Differences Between Debt and Equity
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.
In this article, we will look at debt and equity separately and then do a comparative analysis between them.
Without any ado, let’s get started.
Debt vs Equity Infographics
There are many differences between debt and equity, but both serve the same purpose i.e. to help the company expand on their growth and endeavors. Here are the most important differences between debt and equity –
Key differences between debt and equity
There are many differences between debt vs equity and they are very much visible. Let’s have a look at them –
- 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 make, 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 the significant decisions in the business.
Debt vs Equity Comparison Table
|The basis for Comparison between Debt and Equity||Debt||Equity|
|1. Meaning||Debt is used as a loan and the creditors can only claim the loaned amount plus the interest.||Equity is sharing the ownership of the company with individuals which 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.||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.||Dividend is paid whenever the company decides.|
|6. Does company share profits?||No.||Yes, through dividends.|
|7. When the creditors/equity holders are paid?||Irrespective of earning profits or incurring 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)||Doesn’t create any leverage.|
We have seen all the major differences between debt and equity, both are important for business. Thus, talking about which is more valid is redundant.
We should rather talk about in which proportion a business can use equity and debt. 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 cost of capital.
This has a been a guide to the top differences between Debt vs Equity. Here we also discuss the Debt and Equity differences with examples, infographics, and comparison table. You may also have a look at the following articles to learn more –
- Operating Leverage vs Financial leverage Key Differences
- Debt vs Equity Financing
- Bonds vs Debentures
- Buying vs Leasing
- Interest vs Dividend