What Are Merchant Cash Advances and Working Capital Loans?

Sometimes even the savviest small business owners find themselves with money tied up and unable to cover operational expenses. Merchant cash advances and working capital loans are financing options that can tide small business owners over with liquid capital delivered directly to their bank accounts. If, like many business owners, you need more cash on hand, you may be considering one of these types of financing. When handled properly, these financing tools can keep a cash-hungry business running, but beware – if misused, they may lead you into a vicious cycle of debt.

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Merchant cash advance vs. working capital loan

• Loan vs. non-loans: A merchant cash advance technically isn't a loan. Instead, it's a promise to funnel a certain amount of future credit card sales to the merchant in question. Working capital loans, on the other hand, mostly fall under the traditional definition of loans. When you take out a working capital loan, you receive a lump sum of money and then repay it, usually in monthly installments. While you get a lump sum of money with a merchant cash advance, it is repaid by taking a certain percentage of your credit card sales on a weekly, or sometimes, daily basis. 
  
  
• APR: Merchant cash advances often cost more in the long run, as they are known for their exorbitant APRs. These can sometimes be as high as 200%. Finding working capital loans with reasonable APRs is much easier.
  
  
• Risk: Merchant cash and capital loans, such as invoice factoring, differ in that the former is based on money your business hasn’t yet earned. Invoice factoring, though, is based on your accounts receivable, so it’s based on money you’ve earned but not yet received. As such, merchant cash advances are riskier. You can never be sure that you’ll bring in enough in credit card transactions to cover what you’ve borrowed.
  
  
• Approval: Merchant cash advances are rarely tied to credit scores in the same ways as working capital loans. You might thus have an easier time obtaining a merchant cash advance if your borrowing history is poor.
  
  
• Use allowances: Although most merchant cash and capital loans don’t limit how you can use them, there are exceptions. An equipment loan, which is a type of working capital loan, can only be used to buy equipment. Merchant cash advances have no such limits.

What is a merchant cash advance?

A merchant cash advance is a form of financing that isn't truly a loan. Instead, it is a financing option that provides immediate cash in exchange for a business's future credit card sales receipts. In essence, when a business accepts a merchant cash advance, it sells the revenue of its future credit card sales for immediate payment.

Merchant cash advances are often used by seasonal businesses or those with cyclical sales to keep up cash flow during slow times of the year. Business owners can pay operating expenses and wages when sales are slow, then repay the merchant cash advance when their sales volume picks up and generate a profit. Since merchant cash advances are backed by projected sales, businesses with subpar credit scores also often rely on them for an injection of short-term working capital.

FYI: Besides operating expenses and wages, businesses use merchant cash advances for financing equipment, running marketing campaigns, hiring new employees, expanding inventory, buying materials or acquiring property.

How do merchant cash advances work?

A merchant cash advance traditionally offers an influx of capital based on a business's expected credit card transactions over the course of a specified term. For example, if your business receives a $100,000 merchant cash advance with a 52-week term and a factor rate of 1.25, you would have to pay back $125,000 in credit card sales over the course of the next year.

Merchant cash advance repayment generally breaks down into weekly payments, said Randall Richards, director of business development at RFR Capital. According to Richards, cash advance companies often draw the payment directly from a business's bank account rather than its merchant account associated with credit card transactions. 

"Weekly payments would be based on sales and a multitude of factors," Richards told business.com. "Someone who is only doing $20,000 per month in sales won't qualify for a $100,000 [advance]. The sales have to support the payment, or else the lender is at risk of losing money."

Since merchant cash advances are based on sales, borrowers with poor credit can usually access them even when they can't obtain a traditional loan. Of course, this flexibility means that merchant cash advances are more expensive than bank loans.

"Merchant cash advances are one of the alternatives today for people as they move down and become less and less creditworthy," said James Cassel, co-founder and chairman of Cassel Salpeter & Co. "Merchant cash advances could carry the equivalent of 40% interest rates."

Cassel clarified that merchant cash advances don't carry an interest rate of their own, but the cost of a cash advance can be measured against the interest rates associated with a traditional loan. For example, in Richards' hypothetical of a $100,000 merchant cash advance that costs a business $125,000 over a 52-week term, the interest rate equivalent would be 25%. That is much higher than the interest rates on many bank loans, which might cost a business with great credit 2% to 5% of the loan's principal value, Cassel said. Understanding your factor rate and whether you can negotiate it is useful in reducing the cost of a merchant cash advance.

How do you qualify for a merchant cash advance?

