Definition
A floating charge is a form of security interest or lien over a group of non-specific assets, which may change in quantity and value. It’s commonly used in business loans as it allows the borrower to use the assets while the charge is in place. When the borrower defaults, the charge becomes ‘crystallized’ or ‘fixed,’ converting into a charge on the specific assets at that time.
Key Takeaways
- A floating charge is a security interest or lien over a group of non-constant assets, that change in quantity and value. This means it applies to assets like inventory, accounts receivable, etc., which frequently change over time.
- This type of charge is used frequently in corporate financing because it allows businesses to access loan capital secured against assets, while still being able to use those assets for regular business operations.
- In case of default and liquidation of the borrowing company, a floating charge becomes a fixed charge on the assets in existence at that time. Hence, if the borrower defaults, the lender will have the right to sell off the assets to recover the debt.
Importance
The finance term “Floating Charge” is important because it provides flexibility and security for creditors, especially in business transactions. A floating charge is a type of security interest granted to a creditor over a group of non-constant assets that may change in quantity and value.
Unlike a fixed charge which is tied to a specific asset, a floating charge floats over the assets, allowing businesses to use and trade those assets in their ordinary course of business. In the event of bankruptcy or liquidation, the floating charge crystallizes or turns into a fixed charge over the remaining assets, giving the creditor preference in receiving payment.
This means that they have a higher chance of recovering their money as compared to unsecured creditors. This adds an extra layer of protection for the creditors and allows businesses to secure loans against a variety of assets.
Explanation
The purpose of a floating charge is to offer flexibility to companies seeking credit. It is a form of security that a company can offer to a creditor. This type of charge is essential for companies that have fluctuating types of assets, such as stock.
Giving a floating charge to creditors allows the company to use its assets while still keeping them as a form of security. In a sense, it’s a way for companies to get the best of both worlds: they get to use their assets to generate profits, while also securing loans on the basis of these assets. However, a floating charge also serves a unique role in protecting the interests of the creditor.
It comes into play when a company fails to meet its obligations, such as repaying a loan. When that happens, the floating charge ‘crystallizes’ or converts into a fixed charge. It does so over whatever assets the company has at that point.
This process ensures that the creditor has some level of asset-backed protection in the event of the company’s insolvency. In this way, floating charges can reduce the risk for the creditor while providing needed liquidity for the borrower.
Examples of Floating Charge
A Business Loan: If a company secures a short-term loan from a bank with the understanding of an agreement that their assets will act as collateral, this is an example of a floating charge. In this case, the wide range of assets the company owns, including inventory, accounts receivable, intellectual property, and so on, can be used to form the floating charge. These assets change in quantity and value regularly, hence this charge is ‘floating’. If the company fails to repay the loan, the lender has the right to seize these assets.
Asset-Backed Commercial Paper: It’s a form of short-term investment issued by financial institutions. The issuing company backs this with a floating charge on their assets. Despite being a more risky investment option due to the fluctuation in asset values, it can offer greater returns.
Equipment Financing: A company, especially in industries such as construction or manufacturing, may use equipment financing to purchase machinery needed for operations. The loan is secured by a floating charge on the assets. If the company defaults, the lender has the right to sell off the machinery to recover their funds.
Frequently Asked Questions About Floating Charge
What is a floating charge?
A floating charge is a type of security interest or lien over a group of non-constant underlying assets, such as inventory, accounts receivable, and other short-term assets a company may have. It allows the company to use and dispose of the underlying assets in the ordinary course of business until a default event occurs.
How does a floating charge work?
A floating charge floats or hovers until a certain circumstance occurs – usually the company’s liquidation or default on its obligations under a relevant loan agreement. When this happens, the floating charge crystallizes or solidifies and becomes a fixed charge over the assets covered by the charge at that time.
What are the advantages of a floating charge for businesses?
Floating charges are largely advantageous to businesses as they allow companies to get loans using current assets as collateral. These assets can still be used, sold, or replaced without disrupting the underlying security. This provides the company with greater operational flexibility compared to fixed charges.
Can a floating charge become a fixed charge?
Yes, a floating charge becomes a fixed charge once the charge is crystallized. Crystallization refers to the event where a floating charge becomes fixed or attaching on the particular assets. It occurs in three situations – upon the appointment of a receiver, upon the commencement of liquidation, or by operation of a provision in the charge document.
What is a crystallization of a floating charge?
Crystallization is the process by which a floating charge converts into a fixed charge. If a company fails to meet the terms of the loan agreement and defaults or if the company goes into liquidation, the floating charge crystallizes into a fixed charge on the assets it covers at that time.
Related Entrepreneurship Terms
- Collateral
- Liquidation
- Secured Creditor
- Debenture
- Fixed Charge
Sources for More Information
- Investopedia: They provide a quick and simplified explanation about the fundamental financial and investment concepts.
- Corporate Finance Institute: This source provides online courses about finance. They also have dictionary-style explanations for financial terms.
- Financial Times: A well-established newspaper that includes definitions of complex financial terms.
- Lexology: This platform contains articles written by legal professionals that can give more depth to the legal implications of the term.
