What it means
Businesses advance cash for practical reasons. An employee travelling abroad needs money for hotels and meals before the claim can be processed; a contractor needs materials before the job starts; a sales agent needs to cover costs before commissions come in.
The advance is not an expense when paid, because nothing has yet been consumed; it is an asset, a claim on the recipient, that is cleared when the expense claim, the work or the commission statement arrives and any balance is returned or paid. The accounting is simple: debit an advances receivable account and credit cash when the advance is paid; when the expense claim is approved, debit the expense and credit the advance, with any difference settled in cash.
The control is what matters. Advances should be authorised, limited in amount, cleared within a set period, and reviewed for ageing; an employee with an uncleared advance should not receive another.
Supplier advances should be secured where large (a bank guarantee, a lien over materials) and released against milestones. Unclaimed advances become an unrecorded expense or, worse, an unrecovered loss, and lists of long-outstanding advances are a standard audit finding.
The borrowing forms are a different matter. A credit card cash advance lets a cardholder withdraw cash against the card's credit limit; unlike purchases, it carries no interest-free period, a fee of typically 3% to 5% of the amount, and a higher interest rate than purchases, so that $1,000 withdrawn for a month can cost $60 or more, an annualised rate above 70%.
A payday advance lends against the borrower's next pay cheque for a flat fee that, annualised, can exceed 300%. A merchant cash advance provides a business with a lump sum (say $50,000) in exchange for a fixed larger amount ($62,500) collected as a percentage of daily card receipts until repaid; because the repayment period is short, the effective annual rate is often 60% to 150%, though the contracts are usually expressed as a "factor rate" (1.25) that conceals it.
These products exist because their users cannot or will not access cheaper credit quickly, and they can be rational for a genuine short-term gap when the alternative is a bounced payment, a lost order or a penalty. They are ruinous as a habit, because the cost compounds and each advance is typically repaid by taking another.
Finance managers who see a merchant cash advance on a small company's balance sheet, or an employee repeatedly taking advances, read it as a sign of a cash flow problem that has not been addressed at source.
In practice
Real-world examples.
Example
A construction company advances $80,000 to a subcontractor for materials against a bank guarantee, releasing it against certified progress.
Example
A sales agent receives a $3,000 monthly draw against commissions and ends the quarter owing $1,400 after a slow month.
Example
A retailer facing a tax bill takes a merchant cash advance, repays it over five months, and has to take another because the repayments themselves have squeezed its cash.
Think of it
“A cash advance is money given before it's earned or spent-prepayment requiring later reconciliation.
Formula
Calculation
Advance outstanding = Advances paid minus Expenses claimed against them minus Amounts repaid
Effective Annual Rate of a cash advance = [(Total cost / Amount advanced) / Days outstanding] x 365
Merchant cash advance: Repayment = Amount advanced x Factor rate; Effective annual rate depends on how quickly the daily collections repay it
Worked example 1, employee advance. An engineer is sent overseas for three weeks and receives an advance of $4,000. On return she submits expenses of $3,650 with receipts. Entries: on payment, debit employee advances $4,000, credit cash $4,000; on approval of the claim, debit travel expense $3,650, credit employee advances $3,650; she repays $350, debit cash $350, credit employee advances $350. The advance account returns to nil. Had she not submitted the claim within the company's 30-day limit, the $4,000 would be flagged in the monthly advances ageing report and deducted from her next salary under her employment terms.
Worked example 2, credit card advance. A small business owner withdraws $2,000 on the company credit card to pay a supplier who will not take cards. Fee 4% = $80. Interest at 27.9% a year from the day of withdrawal; the balance is cleared after 25 days: $2,000 x 27.9% x 25 / 365 = $38. Total cost $118 for 25 days. Effective annual rate = ($118 / $2,000) / 25 x 365 = 86%. A bank overdraft at 12% would have cost $16.
Worked example 3, merchant cash advance. A restaurant takes an advance of $50,000 at a factor rate of 1.25, so it must repay $62,500, collected at 15% of daily card takings. Card takings average $2,400 a day, so daily collection is $360 and repayment takes $62,500 / $360 = 174 days, about 5.7 months. Cost $12,500 for an average outstanding balance of roughly half the advance over that period. Approximate effective annual rate = ($12,500 / $50,000) / 174 x 365 x 2 (because the balance declines steadily) = about 105%. If takings rise, repayment is faster and the effective rate higher still; the cost is fixed regardless of how quickly it is repaid. A term loan of $50,000 over six months at 15% would have cost about $2,200.Case study
Seen in the real world.
A courier company with 40 self-employed drivers had a practice of advancing fuel money to drivers on Monday to be deducted from their Friday settlement. It was informal, handled by the dispatch office from a cash float, and recorded on a spreadsheet. When the finance manager reviewed it, she found $27,000 of advances outstanding against a float that was supposed to be $5,000, including $9,000 owed by drivers who had left months earlier, and a pattern in which some drivers received a new advance every week regardless of whether the previous one had been settled.
The advances were in effect an unsecured, interest-free loan book run by the dispatch team. She moved fuel to company fuel cards, which eliminated the reason for most advances; set a written policy for the exceptions (maximum $200, cleared from the next settlement, no new advance while one was outstanding); moved the recording into the accounting system as a receivable per driver; and wrote off the $9,000 from departed drivers, which had never been recognised as a loss because it had never been recognised as anything.
The following year's audit noted the advances account at $1,100 and reconciled. Her report to the managing director pointed out that the company had been lending its own cash on worse terms than a payday lender's customers received: no fee, no interest, no security and no collection.
Watch out
Common mistakes.
- Treating an advance as an expense when paid. It is a receivable until the expense is claimed or the work delivered, and it must be tracked until cleared.
- Allowing advances to accumulate without ageing review, so that departed employees and failed suppliers leave unrecovered balances.
- Judging a cash advance product by its stated fee or factor rate rather than its effective annual rate over the actual repayment period.
Questions
People also ask.
Is a cash advance the same as a loan?
An employee or supplier advance is a prepayment, not a loan, though it must be repaid or cleared. Credit card, payday and merchant cash advances are loans in substance whatever they are called.
Why do credit card cash advances cost more than purchases?
They carry a fee, no interest-free period, and usually a higher interest rate, because issuers regard cash withdrawals as higher risk.
When is a merchant cash advance a sensible choice?
Rarely, and only for a short, specific, profitable need where cheaper credit is unavailable in time. It should never be a rolling source of finance.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%