The first requirement for most merchant cash advance lenders is that you accept credit card payments, since these transactions will be used to repay the loan. Not only do you need to accept credit card payments, you need to show that you garner enough credit card sales to pay back the loan in a timely manner.

This is some other information you should have readily available:

• Your Social Security number
• Your business tax ID
• A couple months' worth of credit card processing and bank statements

Your proof of citizenship and a copy of your business's lease will also help you to qualify.

Lenders will look at how long you have been in business, your monthly revenue and your credit score. Their goal is to assess whether you have a healthy, thriving business that will be able to pay them back. The approval depends on these documents showing that your company is profitable and capable of repaying its debt.

"You can qualify for a merchant cash advance by first applying through a reputable company," said Xavier Epps, financial expert and CEO of XNE Financial Advising LLC. "Do your research first. Each company will have different requirements, but overall, these companies require less paperwork than traditional banks. The important thing is to make sure you can provide documentation for your business."

Pros and cons of a merchant cash advance

Merchant cash advances can be useful tools for many businesses. Whether you are a seasonal business weathering the slow season or a business with cyclical sales, such as a manufacturer that makes most of its sales in Q4, merchant cash advances can offer support. However, for struggling businesses, relying on a merchant cash advance to stay afloat could be the beginning of a death spiral.

"Sometimes it's a business that's so excited and thinks it can't lose but does," Cassel said. "Other times, it's a business that's in deep trouble and just trying to stay afloat, waiting for the one more sale … just trying to survive, because then they believe they will thrive. Sometimes you have to question the viability of the business."

Like all forms of financing, merchant cash advances have both pros and cons. If you plan accordingly, they could be an effective tool for maintaining healthy cash flow and operating your business profitably. When used improperly, they can expedite the demise of a failing business. Managing a merchant cash advance to the benefit of your business means understanding the pros and cons and how to navigate them.

Pros

• Immediate lump-sum payment: Merchant cash advances are useful because they deliver a lump-sum payment to a business immediately. That means when cash flow is low, you can bolster it with a quick influx of capital.
  
  
• Based on sales, not credit score: Merchant cash advances are based on sales instead of credit score, meaning even borrowers with poor credit or no credit can use them.
  
  
• Easy to qualify: Qualifying for a merchant cash advance is relatively easy. It requires a few months of bank statements, a one-page application and some basic information about the business, such as its tax identification number, website and address.
  
  
• Fast approval process: Merchant cash advances can generally be approved more quickly than bank loans, which often take several months for approval. In some cases, merchant cash advances deliver funding within a few days of approval.

Cons

• Expensive: Merchant cash advances are generally very expensive, ranging from a high 40% equivalent rate to an astronomical 350% equivalent rate in extreme cases. The cost depends on the lender and several other factors, but a merchant cash advance is always significantly more expensive than a traditional loan.
  
  
• One-time influx of capital: Merchant cash advances offer a one-time injection of a modest amount of capital. For many businesses, this isn't a problem. For example, the seasonal business that needs to cover its operational costs in the lean months until business booms again will likely do well with a merchant cash advance. A struggling business using a merchant cash advance to hold itself over in hopes that sales will eventually increase, however, could be backing itself into a corner.
  
  
• Restrictive requirements: To accept a merchant cash advance, you must sign an agreement with a lender. In many cases, these agreements include provisions that require your business to abide by certain rules. For example, your business might be precluded from moving locations or taking out an additional business loan. Cassel said you can avoid this problem by having an attorney review any agreements before you sign and negotiating the details of the contract.

What is a working capital loan?

The term "working capital loan" refers to a small business loan or alternative financing option designed to cover near-term costs with a short repayment date. Businesses use working capital loans to cover a wide range of operational costs. These are some types of financing that could be considered working capital loans:

• Lines of credit: A line of credit isn't a loan but a predetermined amount of money a business could borrow from at any time. Much like credit cards, lines of credit only incur interest on the balance borrowed, not the total value of the credit limit. Lines of credit are primarily extended by banks or credit unions, though sometimes businesses with enough leverage can negotiate a line of credit directly with their supplier. The amount of a line of credit is generally based on the business's credit score.
  
  
• Short-term loan: A short-term loan is generally a small-dollar loan to be repaid in one year. Short-term loans reach up to $100,000, providing an injection of capital to cover operational expenses immediately. Interest rates on short-term loans vary but tend to be higher than long-term conventional loans' rates due to their quick maturity period. An example of a short-term loan lender is Fora Financial. You can learn more in our Fora Financial review.
  
