Equity Vs. Debt: 6 Difference

When it comes to the sources of financing, companies or businesses have two primary options. These are equity and debt. Both of these types of finance have their advantages or disadvantages. However, companies use a combination of both to reap the maximum possible benefits from them. That is why a company’s capital structure will include both of them.

However, to use both these sources of finance properly, companies need to understand the differences between equity and debt. While there are many differences between them, the top 6 differences are as below.

1) Meaning

Equity is a type of finance that companies generate from their shareholders. In the case of different forms of businesses, equity comes from owners. However, apart from capital, equity also has other components, such as retained earnings, reserves, etc. Therefore, equity can come from external sources, primarily through shareholders and owners, or internal sources, such as profits.

On the other hand, debt represents liabilities taken from other parties, usually financial institutions. These include loans and debt instruments, such as bonds, that companies use to generate funds. Debts can either be short-term or long-term.

2) Returns

When it comes to equity, the primary return that companies provide to its shareholders comes through the profits it generates in its operations. Shareholders receive a percentage of the earnings of a company through dividends.

However, shareholders also get another type of return from investing in a company’s shares, which comes in the form of capital gains. If the company makes losses, however, it does not have to pay anything to its equity holders.

For debts, the primary source of returns provided by the company is interest payments. Every debt instrument carries terms that allow the debtholder to receive interest on their funds. Companies must pay interest on debts regardless of whether they make profits or losses.

3) Dilution of control

When a company generates equity finance, its control gets diluted. What this means is that the more equity a company generates, the more shareholders it will have with associated voting rights.

However, in case the existing shareholders contribute more equity, a dilution of control may not occur. Nonetheless, a dilution of control is considered bad for companies.

On the other hand, debts don’t usually cause a dilution of interest. It is one of the reasons why companies prefer debt finance over equity finance. Similarly, debt doesn’t come with any voting rights, which allows the company to receive finance without any interference from the debtholders.

4) Cost

The cost of equity finance is generally higher compared to the cost of debt. It is because equity finance comes with a higher risk for shareholders and, therefore, they expect higher returns in exchange.

Similarly, equity finance is, theoretically, forever. Hence, in the long run, companies end up paying more to equity holders for their investments.

On the other hand, debt finance comes with lower costs. As mentioned, the only cost it usually comes with is the interest payments made on it. Similarly, debt finance has a finite life, depending on whether companies obtain short- or long-term loans. Therefore, debt finance is substantially inexpensive.

5) Payment timing

When it comes to the timing of their payments, equity holders usually get paid last. It is because equity holders receive a percentage of the profits of a company to calculate which, companies need to deduct all their expenses first, including any interest payments.

Once the company meets all its other obligations, it can pay the remaining amount to equity holders.

Debt holders, on the other hand, are priority payments for companies. Almost all types of debt require companies to pay them on time regardless of profits or other factors. That places debtholders first on the list of payments made by a company.

6) Usage

As mentioned, equity remains with a company for almost forever. That is why it is a long-term type of finance. Therefore, equity is best for when a company needs to finance long-term needs rather than short-term ones.

If a company uses equity for short-term needs, the costs will exceed the benefits and end up harming the company.

On the other hand, debt comes in short-term or long-term durations. The short-term debt usually lasts up to 1 or 2 years, while long-term debt is for five years or more. Based on the needs of a company, it can choose whether it wants short- or long-term finance. Usually, debt finance is best for short-term usage but can also help with long-term needs.

Summary

Key differentEquityDebt
MeaningEquity is finance generated through shareholders.Debt is finance that comes with liability, usually financial institutions.
ReturnsEquity holders can get dividends or capital gains.Debt holders usually gain through interest income.
Dilution of controlEquity causes a dilution of control and comes with voting rights.Usually, debt doesn’t cause dilution of control or come with voting rights.
CostEquity is considered more costly.Debt is relatively inexpensive.
Payment timingCompanies pay their equity holders last.Debt holders get paid first.
UsageEquity is best for long-term needs.Usually, debt is great for short-term needs but also helps with long-term financing.

Cost to Income Ratio

Cost to Income Ratio Meaning

The cost to income ratio is one of the efficiency ratios which is used to gauge the efficiency of an organization. It is used to compare the operating expenses of a bank vis-à-vis its income. The lower the cost to income ratio, the better the company’s performance.

The cost to income ratio is primarily used in determining the profitability of banks. It depicts the efficiency at which the bank is being run. The lower ratio the better and it indicates more profitability of banks. There is an indirect relationship between the cost to income ratio and the bank’s profitability.

