Considering a Merchant Advance? Make Sure You Know What You’re Getting Into

Most small business owners have faced a cash crunch at some point in their business. Whether you’re a little short to make payroll or you need a boost in cash to purchase inventory, if you own a small business, you’ve likely been there. But, how you handle that crunch can affect how you ultimately get out of it.

For many small businesses, a merchant cash advance can be a fast, easy way to get a quick infusion of cash. If your business does any significant volume in credit card transactions, or you use a point of sale system such as Square or Shopify, almost all of them are offering some sort of short-term financing.

Here’s how it works. Your merchant processor will offer you an advance of up to 50% of your average monthly revenue. So, if you’re doing $100K in sales each month, they might offer you a $50,000 cash advance. You can typically get the cash in your account within 24 hours.

Then, you’ll pay this back over the next 6-12 months, using future revenue that comes in. Typically payment terms will be set at 10-20% of your daily collections, until you’ve paid it back in full.

The payback amount will equal the amount advanced ($50,000) plus an advance fee, typically somewhere between 1 and 5% of the amount advanced. Sounds pretty reasonable, right? But, it’s not so simple.  this is where it gets tricky. A “fee” of 1 to 5% is not the same things as an interest rate of 1 to 5%. This is because an interest rate is divided over a 12-month period (i.e. – if you’re charged a 12% interest rate, you’re essentially paying 1% per month). Also, you only pay interest on the amount that is still outstanding. So, if you’re making daily payments on your advance, your interest should go down every day, but in the case of a fee, it’s fixed, regardless of the payments you’re making.

If you’re charged a fee of just 2% on this $50,000 advance and you’re paying back 20% of your gross receipts per day, it would take you approximately 2 and a half months to pay the advance back, with an effective interest rate of 18-20%. So, even though the cost is “only” $1,000, it’s actually pretty expensive money from a lending standpoint. And, if you go up to a 5% fee, the effective interest rate is over 40%!

Another thing to consider is now you’ve got $667 less per day coming into your business, because that’s coming off the top and going to pay back your advance. This reduces the cash flow coming into your business by $20,000. So, if you were short on cash before, guess what? It’s going to get worse.

Merchant cash advances can feel like an easy way out of a cash crunch, but in reality, they’ll squeeze you even harder. Before you consider taking on any short-term financing, make sure you have made changes to your costs to avoid getting back into the same situation. Cut costs or raise prices so that your current level of revenue can support your current costs.

Alternatives to short-term financing?

• Run a promotion – get quick cash in the door
• Give payment discounts – get customers to pay more quickly
• Delay vendor payments – slow down your vendor payments until you’re caught up

Learn more about forecasting cash flow to help you avoid the cash crunch in our Small Business Bootcamp.