Capital is the basic requirement of every business organization, to fulfill the long term and short term financial needs. To raise capital, an enterpirse either used owned sources or borrowed ones. Owned capital can be in the form of equity, whereas borrowed capital refers to the company’s owed funds or say debt.
Equity refers to the stock, indicating the ownership interest in the company. On the contrary, debt is the sum of money borrowed by the company from bank or external parties, that required to be repaid after certain years, along with interest.
Almost all the beginners suffer from this confusion that whether the debt financing would be better or equity financing is suitable. So here, we will discuss the difference between debt and equity financing, to help you understand which one is appropriate for your business type.
Content: Debt Vs Equity
Comparison Chart
| Basis for Comparison | Debt | Equity |
|---|---|---|
| Meaning | Funds owed by the company towards another party is known as Debt. | Funds raised by the company by issuing shares is known as Equity. |
| What is it? | Loan Funds | Own Funds |
| Reflects | Obligation | Ownership |
| Term | Comparatively short term | Long term |
| Status of holders | Lenders | Proprietors |
| Risk | Less | High |
| Types | Term loan, Debentures, Bonds etc. | Shares and Stocks. |
| Return | Interest | Dividend |
| Nature of return | Fixed and regular | Variable and irregular |
| Collateral | Essential to secure loans, but funds can be raised otherwise also. | Not required |
Definition of Debt
Money raised by the company in the form of borrowed capital is known as Debt. It represents that the company owes money towards another person or entity. They are the cheapest source of finance as their cost of capital is lower than the cost of equity and preference shares. Funds raised through debt financing are to be repaid after the expiry of the specific term.
Debt can be in the form of term loans, debentures or bonds. Term loans are obtained from financial institutions or banks while debentures and bonds are issued to the general public. Credit Rating is mandatory for issuing debentures publicly. They carry fixed interest, which requires timely payments. The interest is tax deductible in nature, so, the benefit of tax is also available. However, the presence of debt in the capital structure of the company can lead to financial leverage.
Debt can be secured or unsecured. Secured Debt requires pledging of an asset as security so that if the money is not paid back within a reasonable time, the lender can forfeit the asset and recover the money. In the case of unsecured debt, there is no obligation to pledge an asset for getting the funds.
Definition of Equity
In finance, Equity refers to the Net Worth of the company. It is the source of permanent capital. It is the owner’s funds which are divided into some shares. By investing in equity, an investor gets an equal portion of ownership in the company, in which he has invested his money. The investment in equity costs higher than investing in debt.
Equity comprises of ordinary shares, preference shares, and reserve & surplus. The dividend is to be paid to the equity holders as a return on their investment. The dividend on ordinary shares (equity shares) is neither fixed nor periodic whereas preference shares enjoy fixed returns on their investment, but they are also irregular in nature. Although the dividend is not tax deductible in nature.
Investment in equity shares is the risky one as in the event of winding up of the company; they will be paid at the end after the debt of all the other stakeholders is discharged. There are no committed payments in equity shareholders i.e. the payment of dividend is voluntary. Apart from that, equity shareholders will be paid off only at the time of liquidation while the preference shares are redeemed after a specific period.
Key Differences Between Debt and Equity
The difference between debt and equity capital, are represented in detail, in the following points:
- Debt is the company’s liability which needs to be paid off after a specific period. Money raised by the company by issuing shares to the general public, which can be kept for a long period is known as Equity.
- Debt is the borrowed fund while Equity is owned fund.
- Debt reflects money owed by the company towards another person or entity. Conversely, Equity reflects the capital owned by the company.
- Debt can be kept for a limited period and should be repaid back after the expiry of that term. On the other hand, Equity can be kept for a long period.
- Debt holders are the creditors whereas equity holders are the owners of the company.
- Debt carries low risk as compared to Equity.
- Debt can be in the form of term loans, debentures, and bonds, but Equity can be in the form of shares and stock.
- Return on debt is known as interest which is a charge against profit. In contrast to the return on equity is called as a dividend which is an appropriation of profit.
- Return on debt is fixed and regular, but it is just opposite in the case of return on equity.
- Debt can be secured or unsecured, whereas equity is always unsecured.
Conclusion
It is essential for all the companies to maintain a balance between debt and equity funds. The ideal debt-equity ratio is 2:1 i.e. equity should always be twice of the debt, only then it can be assumed that the company can cover its losses effectively.
Moses Sharaz says
I found your article on difference between debts and equity very informative!
Thanking you – Moses
Ify says
I found this very helpful,.
thanks
Ruhiu Catherine Njeri says
Very informative information. But why do companies prefer ordinary share capital to debt capital as a source of finance?
Surbhi S says
The company prefer ordinary share capital to debt capital because the interest is to be paid to the debenture holders, at a fixed rate even if there is a loss in a particular year, but in case of ordinary shares, dividend is declared, only if there is a profit in that year.
Prateek says
Very well articulated and informative for beginner’s in finance
Vijay Salaria says
I found it very informative.
Shailesh Bernard Dominic says
For beginners who are trying to understand and figure out Mutual Funds of Equity and Debt, this is the most easiest and clear explanation. Thanks for sharing
RAVI KUMAR MEENA says
very very comprehensive article on this topic..
PETER ARIWAODO says
Very educative i must confess
Dr Pramod Singh says
Very well explained
shivaji patil says
It’s very informative for us