A floating charge is a charge taken on the variable assets of a corporation or a limited liability partnership as security for indebtedness. It enables companies to acquire funds secured by a dynamic asset. The value and quantity of the dynamic assets are not constant, and they can be traded, sold, and/or disposed of over the life span of the business operations even without the consent of the lender.
A floating charge is a charge taken on non-constant assets of a corporation or a limited liability partnership as a security for indebtedness.
Floating charges support companies by allowing them to use current assets to finance business operations.
When a company fails to repay the security interest or enters liquidation, the floating charge converts to a fixed charge, after which the company is not allowed to use or sell the asset.
Understanding Floating Charges
Companies use a floating charge to secure loans against an asset class instead of a single asset. Although fixed assets, such as equipment and property, can be used to secure a loan, the company is not allowed to use such assets.
On the other hand, the assets associated with floating charges are generally short-term assets or current assets. The assets are consumed within a year, and a company is allowed to use them in its business operations.
For example, if cash is used as a security for borrowing, the cash balance will change during the course of a company’s operations. The quantity and value of the cash balance will change over time.
Home Depot Inc. is one of the largest retailers of home enhancement in the U.S., supplying construction products, tools, and services. Let us assume that the company used inventory as security to acquire a loan. The lender either exercises control over the inventory or is entitled to a floating charge, whatever is specified in the loan agreement.
Below is the copy of the quarterly balance sheet of Home Depot:
The inventory is highlighted in orange. We can observe here that the value of inventory varies from one quarter to another. The inventory value was $13,498 for the quarter ending on July 31, 2020, while it was $14,989 for the previous quarter ending on April 30, 2020. Hence, we can say that the asset used to secure a loan – which is inventory in our example –is allowed to vary in quantity and price.
Thus, a floating charge helps companies by allowing them to use current assets to finance business operations. If a company defaults in making the decided repayments, enters liquidation, or faces financial difficulties, the floating charge will crystallize. It implies that the company is now not allowed to dispose of any underlying asset of the floating charge.
Conversion of Floating Charge to Fixed Charge
Generally, for a fixed charge, tangible assets, such as property or equipment, are used to secure the borrowing. In such a case, if the borrower defaults on the agreement terms, the lender takes ownership of the asset to get back the outstanding loan amount.
For example, a mortgage is taken out against a property, and if the borrower fails to meet the repayment commitments, the bank will take ownership of the property and sell it to recover the outstanding loan.
In the event of a company failing to repay the security interest or entering liquidation, the floating charge automatically changes to a fixed charge. The conversion is referred to as crystallization. Once a floating charge gets converted to a fixed charge, the underlying assets can neither be sold nor used by the company in its business operations.
Crystallization can occur if the company ceases to exist, or the lender and borrower go to court and a receiver is appointed by the court. Once the floating charge is crystallized, the asset can no longer be sold, while the ownership of the asset is taken by the lender.
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