How Does It Work?
The merchant cash advance (MCA) financing option is typically used by businesses that have a majority of their revenues originating from card sales (debit or card). By definition, the MCA is not technically a loan as it doesn’t charge interest on the principal that you are advanced. The providers of merchant cash advances are instead paid through the future sales made by the business, wherein they take a cut of future revenues until the MCA is paid out in full.
These financing tools are often found in a couple different types of structures:
- The most common type is where the customer gets a cash advance upfront from the provider with an agreement for a fixed percentage of future sales (known as the holdback) to be remitted directly to the provider.
- The second type has gained popularity as MCA providers look to expand their target market from solely businesses operating on card sales. For businesses that have cash sales making up a majority of revenues, the MCA can still be an option. After the provider advances the cash as usual, the business then pays a weekly (or daily) fixed debit amount to the business. This amount is known as the Automated Clearing House (ACH) withdrawal.
The question now arises as to how the provider makes a profit if there is no interest charged on the actual merchant cash advance?
To answer this, it is pertinent to get familiar with a term called the factoring rate.
The factoring rate is essentially a multiplier on the principal, which details the total amount of fees to be paid. For example, on a cash advance of $10,000 with a factoring rate of 1.25, the customer would pay $10,000 x 1.25 = $12,500 in total principal and fees. Therefore, the provider would ultimately receive $2,500 after the principal is paid back for the risk they take in advancing the money to the borrower.
A Numerical Example:
Consider a pizza shop business that needs $50,000 in cash. The shop generates approximately $1,000 every day in card sales. If the owner now chooses to obtain the cash via a merchant cash advance, the MCA provider might quote him/her a holdback rate of 20% and a factoring rate of 30%. This means that 20% of the $1,000 in daily sales is remitted to the provider and $65,000 in total has to be paid back to the provider inclusive of principal and fees ($50,000 x 1.3 = $65,000).
With a total amount of $65,000 to be repaid and $200 paid back every day, it would take the customer 325 days in total to pay back the merchant cash advance.