Merchant Cash Advance in the Retail Sector, Its Advantages and Disadvantages

The retail sector has some unique financial needs. There are various types of retail establishment across the world which use different types of arrangements to fund their day-to-day capital needs. The larger and more sophisticated retail chains have access to formal loans from banks. However, this may not be the case for small and medium businesses.

Retail companies which fall in this sector do not have access to the same financial products as their multinational counterparts. It is for this reason that there are some specialized financial products which are used by such companies.

Merchant cash advance is one such financial product which is extensively used by small and medium retail businesses. In this article, we will have a closer look at what merchant cash advance is as well as how it really works.

What is Merchant Cash Advance?

A merchant cash advance is a financing option for businesses that either do not qualify for a traditional bank loan or do not have the assets required to provide as collateral in order to avail such loans.

A merchant cash advance is a short-term loan with a flexible repayment schedule which is provided by the lender based on the credit card receipts that the retail business generates within a given period of time. Since a large portion of retail sales are made up of credit card transactions, they have a consistent flow of such transactions which are then used by the financier as collateral in order to provide the advance.

The repayment of these loans is not manually made by the borrower i.e. the retail company. Instead, the repayment of these loans is automatically deducted from the credit card receipts which accrue to the retail company when they sell their products. This means that when retail companies sell their products and accept credit card as a mode of payment, a certain percentage of this payment is held back by the merchant as repayment of the loan.

The average credit card receipts which accrue to the borrower are extremely important for this model to function. It is for this reason that merchant cash advance is only provided to retail companies which have consistently demonstrated the ability to generate credit card sales.

The size of merchant cash advance which is provided by the lender varies across geographies. In some parts of the world, lenders provide no more than 50% of the monthly credit card receipts as merchant cash advance. However, in other parts of the world, lenders do not mind giving out even 250% of the average monthly credit card receipts as a loan. The higher the loan amount sanctioned by the lender, the longer it will take for them to recover such amount. Also, higher amounts generally mean higher risk for the lender as well as the borrower.

How Does Merchant Cash Advance Work?

The typical merchant cash advance agreement which is structured between a business owner and a lender has the following terms and conditions:

1. Advance Amount: This amount refers to the amount of borrowing which has actually taken place. This is the amount which the lender provides to the borrowing retail company as a part of the merchant cash advance agreement. This amount is based on several parameters which include the overall financial strength of the firm as well as the average credit card receivables which accrue to the firm every month.

2. Payback Amount: The payback amount is the amount of money which the borrower has to repay in order to close the merchant cash advance. Hence, the payback amount includes the advance amount, accrued interest as well a processing fee.

   It needs to be understood that the payback amount is a dynamic figure which varies based on the payback period. This is because the repayments made in a merchant cash advance are not fixed. Instead, the repayments can vary based on numerous factors such as daily sales of the borrower and the number of days required to repay the loan.

3. Holdback: Merchant cash advance is not paid back via fixed instalments. Instead, such an advance is paid back via a percentage of the credit card receipts which are held by the merchant.

   For example, if the holdback percentage agreed upon in the contract is 50%, and if the daily credit card sales of the retail company are $1000, then the lender can withhold $500 i.e. 50% of $1000 and pay only the balance to the retail company.

   The rate at which credit card sales will be used to repay the cash advance is called the holdback rate or the retrieval rate. It is common for the holdback rate to be between 5% and 20% of the daily credit card sales.

Many retail businesses prefer taking out merchant cash advances since the repayment of such loans is associated with their sales.

If the sales are high in a particular month, a higher amount is allocated towards the repayment of the loan. On the other hand, if the sales are low in a particular month, the amount being allocated towards repayment reduces and the overall tenure of the loan. In either case, when the cash flow of the firm increases or decreases, it is less likely to default on such cash advances.

Advantages of Merchant Cash Advance

The following advantages which accrue to merchant cash advance make it attractive to many small and medium retail companies.

1. Easy to Avail: The first and foremost benefit of a merchant cash advance is that it is easier as well as faster to avail. Traditional lenders undertake a lot of due diligence before they actually lend out any funds.

   It is common for lenders to have a look at the financial statements of the borrower before deciding whether or not to fund them. However, this is not the case when it comes to merchant cash advances. These advances are based solely on the credit card receipts of the borrower.

   Hence, other financial statements such as profit and loss statement as well as the balance sheet are completely irrelevant to these lenders. This makes it easier for small and medium businesses to obtain loans at a short notice. In many cases, businesses may not even have to go through a formal application process. In some parts of the world, businesses can instantly avail merchant cash advances by simply filling out an application form online.

2. Flexible Payments: The cash flow in retail businesses can fluctuate significantly. These fluctuations can be based on seasons or they may not even have an apparent cause. Hence, small and medium retail business find it difficult to stick to a particular repayment schedule.

   The advantage of merchant cash advance is that there is no fixed repayment schedule. The repayment schedule is based on the cash flow that the retail business is able to generate via credit card sales. Hence, as and when, the sales fluctuate, so does the loan repayment. This situation is favorable for small and medium businesses since they do not want to be exposed to possible default because of lack of cash flow.

   Flexible payments put less strain on the financial situation of the company and hence are preferred by small and medium retail organizations.

