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What Are Merchant Cash Advances and Working Capital Loans

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Could a cash advance or working capital loan from a merchant be the solution to your cash flow problems, or a likely pitfall?

Many small business owners lived through a time when they needed more cash on hand. The management of cash flow is all about business, but even the most sophisticated small companies sometimes find themselves tied up with money and unable to cover operations.

 

In these times, small business owners have a variety of financing options available to help tide them over with liquid capital delivered directly into their bank accounts. Those financial products, however, come with their own set of risks that must be managed properly to prevent disaster.

These tools can maintain a cash-hungry business when handled correctly. They can lead to a violent debt cycle when misused.

 

This guide presents tools such as commercial cash advances and working capital loans and offers advice from financial experts on how to utilize them. Good planning and record keeping is essential for the successful repayment of loans and the profitability of your business.

 

What is Merchant Cash Advance?

 

A cash advance from a merchant is a form of financing which is not really a loan.

 

Rather, it is a financing option that provides immediate cash in exchange for the future sales receipts from a business ‘ credit card. Essentially, when a corporation receives a cash advance from a merchant, they transfer the money from potential credit card purchases for immediate payment.

Seasonal companies or those with cyclical revenues often use merchant cash advances to keep the cash flow flowing during slow times of the year.

 

When sales are slow, business owners can pay operating expenses and wages; then, when sales volume picks up, the business can repay the merchant cash advance and generate a profit.

 

Since commercial cash benefits are supported by projected sales, companies with a less than perfect credit score frequently rely upon them for short-term operating capital.

 

Companies use market cash advances in addition to operating expenses and wages for things like equipment financing, marketing campaigns, hiring new employees, expanding inventories.

How do merchant cash advances work?

 

Traditionally, a merchant cash advance provides an inflow of capital based on the planned credit card transactions of a company over a given period.

 

When a company receives a cash advance of $100,000 for a duration of 52 weeks and the factor cost of 1.25, for example, it has to pay $125,000 in credit card transactions over the next year.

 

The repayment of merchant cash advances is usually divided into weekly payments, said Randall Richards, RFR Capital Director of Business Development. According to Richards, cash advance companies frequently draw the payment directly from the bank account of a company, rather than their credit-card transactions related merchant account.

“Weekly compensation would be dependent on revenue, and a variety of variables,” said Richards. “Anyone who only makes $20,000 a month in revenue will not qualify for $100,000[ advance.] Revenue must cover the grant or the lender is at risk of losing money.”

 

Because merchant cash advances are dependent on revenue, poor credit lenders are typically able to access them even if they can not receive a conventional loan. That flexibility, of course, means that merchant cash advances are also more expensive than bank loans.

Cassel clarified that merchant cash advances do not have their own interest rate, but cash advance costs can be measured against the interest rates associated with a traditional loan.

 

For example, in Richards ‘ hypothetical $100,000 merchant cash advance costing a business a total of $125,000 over a 52-week term, the equivalent interest rate would be 25%. That is much higher than the interest rates on many bank loans, which could cost a large-credit company between 2 percent and 5 percent of the principal value of the loan, Cassel said. Learning the factor rate is useful in reducing the cost of a retailer cash advance, and whether you can maximize it.

Advantages and Disadvantages of Merchant Cash Advance

 

For many businesses merchant cash advances can be useful tools. Whether you’re a seasonal business weathering the slow season or a cyclical sales business like a manufacturer making up most of its sales in Q4, merchant cash advances offer support.

 

However, relying on a merchant cash advance to stay afloat could be the start of a death spiral for the struggling businesses.

 

“It’s sometimes a company that’s so happy and feels it can’t lose but it does. Other times, it’s a business that’s in deep trouble and just trying to stay alive, hoping for one more deal… just trying to survive, because then they think they’re going to succeed,”.

As with all types of funding, cash advances from retailers come with a unique set of pros and cons. If you plan accordingly they could be an effective tool to maintain a healthy cash flow and profitably run your company.

 

Nonetheless, when used poorly, they can also accelerate the deterioration of a failing business. Managing a cash advance for your company is about knowing the pros and cons and how to better handle it.

Advantages

1. Immediate lump sum payment:

Merchant cash advances are useful because they quickly provide a payout to a client for the lump sum, which can be supplemented by a corporation with a quick flow of capital when the cash flow is small.

2. Based on sales, not credit:

Trading cash advances are based on sales rather than credit, meaning that even poorly paid lenders may use them.

3. Easy to qualify:

it is relatively easy to qualify for a commercial cash advance. It takes several months for bank statements, a one-page application and some basic business information such as your tax ID number, website and address.

4. Quick approval:

Trading cash advances will usually be accepted quicker than bank loans, which take a few months to approve. In some situations, business cash deposits offer liquidity in a few days ‘ time.

 

Disadvantages

1. Costly:

Trading cash advances are generally very expensive, ranging from a high equivalent rate of 40 percent to an astronomical rate of 350 percent.

 

The rates rely on various factors, including the lender of a company, but a cash advance from a commercial enterprise is always much higher than the traditional loan.

