Difference Between Debt and Equity

Difference Between Debt and Equity

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Rashmi
Rashmi Karan
Manager - Content
Updated on Nov 23, 2023 15:07 IST

Debt is money borrowed, equity is ownership in a company, or debt is a liability, while equity is an asset. Interesting, isn't it? The article discusses the concepts and characteristics of debt and equity and covers the difference between debt and equity.

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The financing markets have witnessed a lot of dynamism in recent years. New channels and forms of financing emerge, new financial products, and more or less the weight of public financing in the system, depending on the moment of the economic cycle. Despite the diversity of financing products and channels available, debt and equity can be classified into two large financing types. Both are valid for financing the company’s activity but have significant differences and implications. The main difference between debt and equity is that debt is the amount a borrower needs to repay with interest over a set period, while equity is the capital that a company owns and has no repayment obligation.

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What is Equity?

Equity is the Net Worth of a company and the source of permanent capital. Equity investments allow an investor to have an equal portion of ownership in the company. The cost of equity investments is higher than the debt.

Equity comprises ordinary shares, preference shares, and reserve & surplus. 

Equity capital can be obtained through a relative or friend, private capital funds, collective funding platforms, stock exchanges, and markets. The period is generally long-term because it deserves detailed study and finding the person or institution with the necessary capital. In equity investment, there is a risk that success goes hand in hand with the company’s failure. The higher the risk, the higher the expected benefits.

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Characteristics of Equity

  • The financier expects to get very high returns on his capital, but the situation remains unpredictable. 
  • Since there is more uncertainty when discussing the future, the required return is much higher and will depend on the company’s ability to obtain benefits and generate value. 
  • The investor can be involved in the management or take complete control if he owns most of the shares. 
  • To agree on a price for participation in the company, company valuation methods differ from the scoring systems on which debt financing is based. 
  • Shareholders have the opportunity to create wealth through dividend earnings as well as capital appreciation.
  • Investors with a more significant risk appetite can consider investing in equity.
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What is Debt?

Debt refers to the money that someone borrows from another. It can be an individual or a financial institution. The process of debt forms a relationship between the borrower and lender where the former must pay the borrowed amount to the latter within a certain period. In most cases, the debt amount must be repaid with some interest.

The debt is usually short-term, according to the needs of the borrower. The most common types of debt are loans, credit cards, mortgages, and corporate debt.

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Characteristics of Debt

The main features of debt are the following:

  • The financier or lender seeks to obtain a return on the money lent. 
  • The returns are short-term, and the payment schedule is known in advance. 
  • The lender does not participate in the company’s management. 
  • The lender considers the company’s past ability to generate cash, projects it into the near future, and determines if the company can repay the debt. 
  • The debt computes the company’s liabilities, worsening its credit quality if no other variable changes. 
  • Indebtedness reduces solvency and drains the generation of free cash used to service the contracted debt.

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Difference Between Debt and Equity

Let’s look at some other differences between debt and equity.

  Debt  Equity
Definition Debt capital comprises the company's loans, including the bonds cancelled through a fixed payment plan. Equity corresponds to the funds provided by the owners of the companies, whether they are investors or holders of shares.
Repayment The debt must be repaid, and interest over an agreed-upon period is usually in monthly instalments. No repayment obligation. The costs of equity finance depend on the company’s performance and earnings. 
Ownership The owners can retain full ownership. Equity investors invest in a stake in the business, which decreases the owner’s shareholding.
Security  The borrower may have to pledge an asset as security with the lender in case of non-repayment. No collateral needs to be put up.
Position of holders Debt holders are the creditors. Equity holders are the company’s owners.
Instruments  Debt can be in the form of term loans, debentures, and bonds. Equity can be in the form of shares and stock.
Returns Return on debt is known as interest, a charge against profit.  Return on equity is called a dividend, an appropriation of profit.
Risks  Risks are lower since interest is provided even in the case of loss, and the amount invested can be returned. Riskier. If the company is not making profits, returns can be as low as zero.

Conclusion

Both debt and equity have their advantages and disadvantages. Debt is generally less expensive than equity but comes with more risk. Companies with a lot of debt are more vulnerable to changes in interest rates and economic downturns. The cost of equity exceeds the cost of debt and gives investors a share in the company's profits. Equity investors also can benefit from capital appreciation, which is an increase in the value of the company's shares.

The best financing mix for a company will vary depending on its specific circumstances. Companies in the early stages of growth often rely heavily on equity financing, while more established companies may use a mix of debt and equity.

About the Author
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Rashmi Karan
Manager - Content

Rashmi is a postgraduate in Biotechnology with a flair for research-oriented work and has an experience of over 13 years in content creation and social media handling. She has a diversified writing portfolio and aim... Read Full Bio