  
• Invoice factoring: Invoice factoring, also known as accounts receivable financing, is similar to a merchant cash advance in that it is not related to credit but a business's sales. A business sells a lender (or "factor") its uncollected accounts receivable for a significant portion of the total value upfront. The factor then works to collect the outstanding payments and keeps the remaining percentage of the total value not paid to the business. Invoice factoring is generally considered less risky than a merchant cash advance for one simple reason: It's based on existing accounts receivable that have not yet been collected, while merchant cash advances are based on projected future sales rather than an existing asset.
  
  
• Equipment loan: Equipment loans are specifically intended for the acquisition or lease of equipment a business needs to operate. Generally, these loans are backed by the equipment itself as collateral rather than a business's credit; if the business fails to repay the loan, the equipment can be repossessed.

Tip: If you are in need of financing, check out our recommendations for the best small business loa​​ns.

Borrowers who require a working capital loan might need it for the same reasons a company seeks out a merchant cash advance, such as to pay employee wages, purchase equipment, acquire new properties or expand inventory. They are also commonly used by seasonal businesses or those with cyclical sales. [Read related article: How to Decide Which Type of Business Loan Is Right for You]

How do you apply for a working capital loan?

Before you apply for a working capital loan, you should understand how much it costs to cover your day-to-day expenses so you'll know how much capital to ask for. 

Epps said some lenders will ask for an overview of your business's sales, so it's important to collect several months' worth of bank statements, balance sheets and tax returns. You will also need to provide your Employer Identification Number, your business mortgage or lease documentation, and your business credit score. 

It also helps to be prepared to answer questions like these:

• How much money do you need?
• How do you plan to use it?
• When do you need it?
• How much time do you need to pay it off?

FYI: One of the advantages of a working capital loan is that you can often apply online and receive approval for the loan much faster than you could for a traditional bank loan.

"Thanks to fintech, many working capital providers have online applications where you can securely provide information on yourself, your business, and some type of verification, like bank statements, credit card processing statements, connecting your accounting software or connecting your selling platforms," said Alex Sklar, head of business development and strategic partnerships at Payability. "Depending on your business and the partner you chose, funding can happen as fast as 24 hours."

What are the pros and cons of a working capital loan?

Working capital loans tend to be less risky than merchant cash advances while serving similar purposes. However, it's not uncommon for the qualifying requirements to be stricter, since working capital loans are often based on creditworthiness or a form of collateral more tangible than projected future sales. Here's a closer look at the pros and cons of working capital loans.

Pros

• Short repayment period: Working capital loans, by nature, have fast repayment periods, which are useful to businesses that want to quickly clear the debt from their books. Repaying a loan within one year means you aren't forced to pay interest on the loan for years to come.
  
  
• Flexibility: Depending on the type of working capital loan, funding is relatively flexible. Certain loans, like equipment financing, are more restrictive, but lines of credit, short-term loans and invoice factoring can all be used to cover a wide range of costs.
  
  
• Fast approval process: Short-term loans generally have a faster approval process than conventional loans because they are designed to fill an immediate need for the borrower.

Cons

• Higher costs: A short-term loan matures more quickly than traditional loans, so you should expect to pay higher interest rates. The interest rate varies by the precise type of loan, but working capital loans are generally more expensive than longer-term loans.
  
  
• Short repayment period: While the short repayment period is a blessing to companies that want to clear debt from their books, it can be a challenge for businesses that struggle to repay their loans. Since working capital loans have a much narrower window than long-term conventional loans, you have much less time to pay back the principal.

If you need fast cash, consider a merchant cash advance or working capital loan.

Many businesses need help to support their cash flow. After all, cash flow is oxygen to a business: Without it, it won't be long before the business chokes and operations stall. Merchant cash advances, lines of credit and working capital loans are financing options that can buoy up your business while you await future sales. However, without a clear plan in place, these forms of lending can spell disaster for a business.

To make the most of any type of financing, you should have a clear road map to repayment and the ability to execute that plan successfully. Good recordkeeping and a strong understanding of your business are critical.

Accepting a loan in hopes that you might generate future sales to cover it is a major risk. When in doubt, consult an accounting professional before accepting money from a lender of any kind. With a bit of planning, merchant cash advances and working capital loans could be precisely the support you need until you're back on track to profitability.

Simone Johnson and Adam Uzialko contributed to the reporting and writing in this article. Some source interviews were conducted for a previous version of this article.