3. Credit Score Not Required: Small and medium sized retail companies may have come into existence only in the recent past. This could be one of the reasons that they do not have a high credit score.

   It is also possible that some of these companies may have run into financial trouble which would have reduced their credit score. In either case, these companies will not be able to obtain funding from traditional lenders on favorable terms. It is for this reason that companies which either have a short trading history or have faced some kind of financial debacle in the recent past are more inclined towards obtaining merchant cash advances.

4. Collateral Not Required: Merchant cash advances are secured against the future cash flows that the retail company is likely to receive. Lenders use the data about past sales to predict future sales revenues and lend against those revenues.

   The merchant cash advances are not secured against other assets of the borrower. This means that the lender only has a claim on possible future cash flows and not on any other assets. It is for this reason that borrowers are not required to submit any collateral in order to avail of these loans.

   The fact that no collateral has to be provided makes it an attractive proposition for many small and medium businesses who may not have any collateral to pledge in order to receive a loan. It is common for newer retail businesses to be bootstrapped. Such businesses tend to lease almost all their assets and may not own the assets required to pledge as collateral.

5. No Restrictions on the Usage of Funds: Another significant advantage of merchant cash advance is the fact that lenders do not place any restrictions of how borrowers can spend this money.

   Lenders give borrowers a free hand to utilize this money for any business purposes. This is opposed to traditional bank loans wherein the purpose for which the funds can be utilized is controlled.

   It is common for retail companies to use these funds to purchase inventory, fund marketing campaigns, pay back debts or even renovate the store premises. The added flexibility means that merchant cash advances may actually be more affordable if the funds are being utilized for certain purposes.

6. Scalability: Merchant cash advances are based on the sales revenue being generated by the retail organization. This means that as and when the revenues generated by these firms increase, their ability to borrow money also tend to increase simultaneously. This can be beneficial for small and medium retail businesses who are trying to raise funds quickly since they want to grow at a rapid speed.

Disadvantages of Merchant Cash Advance

1. High Interest Rate: The first and most obvious disadvantage of merchant cash advance is the fact that these advances tend to have a higher interest rate as compared to traditional bank loans. This is because of the fact that traditional bank loans are generally secured by the assets of the borrowing firm. However, this is not the case with merchant cash advances. Such advances are only secured with the future cash flow of the firm. It is for this reason that they are considered to be riskier and as a result, it is common for lenders to ask for a higher interest rate as compared to regular loans.

2. Shorter Repayment Periods: Merchant cash advances do not have a fixed repayment period. The repayment of these loans depends upon the cash flow which the underlying business is able to generate.

   However, on average, merchant cash advances are structured in such a way that their repayment tends to be done in a shorter period of time. This means that there is a greater debt burden on the business till the time that the debt has been repaid.

   Hence, the debt coverage ratio of the business tends to worsen in that time frame which may even cause the business to fall into a debt trap and require more loans in order to meet their cash flow requirements.

3. Interference in Operations: Lenders which provide merchant cash advances have noticed that once the borrowers have received the advance, they tend to change their operations in order to delay repaying the loan.

   For example, it is common for the borrowers to ask for their customers to pay them in cash instead of via a credit card. This is because the merchant has a lien on credit card sales but not cash sales. Hence, it is common for retailers who have taken merchant cash advances to provide a discount for cash payments. Over the years, lenders have observed this trend. It is obvious that they want to avoid this situation and hence have started asking for increased control over the operations of the borrowers.

   Lenders have started imposing terms and conditions which restrict the offers that borrowers can give their customers. It is also common for lenders to restrict the borrowers from using the services of certain credit card payment processors. Many small and medium retail firms that use merchant cash advances find these terms and conditions to be too restrictive.

4. Opaque Terms and Conditions: Merchant cash advances have developed the dubious reputation of having several complex hidden terms and conditions. The contracts which govern the lending can be quite complex and may include several different types of fees and charges which may be applicable in different scenarios.

   Hence, many small and medium retail business find it difficult to understand these terms and conditions. This is considered to be a significant disadvantage of using such advances to obtain funds.

5. Complex Pricing: The pricing of merchant cash advances is not very straightforward either. This is because the repayment of such loans is not time bound. However, the rules for repayment are quite complex.

   It is common for interest rates to be increased if the repayment goes beyond a certain specified number of days. Also, there are a wide variety of charges which may be charged to the borrower at different points of time in different scenarios. It is for this reason that larger and more established retail companies tend to avoid merchant cash advances.

6. Data Privacy: Many retail companies want to maintain the privacy of their data. They do not want their sensitive financial information such as their sales data and cash flow position to be available to third parties. However, when it comes to merchant cash advances, retail companies are compelled to share their daily sales and other financial data with the lender.

   It is possible for the retail company to enter into a non-disclosure agreement with their lender to prevent further sharing of data and to ensure data privacy. However, there are many retail companies which want to avoid taking such loans in order to maintain data privacy.

7. Lack of Regulation: Merchant cash advances do not fall under the category of regular loans. It is for this reason that many government regulations related to loans do not apply to such advances.

   Also, in many parts of the world, government usury laws which restrict the interest rate which can be paid by the borrower also do not apply to them. There are several retail companies which try to steer clear of borrowing loans which are not regulated by the law. This is another significant disadvantage of merchant cash advances.