Definition
A floating charge is a form of security interest or lien that can be applied to a group of non-constant assets of a company or other legal person. It is not attached to specific assets but covers assets with a fluctuating quantity and value, like inventories, accounts receivable, etc. The charge floats until a default event, at which it crystallizes into a fixed charge on the assets it covers at that time.
Phonetic
Phonetics: /ˈfloʊtɪŋ ʧɑːrʤ/
Key Takeaways
- A Floating Charge is a form of security interest or lien that can be placed over a company’s collection of non-constant or ‘floating’ assets, such as inventory, cash, receivables, etc., to secure or collateralize a loan. This charge remains dormant until the company defaults on its loan obligations.
- Floating Charges are unique in that they allow businesses to use their current and future assets as collateral. Hence, making securing loans easier and more flexible.
- In case of bankruptcy or liquidation, Floating Charges become ‘crystallized’ or ‘fixed’ into ‘Fixed Charges’ over the assets they cover at that time. However, they generally rank behind fixed charges in terms of the repayment priority, meaning the lenders with fixed charges will receive payment first.
Importance
A floating charge is crucial in business finance as it provides a method for businesses to secure loans using asset-backed security without restricting their ability to use those assets in their day-to-day operations. It allows businesses to leverage their fluctuating assets like inventory, receivables, or securities as a sort of collateral. This charge, which can cover present or future assets, only “crystallizes” or becomes fixed when specific conditions occur, often when the company defaults on its loan. Therefore, it gives flexibility to businesses while providing a level of security to the lenders. It plays a significant role in managing finances and securing loans, especially for businesses with changing assets.
Explanation
A floating charge serves as a very efficient way for businesses to secure loans or other forms of credit. The purpose behind the usage of floating charges is that they provide a certain degree of protection to lenders in the event a borrower defaults on their payments, whilst offering flexibility to borrowers as they can obtain a credit line by using their business assets as collateral. It is most commonly used by companies that have a substantial number of variable assets, including inventory or receivables, which are not fixed and can fluctuate over time.This type of charge is ‘floating’ because it is not tied to a specific tangible asset when the loan is made. Instead, it ‘floats’ over the borrowers’ present and future assets. In a normal business cycle, the value of these assets continues to change, and a company remains free to use or sell its assets, despite the charge. Only when a default happens or a stipulated condition is met, does the charge ‘crystallize’ or become ‘fixed’ , at which point specified assets then become the legally defined collateral for the loan. Thus, a floating charge allows businesses to keep utilizing and managing their assets, while these same assets serve as security for lenders.
Examples
1. Company Lines of Credit: A business may open a line of credit with a bank using its current assets, like inventory or accounts receivable, as collateral. This is an example of a floating charge, as these assets can change over time in terms of quantity and value. The bank secures its risk by holding a floating charge over assets that fluctuate.2. Asset-Backed Commercial Paper: Corporations that issue asset-backed commercial paper typically use the short-term debt instrument to finance their operations. They secure the commercial paper with assets such as receivables, and often the pool of receivables is eligible for addition or removal of individual receivables. This pool operates as a floating charge asset.3. Invoice Factoring: Many businesses use invoice factoring to improve cash flow and get immediate capital. When a business sells its invoices to a third-party factoring company, the factoring company usually takes a floating charge over the book debts of the business. This means that the company is able to continuously raise invoices and enter into new contracts without seeking permission from the factoring company, which makes it a floating charge.
Frequently Asked Questions(FAQ)
What is a Floating Charge in the context of finance and business?
A floating charge is a type of security interest or lien that covers a pool of assets that may change in quantity or value, such as inventory, accounts receivable, etc. It ‘floats’ or ‘hovers’ until it is converted into a fixed charge, typically upon default.
When does a floating charge become a fixed charge?
A floating charge becomes a fixed (or crystallized) charge upon the occurrence of certain specified events, typically the borrower’s default, insolvency, or breach of specific covenants in the loan agreement.
Is a floating charge applicable only to certain types of businesses?
No, any type of business can use a floating charge as long as it has a fluctuating pool of assets, like inventory or receivables. However, it’s commonly used by companies rather than by small businesses or individuals.
How does a floating charge benefit the lender?
A floating charge gives the lender a safety net. If the borrower defaults, the lender can convert the floating charge into a fixed charge, sell the assets, and use the proceeds to pay off the debt. However, until the conversion, the borrower can freely use or dispose of the assets.
Can a borrower continue to use or sell assets under a floating charge?
Yes, under a floating charge, a borrower can continue to use, sell, or otherwise dispose of the assets in the ordinary course of its business unless and until the charge crystallizes into a fixed charge.
What happens to a floating charge if a company goes into liquidation?
If a company goes into liquidation, the floating charge will crystallize into a fixed charge. The assets are then generally sold off to pay the lender. In some jurisdictions, certain preferential debts will have priority over a floating charge.
How is a floating charge created?
A floating charge is typically created by a contract, such as a debenture or loan agreement, between a company and its lender. The agreement needs to be in writing and typically must be registered with a specific governmental or regulatory body, depending on the jurisdiction.
What type of assets can be included under a floating charge?
Any type of asset that can fluctuate in number or value can potentially be included in a floating charge. Common examples include inventory, accounts receivable, unissued shares, and future assets. The specific assets included will depend on the terms of the charge document.
Can a company have more than one floating charge?
Yes, it’s possible for a company to have multiple floating charges. However, the order of repayment in the event of the company’s insolvency will depend on the order in which the charges were created unless the debts are of equal priority.
Related Finance Terms
- Collateral
- Liquidation
- Secured Creditor
- Debenture
- Charge Certificate
Sources for More Information
