What a merchant cash advance actually costs

A merchant cash advance is not a loan. It is a purchase of your future receivables at a discount. That is not a technicality. It is the reason the pricing looks the way it does, and the reason the number you are quoted is not the number you should be comparing.

The quote you get

An advance is quoted with a factor rate. You will hear something like: $50,000 at a 1.35 factor, repaid daily over roughly six months.

The arithmetic on the surface is simple. $50,000 multiplied by 1.35 is $67,500. You receive fifty, you repay sixty-seven and a half, so the cost is $17,500. Presented as a percentage of the advance, that is thirty-five percent, and thirty-five percent does not sound alarming.

It is not thirty-five percent. It is not close.

Why the number is misleading

Two things are missing from that presentation, and they compound each other.

The term. Thirty-five percent over six months is not thirty-five percent a year. Annualise it and you are already past seventy percent before anything else is accounted for.

The repayment pattern. This is the part that gets missed. A merchant cash advance is repaid daily or weekly, starting almost immediately. You never have use of the full $50,000 for the full six months. From day one the balance is falling, but the cost was fixed at the start and does not fall with it.

Compare that to a term loan, where interest is charged on the balance outstanding. On an advance you are paying the full $17,500 regardless, on an average outstanding balance closer to half the face amount.

Run that properly and a 1.35 factor over six months of daily payments lands at an annualised cost somewhere in the region of 120 to 140 percent, depending on the exact schedule.

How to check it yourself

You do not need a model. A rough conversion that gets you close enough to make a decision:

1. Take the total cost. Advance amount multiplied by the factor, minus the advance amount.
2. Divide by the advance amount. That is your cost as a percentage of what you received.
3. Multiply by twelve, then divide by the number of months in the term. That annualises it.
4. Multiply by roughly 1.8. That approximates the effect of the declining balance you never got to use.

On our example: $17,500 divided by $50,000 is 0.35. Times twelve, divided by six, is 0.70. Times 1.8 is approximately 126 percent.

That is the number to compare against the working capital line at eleven percent that you did not apply for because you assumed you would be declined.

The part nobody mentions

Daily debits come out whether or not the week was good. An advance sized against a strong month becomes a serious problem in a slow one, and the most common consequence is a second advance taken to service the first.

That pattern has a name in the industry. It is called stacking, and it is how businesses that were merely tight become businesses that are finished. If anyone offers you a second advance while the first is outstanding, treat it as a warning rather than an option.

When it is still the right answer

This is a real instrument and it has legitimate uses. It is defensible when all of the following are true:

• The use is short and self-liquidating. Inventory for a confirmed order. Materials for a signed contract with a defined completion date.
• The return on that specific use clearly exceeds the cost. Not hoped to. Calculated to.
• You have modelled the daily debit against your worst recent week, not your average one.
• Cheaper capital was genuinely unavailable in the time you have, and you actually checked.

If all four hold, an advance can be the correct commercial decision. If any one fails, it usually is not.

The honest summary

A merchant cash advance is expensive money that is easy to get. Sometimes expensive and fast beats cheap and unavailable. But that trade should be made deliberately, with the real number in front of you, rather than because thirty-five percent sounded reasonable.

If someone is arranging one for you and has not shown you the annualised cost, ask for it. Their answer will tell you what you need to know about them.

This is general information about how a commercial finance instrument is priced. It is not legal, tax, accounting, or investment advice, and it is not a recommendation for or against any product. Figures are illustrative. Your circumstances deserve advice specific to them.