Differences Between Debt and Equity
Debt refers to the source of money which is raised from loans on which the interest is required to be paid and thus it is form of becoming creditors of lenders whereas equity means raising money by issuing shares of company and shareholders get return on such shares from profit of company in form of dividends.
Debt and equity are the external sources of finance for a business. When a business needs a lot of money for an expansion of projects or for reinvestment and improving their products, services, or deliverables, they go for equity and debt.
- Equity is helpful for those who would like to go public and sell the shares of the company to individuals. To conduct an IPO, a company needs to bear various costs; but the end result is most cases are helpful.
- In the case of debt, the story is slightly different. Businesses opt for debt for two main reasons. Firstly, if the business has gone through the route of equity, then they would take a portion of the debt to create leverage. Secondly, many businesses don’t want to go through the complicated process of IPO and that’s why they opt for a route to take debt from the banks or financial institutions.
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Debt vs Equity Infographics
Let see the top differences between debt vs equity.
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Key Differences
- Debt is called a cheap source of financing since it saves on taxes. Equity is called the convenient method of financing for businesses that don’t have collaterals.
- Debt holders receive a pre-determined interest rate along with the principal amount. Equity shareholders receive a dividend on the profits the company makes, but it’s not mandatory.
- Debt holders aren’t given any ownership of the company. However, equity shareholders are given ownership of the company.
- Irrespective of profit or loss, the company must pay debt holders. However, equity shareholders only receive dividends when the company generates profits.
- Debt holders don’t have any voting rights. Equity shareholders have voting rights for making significant decisions in the business.
Comparative Table
| Basis for Comparison | Debt | Equity | ||
| 1. Meaning | It is used as a loan and the creditors can only claim the loaned amount plus the interest. | It means sharing the ownership of the company with individuals that allow them to receive dividends & voting rights. | ||
| 2. Involvement | Much less since there’s no ownership sharing. | More because equity financing is all about sharing ownership. | ||
| 3. Cost of Capital | Fixed/Pre-determined cost of capital. | The cost of capital is not fixed. | ||
| 4. Voting rights | Creditors don’t receive any voting rights. | Equity holders receive voting rights. | ||
| 5. Dividends | No dividend is paid. | A dividend is paid whenever the company decides. | ||
| 6. Does the company share profits? | No. | Yes, through dividends. | ||
| 7. When the creditors/equity holders are paid? | Irrespective of earning profits or incurring a loss, debt holders need to be paid. | Unless the company makes profits, the equity shareholders don’t get paid. | ||
| 8. Time of payment | Paid first. | Paid last. | ||
| 9. Leverage | Create leverage (Financial Leverage)(Financial Leverage)Financial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more | It doesn’t create any leverage. |
Conclusion
We have seen all the major differences between debt and equity, both are important for a business. Thus, talking about which is more valid is redundant.
We should rather talk about in which proportion a business can use them. Depending on the industry and the capital intensiveness of that industry, the business needs to decide how much new shares they will issue for equity financing and how much secured or unsecured loan they would borrow from the bank. Striking a balance between debt and equity is not always possible. But the business should make sure that they can take advantage of the leverage and at the same time, not paying too much in the cost of capital.
Debt vs Equity Video
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