definition should be enough to get things started. First things first: A merchant advance is a sum of money given to a business firm in exchange for the future credit sales of that business. In other words, it is not a loan that is directly repaid with an interest the way a typical loan from a commercial bank normally would be repaid.
But unlike loans from traditional sources, merchant loans—so to speak—are usually small loans used to meet, in most instances, immediate business needs. So firms that offer such cash advance usually place an upper limit on what can be obtained, a limit much less than what obtains with loans from commercial banks.
For most persons, there is always the question whether a cash advance is a right step out of the financial predicament of their businesses. In order to address this concern, it is necessary that one understands how exactly the whole process works and what lapses—if any—there are in the system. Or possibly what risks the business is up against.
If we are to understand how merchant advance loans work, then we need a business scenario to illustrate the basic concepts. For a start let us consider a certain business, which manufactures miniature electronic components. This business happens to be in need of a small loan as it seeks to obtain some modern equipment in order to automate some of its manufacturing processes.
The firm also hopes that this automation will significantly reduce cost. So it approaches another firm that offers merchant loans for the advance. It is usually a straightforward process since all the lending company has to do is to examine the credit sales record of the business for the past couple months. In most cases, the decision whether or not to issue the advance is made in a week or less.
How is the advance recovered by the lending company?
The standard practice for lending firms is to multiply the small loan by a certain factor and the result gives the total amount payable by the business firm. It is the small margin created by this factor that the lending firm profits from. But when it comes to the exact method of recouping the funds, there are usually two options open to business firms who acquired the small loan.
- Percentage of future credit sales mode of payment
One of the options requires that a fixed percentage of the credit sales, a small amount is remitted to the lending company until the total amount has been paid. In this method, the actual amount paid will depend on how well the business does. For instance, if the manufacturing company anticipated a substantial reduction in cost plus an increase in revenue as a result of the acquired machinery, and if this happens, the advance will be more quickly repaid.
And if it happens that the credit sales plummet, the loan takes a longer time to repay. To understand this let us assume that advance was expected to be repaid in 10 weeks based on an initial assumption of credit sales. If it turns out that the sales fall below this initial figure and the percentage of the future credit sales charged by the lending firm stays the same (which is so in the case of merchant advances), then the payment period is automatically increased. This is to say that payment timeline is adjusted to suit the state of affairs of the business.
- Fixed payment mode of payment
For this mode of payment of merchant small loans, there is usually a fixed amount that is paid at the interval stipulated by the lending firm. This amount is usually arrived at when the expected future revenue from the credit sales of the borrowing firm is calculated. The percentage and expected credit sales are used to compute this fixed amount. So whether credit sales exceed the expectation or not, this same amount is paid.
It is obvious, therefore that in this mode of payment, the time interval remains the same regardless of what the state of the business is. It is also considered that this method will put much strain on the cash flow of a business when credit sales are down. But this is an extreme case and not exactly common.
One more thing: the reality of both methods is that they are actually the same, or at least they have the same effect if the expected sales turn out to be actual. Although this might not be common on the whole, both methods are effective in repaying small loans obtained through merchant cash advance.
Why a MCA might be the right option for your business
The first thing to know about merchant cash advances is that they are small loans that target mainly small and medium scale business enterprises. The other thing that might make you look in the direction of merchant loan is if your business has a poor credit score. Yes, it is true that credit scores do not necessarily impact on the decision of the lending company even if it will be examined.
The main factor on which judgment is based is the credit sales for the last couple months. And, of course, if one needs a really quick access to funds with a high rate of approval then a merchant loan stands as the best option. For there is no comparing the speed and ease (with which a merchant advance is obtained) with what that of securing a small loan from a commercial bank.
But if only one thing excites you about merchant cash advances, then it should be that there is no requirement for collateral—not at all. It means that the question of losing personal property in the event the advance cannot be repaid does not arise. And if it happens that the business closes down it is almost always a loss for the lending firm. So a merchant loan is almost risk-free on the part of the borrower.
Some downsides of merchant loans
In spite of the numerous appeals of getting small loans through cash advance companies, there are some aspects that are worth pondering on. In actuality, the interest rate associated with merchant advances are much higher when compared to other traditional sources of raising capital. But when this drawback is weighed against the speed and ease with the advance can be obtained, it is seen that it is a much better option than bank loans.
Another aspect of merchant cash advance that bothers a few is the fact there is no actual reward for quick payment. In short, it appears that the quicker the loan is paid, the higher the annual percentage rate seems to climb. This creates quite an interesting paradox, but it must be restated that this is not much of a problem provided the loan is repaid in good time.
Of course, most persons consider contracts relating to merchant cash advances for small loans to be quite complex as it is loaded with unfamiliar terms; and this could pose a real challenge at first. But it takes a little patience to thoroughly understand what those terms mean and, therefore fully understand the contract.
Finally, there is a view that the ease with which merchant loans can be obtained might pose a real danger to businesses. Those who share this view claim that a certain cycle of debt might trap this firm as it goes from seeking one cash advance to another. But as has been stated in the beginning, merchant cash advances are provided for businesses in order for them to be able to raise the capital needed to revamp a business or pursue a particular business objective. With this in mind, the question of recurrent borrowing does not arise.
So far so good, we have examined how it is that a cash advance is the best option anyone might think of when it comes to getting small business loans. If this is true for most other businesses, it certainly can be true for yours.