Businesses in a crunch have the option to turn to Merchant Cash Advances (MCAs) or Cash Flow Loans for a source of quick funding without the worry of credit ratings or collateral. These options stand to be useful for businesses that can afford them, however the business must fully understand the repayment terms of the Cash Advance. Businesses often overlook a subtle but important issue when considering an MCA — cash flow.
The best way to understand cash flow issues is to observe this scenario:
Your typical neighborhood fast service restaurant (say, Thai food) has $30,000 in monthly gross revenue. They need to remodel the kitchen, which will cost an additional $27,000, so they take an advance of $30,000 and sign up to pay back $35,100 in 6 months. That comes out to approximately $5,850 per month.
That payment does not appear to be very much for a busy restaurant until the restaurant’s expenses are calculated. The average restaurant operates with 10% margins, depending on whether the owner is also an operator. Here is a typical breakdown:
The restaurant cannot support the monthly aggregate payments of $5,850. Unless the owner does the math ahead of time, she will not notice until a few months after getting the cash advance. The tables below illustrate bank activity during the first three months after receiving the MCA:
The MCA went in and out of the bank account (we seldom see the money stay for long because the need is immediate). The bank balance refers to cash on hand that is used to pay for ingredients, clear checks, and pay bills. The small business will start to bounce checks as early as the third month.
Like the restaurant in the scenario above, most small businesses choose MCAs that come with 6-9 month terms, much shorter than the typical small business bank loan that has terms of 48-72 months. Although short-term MCAs often result in a lower total cost, the short payback period not only creates very high APRs but could also jeopardize the viability of the business. An advance that needs to be paid back in such a short time period results in very high monthly payments. When the payments exceed the profit margins, the business starts to experience negative cash flow, which threatens the viability of the business.
The scenario seems to be clear that small business owners must stay away from short payback periods. Unfortunately, that rule isn’t always clear when they are considering the MCA offer. This lack of clarity exists in other loan options as well, such as cash flow loans. Lets look at the pricing structure of this cash flow loan provider:
Usually the financing provider will not show the monthly payment, which decreases significantly with the term length of the loan. Thus, the loan seeker will only consider the total cost of the advance, which increases with the length of the payback period. This can be a recipe for disaster if the monthly operating cash flow from the business cannot sustain the monthly loan payment.
If, instead, the business looks at the monthly payment from the table above and opts for the 18-month loan, whose monthly payment is less than half of a 6-month loan. The 18-month loan has a much higher financing cost over its lifetime but it’s actually more affordable for the business as the monthly obligation is a lot lower and the business is less likely to fall into negative cash flows.
A higher loan cost over a longer-term length could save your small business from negative cash flow problems; be sure to consider your monthly bank balance before choosing that short-term Merchant Cash Advance!
About the Author — Alex Dang is the business development officer at Opportunity Fund, a leading micro lender in northern California .
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