Selling equity and debt instruments are two popular methods that companies mostly adopt to raise funds for starting and/or continuing their business operations. The individuals and organizations to whom equity instruments are sold and funds are collected from them are known as stockholders or shareholders. The individuals and organizations to whom debt instruments are sold to obtain funds from them are known as debtholders. Both stockholders and bebtholders invest their money in companies with an expectation of earning a reasonable return on their investment. As a return on their investments, companies pay dividend to stockholders and interest to debtholders.
Payment of dividends is a distribution of business profit among shareholders and is decided and declared by the board of directors depending upon the company’s financial position and other core economic factors. The two important factors are the company’s cash position and availability of reinvestment opportunities etc. A company that finds ample reinvestment opportunities around it would certainly choose for the reinvestment of its available profits rather than distributing it among shareholders in the form of dividends. A wise reinvestment decision would result in increased shareholders’ value.
From above discussion, we can conclude that the payment of dividend in every period is not obligatory. Management can skip the payment of dividends if it does not seem appropriate in a period.
The payment of interest to bondholders is purely a business expense which the company is legally bond to pay to its bondholders according to terms and conditions of the debt agreement. Successful companies try to keep a right mix of equity and debt capital to avoid the payment of unnecessary interest expenses which could otherwise put them at serious financial trouble in future.
This article aims at defining and explaining the difference between debt and equity instruments.
Definitions and meanings:
Equity represents ownership in a business. In other words, it represents the stockholders’ contribution towards the acquisition of organization’s resources which are commonly termed as assets.
Two popular classes of shares that company mostly issue to raise funds are ordinary shares (also termed as common stock) and preference shares. Ordinary shares represent real ownership in the company whereas preference shares are hybrid securities in nature (i.e., they have the characteristics of both equity and debt instruments).
Components of equity:
Generally, the stocks or shares of a company are regards as equity. However, it may consist of many other items. In a corporate form of business, the total stockholders’ equity usually comprises of the following four components:
- Par value of outstanding shares of both common and preferred stock,
- Additional paid in capital on both common and preferred stock,
- Retained earnings (undistributed portion of profit that is retained in the business for future growth and debt settlements etc.),
- Treasury stock (repurchased shares out of previously issued common stock; reduces the dollar value of total stockholders’ equity because it is deducted from the total of first three components).
Debt is the sum of money which is borrowed by a company from individuals, firms, organizations and governmental institutions. In other words, it represents the contribution of creditors towards the resources of the business. The debt is repayable according to the terms and conditions laid down in the debt agreement. Broadly, the debts can be divided into two categories, short term debts and long term debts. Short term debts are usually repayable within one year period and are categorized as current liabilities whereas long term debts are repayable after one year period and are regarded as non-current liabilities.
In a corporate form of business, most of the debt arrangements are made through issuing of bonds, debentures and loan certificates etc. of different denominations and features.
The rest of this article differentiates the terms equity and debt in more detail.
Difference between debt and equity:
The main points of difference between debt and equity are explained below:
1. Economic status:
Equity is the cash which a company owns. This cash is raised by selling ownership of the company to investors who then become shareholders and own a certain percentage of holding/interest in the business. This cash is actively invested into business activities with an intention to generate revenues and operating income in foreseeable future. Debt is the cash which is owed by the company to the relevant lenders. This cash can be used for many purposes for example, investing into new projects, fulfilling previous liabilities and maintaining the gearing ratio of company according to industry standards etc.
2. Cost of finance:
The cost of equity is the amount of dividends a company distributes among its shareholders. These dividend payments are made according to the dividend policy of the particular company. Debt investment costs interest payments to a company. Company has to pay fixed amounts of interest on their debt borrowings which is in accordance with the conditions set in the loan agreements. Although, interest payments are regular and more frequent than the dividend payments, debt capital is deemed to be less costly than share capital, because the risk-exposure for lenders is lower than the shareholders, which is why in many situations debt capital results cheaper than the equity capital.
3. Span of investment:
Equity is long term investment as compared to debts or loans. Funds raised as equity remain within the company for longer periods than those of debts or loans. The reason being equity is technically the buying of ownership of the company while debts are taken as liabilities and for situational needs. Therefore debts are paid off after a certain period of time while cash raised from issuance of shares circulates for much longer periods.
4. Financial instruments:
Equity can be raised by issuing different kinds of instruments. Ordinary shares, preference shares, redeemable shares, irredeemable shares, non-voting preference shares, right issues etc. are some examples. Bonus issue are a type of shares that do not raise any equity and are offered to shareholders when a business is short of cash. These are issued according to the current percentage of holdings to already existing shareholders. Debt can be raised by issuing debt instruments or raising cash from a financial institute. Bonds, debentures, loan certificates, securities etc. are some examples of debt instruments. If debt is directly obtained from a financial institute like bank, saving association, credit union etc., the money is lent to the business based on its credit ratings.
5. Terms of finance:
Equity is an unsecured investment for shareholders. The company does not offer any security to the shareholders except returns in form of dividends and capital growth in their investments. In case of bankruptcy, shareholders as primary investors of the business can lose their investments if no cash is left after clearing all liabilities of the business. Debt can be both unsecured and secured. A business may offer its existing asset or assets in terms of security to a lender. In case of liquidation of business, the debt holder has always a prior claim on assets as compared to equity holders even if the debt is an unsecured debt.
Debt versus equity – tabular comparison
A tabular comparison of debt and equity is given below:
|Is the cash that company owns.||Is the cash that a company owes.|
|Cost of Finance|
|Is usually more costly than debt capital.||Is usually less costly than equity capital.|
|Span of Investment|
|Is raised as long term investment into the business.||Is raised to fulfill small, medium or long terms cash needs of a business.|
|Ordinary shares, preferences shares, redeemable shares, irredeemable shares etc. are some types of equity instruments.||Bonds, debentures, loan certificates etc. are some examples of debt instruments.|
|Terms of finance|
|Equity is an unsecured investment.||Debt can be both secured or unsecured.|
Conclusion – debt vs equity:
Cash is considered as the blood in almost any form of business organization. Every business organization needs cash to commence and continue its operations which is mostly obtained in two ways. An organization either borrows cash from fund providers which is termed as debt or loan or collects cash by selling shares of its common or preferred stock at par or premium.
It is very important for businesses to maintain a certain level of debt to equity ratio so that debt may not exceed a certain limit. The companies with heavy debts are known as highly leveraged companies. Such companies have to pay a heavy amount of cash for annual interest expenses which could eventually lead them towards bankruptcy. An ideal debt to equity ratio can be 1:1 which represents that the funds obtained through debt and equity equally contribute towards the resources owned by the business. The norm of 1:1 ratio may however not be applicable to all businesses. It may vary according to size, industry, niche market and jurisdiction in which a company carries on its operations.