In simple terms, debt is the sum acquired from the outside or external sources along with the liability of some specific amount of interest at the time of repayment of borrowed funds and the equity is the owner’s capital; however, both debt and equity funds are raised to increase the share capital of the company.
Debts are the credits for the company and hence return on debts, i.e., interest on the debt is treated as a charge against income whereas equity funds are self-invested funds of the proprietor and hence return on it, i.e., a dividend is treated as an appropriation of profit.
However, equity funds are the owner’s capital; thus has no specific time limit to return the funds, as equity holders get paid after appropriation of all other debts and liabilities whereas debts are the borrowed funds from the outside investors and need to be repaid within a specific time limit whether the company earns profits or faces losses.
The mode of debt can be term loans, debentures or bonds, whereas the mode of equity can be shares and stocks of the company.
Content: Debt Vs Equity
- Difference and Comparison
- What is Debt?
- Types of Debts
- What is Equity?
- Types of Equity
Difference and Comparison
|Basis of Comparison||Debt||Equity|
|Definition||Debt is a loan borrowed from the outside sources such as banks and financial institutions along with the interest liability up to a fixed percentage.||Equity is the internal source of fund gathered from family, friends, other investors or self sum and is raised to increase the share capital of the company.|
|Nature of their Claims||Debt holders have fixed claims up to the limit of there principle and interest amount.||Equity holders being owner of the company have residual claims overall remaining's after paying all promised claims.|
|Priority on Liquidation||As debts are the loan taken from the creditors, hence the company is bound to repay such debt funds in priority before making any payments to its shareholders.||Equity holders acquire the last position for getting any dues or sum at the time of liquidation as they are the owner of the company.|
|Risk Limit||Risk is limited||Risk is Unlimited|
|Life Span||It has a fixed life.||It has an infinite life.|
|Types of returns||Debts provides steady returns in the form of "Interest".||Equity has a volatile return in the form of "Dividend".|
|Balloting/ Voting Rights||Debt holders are the creditors of the company; thus, they don't have any balloting or voting rights in the company.||Equity holders have full balloting or voting right while making decisions for the company.|
|Managerial Control||Debt holders have no managerial control in the company as their role in the management is static.||Equity holders have full control over the managerial decisions taken by the company.|
|Financing Options||Bank Debts, Corporate or Government Bonds, Leasing are some debt financing options.||Owner's Equity, Venture Capital, Private Capital, Unit link insurance plans, Equity link saving schemes are some equity financing options.|
|Taxes||Debts create tax deductible payments.||Equity does not generate tax benefits for its payments.|
|Percentage of Yield||Debts holders earn a low percentage of yield then equity.||Equity holders earn higher yield percentage as they are the risk-takers.|
|Security||Debt raiser requires security against his lent money.||No such security is required for raising equity funds.|
What is Debt?
Debt is one of the 4 pillars of financing literacy; in general terms, debt is nothing but a borrowed money from outside sources which has to be paid back after a certain period of time.
Thus, before opting for debts, it is necessary to think very carefully as it always increases the burden of paying more money than borrowed funds as lenders offer service with a fee.
They work out the fee by adding a borrowed percentage to the monthly instalments and such fee is called “Interest”.
Individual, companies, countries and government can have debts, i.e., each of them can owe each-others money for raising their capital funds for a fixed period of time in the form of loans or credits.
However, debts can be differentiated amidst good debt and bad debt.
Good debts are such debts which increase the value of the investment over time more than the value of debt borrowed.
For Example, taking student loan in the long run, it will help in earning higher amount of salary; thus, this debt is taken to get ahead in life and can earn more income than the borrowed debt.
Bad Debts are those debts which won’t increase the investment value as much as debt value over the period of time.
For Example, suppose company take a loan with 10% interest rate and making only 8% every year; therefore, the company is losing money, and such debts are treated as bad debts for the company, so it’s better to pay off such debts.
Types of Debts
Debts are generally divided into two types:
- Secured Debts
Secured Debts are given against the security of some assets such as mortgage loan, i.e., banks provide loans against house mortgage and if the borrower fails to repay such loan bank can foreclose and recover the amount of loan by selling the mortgaged property or asset.
Similarly, with a car loan, i.e., if you mortgage your car against a loan and fails to pay a debt, the lender will recover such debt from your mortgaged asset sale.
These type of loan is less risky for the banks or financial institutions as well as good for a healthy borrower as it is given with a low rate of interest.
Some of the examples of secured loans are secured credit cards, vehicle loan, life insurance loans, etc.
