Merchant cash advances give your business the ability to trade tomorrow’s earnings for cash you can use today. These are the accounts receivable you anticipate collecting. Factoring lines of credit are quite similar, but the money comes from a factoring company. The amount you receive is based on the outstanding invoices that increase or decrease your outstanding accounts receivable.
A merchant line of credit or a factoring line of credit is not considered “a loan” in the traditional sense, but they use outstanding invoices or anticipated invoices as collateral.
Merchant Cash Advance
A merchant cash advance is a money advance given to your business based on credit card sales you experience. You estimate the amount of credit card sales, and a merchant cash advance is based on a percentage of that amount. Merchant cash lenders do evaluate your risk and credit, but differently than a bank. MCA lenders look at daily credit card receipts and give you a cash advance based on whether you can promptly pay back the advance.
Rates on an MCA are usually much higher than other financing options. Read the fine print and understand the term you are being offered. There are fees and holdback amounts that are also used in a merchant cash advance.
Holdback and Factoring
A holdback amount is a percentage of daily credit card sales directly applied to your cash advance. Holdback percentages are usually between 10 and 20 percent and are fixed until you pay back the cash advance.
A merchant cash advance repayment is based on how many credit card transactions your business does. So if you have high credit card transactions, you can pay back your advance quickly. But, of course, if transactions are lower on certain days than predicted, the lender will draw less from your account.
Factoring rates are the difference between the interest rate and a holdback amount. Most merchant cash advances charge this factor rate, and the rate isn’t amortized over the life of the advance. Usually, typical factor rates on merchant cash advances are very high and can be double or triple digits. It all depends on the provider.
A merchant cash advance may make sense for your small business if you need cash quickly to pay emergency payments. However, do measure the costs of the merchant cash advance over types of loans. Qualifying criteria are less stringent than a traditional loan, but a merchant cash advance is expensive. However, some small business owners successfully use a merchant cash advance to access immediate capital for their businesses.
A merchant cash advance is not reported to the business credit bureaus because it is not a loan. As just an advance, it neither builds nor strengthens your credit profile. Be careful, rates vary from provider to provider, and an MCA is an expensive type of financing.
Factoring Line of Credit
Factoring is not a loan. You are not issued debt as part of the transaction. The funds provided to a business are in exchange for the accounts receivable. There are a few restrictions regarding the use of factoring funds.
However, a factoring line of credit provides a quick solution to managing cash flow. Your cash flow is the rate at which money flows into and out of your business. If you are waiting months for a customer to make payments your cash flow is reduced preventing a business from having savings or carrying on growth activities.
Most lenders require collateral. Factoring companies operate by using only your accounts receivable as collateral. Factoring your receivables can be good for those businesses with long net terms for their customers but need immediate cash for operational expenses to help with business growth. Usually, small businesses looking for factoring opportunities are experiencing cash flow shortages because of slow turnover in accounts receivable.
The average cost of factoring falls between 1 to 5 percent. The volume in your accounts receivable plays a big part in calculating factoring rates. If you have high monthly amounts, you will pay lower fees. There are factoring companies that offer volume discounts.
Factoring fees or rates are determined by multiplying the factoring rate, usually from .055 percent to 2 percent. For example, if the rate is 1.5% of $100,000 for 12 months, your factoring rate is $18,000 for $100,000 borrowed.
Outsourcing your sales and freeing up your time can be an advantage of factoring. In other words, the factoring company takes over your accounts receivable and is responsible for collecting the payments on invoices. Factoring can help with smoother cash flow and financial planning, but it is expensive. And you have no control over your accounts receivable.
The downside to factoring lines of credit is the customers are not paying you; they are paying the factoring company. So you do have less control, and you give up that cushion.
Factoring lines of credit are high-risk funding and may result in over-dependence on factoring, trading, mismanagement, and possible dishonesty of clients. In addition, factoring is not economical for small companies that have little invoice turnover.
Be aware of these features of a factoring line of credit:
- It is costly,
- You are out of control in your accounts receivable,
- There are now three parties in your business, the seller, the debtor, and the factoring company,
- It does help to generate immediate cash flow,
- The factoring company assumes the full accounts receivable liability of the debtor,
- The factoring company has the right to do whatever they want to do to recover the accounts receivable.
Factoring lines of credit have faster approval, and approval generally happens within days of your application. The provider looks at the creditworthiness of your customers and does not ask for an in-depth credit analysis of your company. Factoring will grow as our company grows and this is a definite advantage.
Merchant lines of credit have quick approval applications. Credit does matter, but a merchant line of credit lenders does not take an in-depth credit analysis of you and your business. A merchant line of credit is based on a dollar limit.
Both ways of financing are somewhat expensive. Thoroughly investigate both types of borrowing to make the best decision for your company.