How Risky Are Cash Advances?

While a quick source of capital, cash advances can be a gamble. Ask yourself these four questions before tapping into this source.

It’s no secret that small businesses are looking for alternative financing sources. A Pepperdine University report released in July found that 61 percent of banks said they were turning down tradtional loans that they might otherwise have granted because of changed regulatory practices and the current economic climate.

Enter merchant cash advances. While technically not a loan, a cash advance is a lump sum (usually less than $150,000) given to a business owner in exchange for a specific share of future credit and debit card sales.  And thanks to quick approval and almost instant access to capital, they’ve recently become a go-to, albeit risky, source for some small business owners.

The practice, which is mostly unregulated, drew attention in 2008 and 2009 when credit dried up. At the time, the number of providers exploded to around 50 (up significantly from the dozen or so at the beginning of the decade), and some small business owners complained of fly-by-night advance providers charging usurious rates.

Those practices are becoming a thing of the past, says David Goldin, CEO of merchant cash advance provider AmeriMerchant and president of the North American Merchant Advance Association. NAMAA was formed by 10 merchant cash advance providers in 2008, and seeks to set ethical standards for the industry.

And while the industry has begun to set standards, the fine print and high interest on merchant cash advances can still make them a risky choice. Here, experts reveal four questions you should ask yourself to determine whether a cash advance is right for your small business.

1. Have you done enough research?  If you are going to take a cash advance, do thorough research on the merchant cash advance provider before signing anything. Goldin says that his organization’s website hosts a variety of resources for company owners who may be considering an advance.

“We have a best practices file on our website that provides a clear disclosure of fees,” Goldin says.

As for companies that may have engaged in abusive practices in the past, Goldin reiterates that those are no more in an industry that has learned to regulate itself. “Let’s put it this way, there have been a lot of companies that have gone out of business,” Goldin says.

Cash advance providers often engage in aggressive marketing campaigns. Small business owners need to search out reliable third-party financial advisors.

Day recommends the Credit Research Foundation and National Association of Credit Management as resources for small business owners who may be looking for expert advice on business credit and cash advances. Both organizations also have websites with online resources that may be helpful to owners looking for alternate sources of credit.

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2. Will you have enough to cover the interest? Matthew Westenburg, a certified public accountant with Nebraska-based SP Group, says advances are expensive, and that interest can add up with unanticipated speed, even for the merchant who took the time to read the fine print.

“Next to borrowing from Tony Soprano, MCAs are very expensive and often have repayment penalties that prevent the borrower from getting out of a difficult situation,” Westenburg says. “From experience, I have seen MCA companies have a fixed repayment factor for money borrowed. The factor can range from 1.25 to 1.5 or greater, on the amount funded depending on the situation. This means that the guy who borrowed $50,000 will be expected to pay back $65,000.”

3. Do you have a rapid business cycle? Merchant cash advances also have a short repayment cycle, Westenburg says, meaning that cash advances are best suited to businesses that have rapid business cycles.

“With this short repayment period, a majority of the company’s credit card revenue is deferred to pay back the loan instead of being available to cover operating expenses,” Westenburg says.

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4. Is it a one-time deal? The final stage of distress for a company struggling to manage a cash advance comes when it takes out another advance to help cover or recover from the first. Companies will typically do this as the payments from the first advance start to cause reduced amounts of cash to flow to the business.

Cash advance providers know that businesses need more cash, and are sometimes all too willing to extend a helping hand.

“MCA companies are great at offering to loan additional money to borrowers based on the increase in monthly credit card transactions or when a loan matures,” Westenburg says. “It is very easy for a company to fall into the trap of continued borrowing from an MCA when it may no longer be necessary.”

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