- Unsecured Debts
They are exactly opposite to the secured loans, i.e., no security is pledged against such loan. One of the best examples of unsecured debt is unsecured credit cards, which comes with a high rate of interest as it involves high risk.
If borrower won’t pay a sum, the lender needs to go to the court for reclaiming his money. And there are high chances that they may not be recovered; however, it will harm the borrower’s credit scores.
What is Equity?
Equity is the ownership share or the capital raised by the owner or investors of the company, i.e., the owner’s capital, as well as capital gathered from issuing shares to the investors, becomes the equity for the company as equity holders also become the partial owners of the company.
Such shareholders enjoy the rights as well as bears the liabilities of the company.
In accounting terms, equity can be determined by reducing the liabilities from the assets of the company.
Equity shares in the market are the most common investment option for the investors who want to invest their capital in the market; however, they carry an equal risk along with a high return on it.
Equity holders get paid off in form of “dividend” only after clearing all outside liabilities of the company even if the company gets liquidated the equity holders will get their share at last.
Equity holders also enjoy the perks and benefits of the company at the time of profit, however, the amount of dividend is not fixed, it depends upon the company’s performance and earnings made during the year.
Types of Equity
The equity can be divided amidst different types; they are as follows:
- Owner’s Equity
Owner’s equity is the proprietor’s own fund invested in the company as a capital fund to raise the overall amount of share capital. In other words, owners’ equity can be described as the owner’s right over the assets of the company after deducting all liabilities from all assets.
- Common Stock
Common stock is the main class of stock when you buy common stock; you become the partial owner of the company, i.e., become common shareholders and enjoys full voting rights.
Common stockholders elect the board of directors; however, common shareholders are not guaranteed a dividend, it will be decided by the board of directors whether to give a dividend to common stockholders or not by way of voting.
Common stockholders get paid after creditors and preference shareholders of the company; however, if the company earns a massive amount of profit the price of common stock will go up and the investment value will also go up.
- Preferred Stock
Preferred Stock is generally known as preference shares, and those who buy such shares are known as preference shareholders, and such stock by their name only defines that they get preference before equity shares payment in a fixed amount as a dividend.
However, preference stockholders do not enjoy any voting right in the decisions of the company.
- Retained Earnings
The earnings or the profits saved by the companies after summing dividend payments to their stakeholders are termed as retained earnings.
Retained earnings are the source of internal financing, and the company utilizes such earnings for future expansion of their business.
- Treasury Stock
Reacquired Shares of the company are termed as treasury stock. i.e., issuing company buyback its share from the marketplace or from the shareholders who are not yet retired; thus, it reduces the shareholder’s equity of the company.
- Debts are the borrowed funds from the outside sources such as funds borrowed from the bank and financial institutions as a loan with a certain interest liability, in contrast, equity is the internal source of fund gathered from family, friends, other investors and self-sum raised to increase the share capital of the company.
- Debt holders have fixed claims up to the limit of their principle and interest amount, in contrast, equity holders being the owner of the company have residual claims over all the remaining after paying all promised claims.
- Debts are the loan or borrowed funds taken from the creditors; hence the company is bound to repay such debt funds in priority before making any payments to its shareholders.
In contrast, equity holders acquire the last position for getting any dues or sum at the time of liquidation as they are the owner of the company.
- Debts acquire limited risk factor; in contrast, equity acquires unlimited amount of risk.
- Debts are the borrowed finance and; thus, have a fixed life, in contrast, equity is the owner’s fund; therefore, have infinite life.
- In debts returns are steady and received in the form of interest, in contrast, the type of return in equity is volatile and is received in the form of a dividend.
- Debt holders are the creditors; thus, do not enjoy voting right in any matter of the company, in contrast, equity holders have full voting right while making any decisions in any matter of the company.
- Debts holders have no managerial control in the company as their role in the management is static, in contrast, equity shareholders have full control over the managerial decisions taken by the company.
- Bank debts, corporate or government bonds, leasing are some debt financing option, in contrast, the owner’s equity, venture capital, private capital, unit link insurance plans, equity link saving schemes are some equity financing options.
- Debts create tax-deductible payments, whereas equity does not generate tax benefits for its payments.
- Debt holders earn a low percentage of yield then equity, whereas equity holders earn higher yield percentage as they are the risk-takers.
- Debt raiser requires security against his lent money, whereas no such security is required for raising equity funds.
Debts are the liabilities for the company as it is a loan taken for expansion of business or for raising the capital of the company. Thus, debt holders are the creditors for the business.
However, Equity is the shareholder’s fund in the company, which can be identified after deducting all liabilities from all the assets of the company.