Corporations need to secure loans in order to do things like manage inventory, manage payroll, and expand business capabilities. Most loans require a security of sorts to ensure that the loan will be paid back, like any other loan that the average person would get.
A floating loan acts as that security in a lot of cases, and it is increasing in popularity. Here is an example:
You own a rent a car business and you want to secure a loan to expand your facility becuase business is booming. You have a large fleet of rental cars, so the bank uses those cars as the security for the loan. As long as you pay the loan back, the assets are fine, if not, the cars can be seized and sold to pay back the loan.
This example is fundamentally what a floating charge is. You have an asset group, the cars, and they have a changing value, and depreciate over time. The basis of a floating charge is to use a group of assets that change in value over time as a security for a loan. It may or may not be a good idea within the automotive industry, however if the bank uses the fleet as the asset base, rather than the individual cars of the fleet, they can hedge the depreciation risk, because a rental car company will need to rotate stock continuously.
If the rental car company failed to pay the loan, the entire fleet would become frozen as assets and be sold, regardless of whether the fleet started with two cars, and now had fifty.
Generally, in order for a creditor to seize anything in a floating charge scenario, the floating charge needs to crystallize. It then becomes a fixed charge. At this point the assets can be liquidated. A floating charge conversion usually is triggered by a default or bankruptcy.
Scope of Floating Charge
There have been criticisms as to the scope of a floating charge. What has happened in the past, and still occurs is that the secured creditor stages the loan and floating charge in such away that it includes all assets of the business it is lending too. This could result, in the rental car example, in not only the vehicle fleet being liquidated, but all of the companies computers, furniture, and essentially anything that isn’t nailed down.
Floating charges are a popular equity tool but are open to abuse. If a business follows this route, they need to be careful to check the fine print and ensure their liability is limited.