Difference Between Debt vs Equity
The word ‘Debt’ means a borrowed amount used in business for the purpose of expansion, meeting short-term operating expenses, for any payment purpose, etc. Whereas ‘Equity’ means the fund contributed by the promoters or the shareholders of the company, and it represents the seed capital of the company by which the business was first started. Let us study Debt vs Equity in detail in this post.
What is Debt?
Debt can be funded by means of Loans or by Debenture. Loans can be funded by any financial institution or by banks, or by any other parties by means of unsecured loans. Unsecured loans are loans where the lenders do not have any authority of lending, and the interest amount is very high and contains fewer regulations compared to Secured Loans. Debentures or Loans from a Financial Institution are known as secured loans and are abided by certain regulations as guided by the Country’s central bank. It contains a fixed interest as prevalent in the market. Debentures (or Bonds) or Bank Loans have a pre-decided interest rate, which is needed to be paid by the Borrower on a Monthly/Quarterly basis as decided by both parties. Payment of the interest and the principal amount does not have any relation with the nature and profitability of the business; the Debenture holders enjoy a fixed rate of interest known as coupon rate till the entire loan is repaid. Debt can be of two types as per its tenure nature viz. Short-term and Long-term. Any Borrowings which has been taken for a tenure of less than one year is known as Short-term loans, and a loan taken more than one year is known as Long-term loans.
What is Equity?
Equity, on the other hand, is being funded by the shareholders of the Company, and they take the entire risk of the business, such as if the business is going through losses, then the Equity holders are entitled to take the risk, and the losses amount would be debited from the Shareholder’s Reserve. In the case of profits, a dividend can be received by the shareholders. Equity can be further divided into two types viz. Preference Shareholders and Equity shareholders. Preference Shareholders enjoy special rights over Equity shareholders, such as in case of profit left for the Shareholder, the Preference shareholders are entitled to sharing of profits before the Equity shareholders. But on the other hand, Equity shareholders have voting rights, unlike preference shareholders.
Analysis of Debt vs Equity in Business:
The concept of Debt is like a threat to the company, as any kind of business is layered with different uncertainties; during a downward business cycle, a company most of the time does not make healthy profits and, in most cases, faces series of challenges to sustain its profits. The margin always faces trouble, and the business is dependents on volume growth. So if a business is funded by High Debt and low equity, the business has to pay the high interest cost from the tepid profitability situation, and the Equity holders are bound to suffer in these situations. However, a certain level of debt is assumed to be healthy owing to the risk-bearing nature associated with the business. As per analysts, the Equity plus Reserves should be higher or equals to the amount of the total borrowing (both long-term and short-term). The calculations of Debt to Equity is measured by the D/E ratio, which can get by –
Debt to Equity ratio = Long-term Debt+ Short-term Debt/ Equity+ Share holder’s reserves. A healthy D/E ratio is assumed to be 1 or less than 1.
Head To Head Comparison Between Debt vs Equity (Infographics)
Below is the top 5 difference between Debt and Equity
Key Differences between Debt vs Equity
Both Debts vs Equity are popular choices in the market; let us discuss some of the major Differences Between Debt vs Equity:
- Though both Debts vs Equity comes under the Liability side of the Balance sheet, the features are completely different in nature. Equity is associated with the owner of the company, whereas Debt is associated with the Lender of the Company.
- Debt can be zero, but the Equity part can never be zero unless the business goes for liquidation.
- Priority is given to the Loan Provider as they are generally the external parties of the company, whereas Equity gets their dues after all the expenses and liabilities are made.
Debt vs Equity Comparison Table
Below is the topmost comparison between Debt vs Equity
|The basis Of Comparison||Equity||Debt|
|Related to||Related to the Capital invested by the shareholders in a business unit. The profits compiled on each year are added to the reserves known as Share holder’s reserves. Equity= Owner’s Equity+ Shareholder’s reserves.||The amount of fund invested by a third party or a lender in lieu of Fixed rate of interest cost for a pre-decided time frame.|
|Meaning||The equity constitutes the capital of the owner and the total cumulative profit earned by the business except the dividends paid to the owners. Equity can be negative in case of losses made by the business. During the liquidation of the business, Equity shareholders are the last ones to get their dues.||Borrowings include short-term and long-term borrowings that bear a fixed interest. The lenders do not concern about the business situation. In any adverse situation, the Business has to pay the Borrowed amount. However, during the liquidation of the business, the Short-term loan (under Current liabilities)and the Loan providers (Non-current liabilities) are entitled to get their dues after Assets are being sold.|
|Interest Cost and Dividend||As the Shareholders are the actual owners of the company, so after all the expenses and liabilities, the owners take a part of the Profits as Dividends, which is decided by the Directors in a board meeting and approved by the shareholders.||The amount of the loan, the rate of interest, and the tenure of the loan is decided before the loan is taken by the business. Payment of the entire loan plus interest is being divided by the tenure, and a certain amount needs to be paid every month or every quarter.|
|Calculations||Equity + Share holder’s reserves||Short-term Borrowings+ Long-term Borrowings|
|Financial Markets and Business||The business situation is directly co-related with the Financial Market. An increase in Shareholders’ funds is generally positive for both.||The same thing prevails over the Debt as well. If the loan amount becomes higher, then it eats the profitability of the company and is not a good sign for the Financial market and the business.|
Debt vs Equity is two parallel concepts of which had prevalent and is very much relevant in modern Businesses. Debt or Borrowings are very much different from the Equity or Shareholders’ fund as they both are conceptually different in nature and bear different characteristics as well.
This has been a guide to the top difference between Debt vs Equity. Here we also discuss the Debt vs Equity key differences with infographics and comparison table. You may also have a look at the following articles –