Debentures and Floating Charges
A debenture is a debt instrument, essentially a document from the company declaring that a debt is owed to the lender. It clarifies the value of the debt, the interest rate, and the date by which it must be repaid in full. It is often a fixed-rate loan. On the other hand, a floating charge is a part of the debenture used to provide security over a range of assets that increase or decrease in value over time, such as raw materials and inventory. They are used by businesses to help them in securing long-term loans.
What is a Debenture?
A debenture is a document that fundamentally acknowledges that a company has debt that must be repaid-with interest at a fixed rate issued by the business. The debt must be paid by the end of the maturity period, which often exceeds ten years, indicating that the loan is long-term. The debenture includes all of the essential details, such as the value of the debt, the date it must be repaid, the interest rate, and a signature to show its validity.
Debentures are not secured by collateral, making them insecure and putting the lender at risk because there are no assets to back up the loan should the company default. Sometimes debentures can be secured, meaning that the collateral can be liquidised to ensure the lender receives their repayment. However, this is rare.
A debenture aims to offer security to lenders, making it more likely that they will provide funding for the business. Once approved, the document becomes a binding contract, allowing the lenders to receive the money they are owed before the unsecured shareholders in liquidation. A charge is also included in the debenture, such as a fixed or floating charge.
Advantages and Disadvantages of Debentures
One of the many benefits of debenture is that lenders are more willing to give a business funding once a formal contract is in place, giving them security if a business declares bankruptcy. This way, companies can receive a loan to aid them in maintenance and development, whilst lenders benefit from the interest rate and repayment protection. Compared to other loans, the interest rate is significantly lower, making it the cheaper option and the extended maturity time that businesses have to pay it off.
As with any loan, there are disadvantages to debenture. Because it is a signed, formal contract, businesses have agreed to pay the loan in instalments and with interest every time the fee is due (usually monthly but can vary). In times of financial instability such as inflation, the interest remains the same. This loan can be challenging to pay off, especially for a more extended period. Additionally, if there is a fixed charge, the company has less authority over the assets it can sell.
What is a Floating Charge?
To understand what a floating charge is, it is helpful to gain insight into the two types of charges associated with debentures. They are categorised into fixed charges and floating charges. Fixed charges are advantageous to the lender because they state a company cannot sell the stated assets in the case of liquidation before the lender is repaid the outstanding debt.
Alternatively, floating charges are assigned to assets that fluctuate in their value, such as inventory, stock, property and machinery. These assets can be sold flexibly without giving the lender the power to reserve this right unless the company goes into liquidation and they are converted to fixed charges.
Advantages and Disadvantages of a Floating Charge
The primary benefit of floating charges is that they give a company more flexibility to acquire or sell assets without abiding by the fixed charge rules. As a result, businesses can make more independent transactions and operate with autonomy instead of asking for approval from the lender when wishing to buy or sell assets.
Floating charges can also have drawbacks. If a floating charge is assigned to an asset one year before a company goes into liquidation, the charge becomes invalid. Consequently, the floating charge becomes inadmissible, and the appointed assets can be sold to repay the lender.
Debentures and Floating Charges – To Conclude
In conclusion, debentures and floating charges are used to benefit both businesses and lenders, allowing a loan to be secured and offering security to the investor. Debentures are legally binding documents that are essential state elements of the loan, whilst floating charges are included to give the business freedom over their assets.
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