2. One-time capital inflow:

Merchant cash advances provide a modest amount of capital for one-time injections. This is not a concern for many corporations.

 

For example, a commercial cash advance would probably be good for the seasonal business that will have to cover operational costs in the short term until the business booms are back in the future. However, a difficult company with a commercial cash advance can stand by hoping that the sales will eventually increase.

3. Limitable requirements:

A company must sign an agreement with a lender to accept a cash advance for a merchant. In many cases, these agreements contain provisions requiring the company to comply with certain rules.

 

For instance, your company may not be able to move locations or to take out an extra business loan. Cassel said that you can avoid this by reviewing any agreements before you sign and negotiate the contract details.

What is Working capital loan?

 

The word “working capital loan” applies to a small business loan or alternative funding option structured with a short maturity period to cover the near-term costs.

 

Enterprises often use working capital loans to cover a wide range of operational costs. There are many different types of financing which might be considered a working capital loan, including:

Credit lines:

A line of credit is not a loan but rather a fixed amount of money from which a company can borrow at any time. Like a credit card, credit lines only incur interest on the borrowed balance, not the total credit limit value.

 

Credit lines are usually provided by banks or credit unions, though businesses with ample leverage can sometimes obtain a credit line directly with their supplier. The amount of a credit line is generally based on the credit score of an enterprise.

Short-term loan:

In general, a short-term loan is a small dollar loan to be repaid within one year. Short term loans range up to $100,000, providing an injection of capital to borrowers to cover immediate operating expenses. Interest rates on short-term loans can vary but due to their rapid maturity period tend to be higher than traditional longer-term loans.

Invoice factoring:

Invoice factoring, also known as receivable financing accounts, is similar to a cash advance for the merchant as it is not related to credit but rather to the sales of a business. A business sells its uncollected accounts receivable to a lender (or “factor”) up front for a significant portion of the total value.

 

The factor then works to collect the outstanding payments and keeps the remaining percentage of the total value that the business does not get.

 

Invoice factoring is generally considered less risky than a cash advance from a merchant for one simple reason: Invoice factoring is based on existing receivable accounts that have not yet been processed, whereas cash advances for retailers are based on projected future revenue rather than an actual asset.

Equipment loan:

Equipment loans are intended specifically for the acquisition or lease of equipment necessary for the operation of a business. Such loans are usually secured by the equipment itself as collateral rather than the assets of a company; if the business fails to repay the loan, the equipment may be repossessed.

Borrowers needing a working capital loan may need them for the same reasons a business is seeking cash advance from a seller, including salary compensation, equipment purchase funding, new property acquisition and inventory expansion. They are also commonly used by seasonal or cyclical-sales companies.

Advantages and Disadvantages of Working capital loan

Working capital loans tend to be less risky than cash advances from retailers but they often serve similar purposes.

 

Nevertheless, qualifying requirements are not rare, since working-capital loans are often more tangible than anticipated future sales based on loan worthiness or some other form of collateral. Here’s a closer look at some of the pros and cons linked to working capital lending.

Advantages

1. Short repayment period:

Working capital loans have rapid repayment periods which are useful for companies wishing to clear debt from their books quickly. Within one year, the repayment of the loan means that for future years, companies will not have to pay interest.

2. Flexible:

The financing is relatively flexible, depending on the type of working capital loan. Many loans are more constrained, such as equipment financing; however, credit lines, short-term loans and invoice factoring can all be used to cover a wide range of costs

3. Fast approval process:

Short-term credit usually takes place faster than conventional credit, because the credits are intended to meet a borrower’s immediate need.

Disadvantages

1. Costly:

Short-term lending matures faster than conventional lending so that borrowers are expecting to pay higher interest rates.

 

Most work capital loans vary in interest rates, but are generally less expensive than a long-term debt, depending upon the specific type of loan.

2. Short repayment period:

While the short repayment period is a blessing for firms wishing to debt out of books, it can be a challenge for companies struggling to repay their loans. As working capital lending is much smaller in scope than conventional longer-term lending, companies have a much faster reimbursement of the principal.

In Conclusion

To sustain their cash flow many companies need assistance. After all, cash flow is oxygen to a company and it’s not long before the chokes and activities are halted without oxygen Merchant cash advances, credit lines, and working capital loans are strategies that can help businesses rebound while anticipating future sales.

 

But these types of financing can spell disaster for a company without a clear plan in place.

Have a clear road map to repay and the ability to execute the strategy effectively to make the most of any form of financing. Good record-keeping and a strong business understanding are crucial.

 

Acceptance of a loan in hopes that you may generate future sales to cover it is a significant risk. If in doubt, consult with a professional accountant before accepting any money of any kind from a lender.

 

But a little planning will give you the encouragement you need to get through the tough times before getting back in touch with productivity for trading cash advances and working capital credit.

 

 

Komolafe Timileyin is a passionate entrepreneur that loves to solve entrepreneurial issues. He is also a blogger and an upcoming Engineer.

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