We calculate cost to income ratio with the following formula:

Cost to Income ratio= Operating cost/Operating income

Operating expenses of banks include:

  • Professional services
  • Rent/Lease
  • Sales and marketing
  • Telecommunications
  • Office supplies
  • Utilities
  • Salary to staffs
  • Interest expense

   Operating income of banks include:

  • Interest income
  • Fees and commission
  • Brokerage charges
  • Discounting charges

The same ratio can be written for banks as Operating costs/ Financial margin

It is useful in analyzing the banking stocks. There exists inverse relationship exists between the Cost Income ratio and bank profitability. Banks use this ratio to track the movement of costs vis-à-vis its income for the same period. It can be computed on a yearly basis and compared year on year and with another bank too. High cost to income ratio may indicate multiple things:

  • Bank is not managed in an efficient manner
  • Too much of competition in the banking industry

To reduce this ratio the company either needs to increase its operating income or decrease its operating expenses. Employee expenses and administration expenses come under the operating expenses.

Let us take the following example to calculate cost to income ratio of Sinra Inc. a small bank.

Sinra Inc

Income statement

As of 31st Dec. 2019

Particulars2019 (USD)
Income from financing85,234
Income from Portfolio546,892
Income from investment253,648
Other income156,324
Total income1,042,098
  
Expense from financing123,457
Expense for client deposit128,989
Expense for borrowed loan235,465
Other expenses123,659
Total expense611,570
  
Financial margin430,528
Loan/loss provision125,435
Foreign exchange gain/loss56,898
Operating income after LLP and forex adjustment248,195
  
Operating expenses175,000
Employee expenses85,000
Administration expenses90,000
  
Income before tax73,195
Taxes paid4,500
Income after tax68,695

Calculate cost to income ratio for Sinra Inc

Solution,

Operating costs             = 45,000

Financial income           = 1,042,098

Financial expense         = 611,570

Operating income        = 1,042,098- 611,570 = 430,528

Cost to income ratio    = operating cost/ Operating income

                                    = 175,000/430,528*100

                             =40.64%

This ratio of 40.64% implies that Sinra Inc. made expenditure of 40.64% to generate operating income. However, for actual comparison we need to compare with bank’s past figures or its peers in the industry. Here, the costs seem to be lower so the bank is performing efficiently.

Lower the ratio, better profitability the company may achieve. When the ratio is higher vis-à-vis previous year, then it means the company is not performing properly than the previous year.

The cost to income ratio can be computed by the following steps:

  • Deduct interest income and interest expenses to arrive at net interest income.
  • Add commission and discount income to net interest income (income from financing, income from portfolio, income from investment
  • Add other income to get total income.
  • Deduct operating expenses and financing expense to get net income.
  • Adjust for LLP and foreign exchange gain/ losses.
  • Deduct operating expenses to get net income before taxes
  • Deduct taxes paid and we get net income after taxes.
  • Cost to income ratio is obtained by dividing operating expenses to operating income.

Operating expenses don’t include loan write-offs.

Example:

Let us understand this ratio with another detailed analysis of an example:

AmountFY 2019FY 2018
Interest earned90.2570.21
Other income4065
Total income130.25135.21
Interest expenses3025.32
Operating expenses2032
Employee cost1218
Other operating expenses814
Computation  
Net interest income60.2544.89
Operating income2033
Cost to income ratio100%96.97%

Here, the cost to income ratio is very high in both the years which is not a good indicator of efficient performance of the company. They are spending what they are earning from operations. They must look at options to reduce their operating expenditure. 

Let us take the final example of ABC Bank ltd.

AmountFY 2019FY 2018
Interest earned4135
Other income2018
Total income6153
Interest expenses1815
Operating expenses98
Employee cost65
Other operating expenses33
Computation  
Net interest income2320
Operating income1110
Cost to income ratio81.81%80%

Here, the cost to income ratio is again very high for both years. This ratio can be acceptable at the initial years of operations only. Else, the management needs to take a serious note of higher operating expenses and lower operating income.

Asset Management Ratios

Definition

Asset management ratios are a group of metrics that show how a company has used or managed its assets in generating revenues. Through these ratios, the stakeholders of a company can determine the efficiency and effectiveness of the company’s management.

Due to this, they are also called turnover or efficiency ratios. As the name suggests, these ratios usually consider only two factors, a company’s assets and revenues.

Since companies have various types and classes of assets, there are also different ratios for different assets. Some of the most commonly used asset management ratios include inventory turnover, accounts payable turnover, days sales outstanding, days inventory outstanding, fixed asset turnover, receivable turnover ratios, and cash conversion cycle.

Purpose

The purpose of why stakeholders calculate asset management ratios depend on the type of stakeholder. Usually, asset management ratios are crucial for investors and shareholders. Through these ratios, they can calculate the efficiency and effectiveness of their investments. Usually, the better these ratios are, the higher the chances of investors and shareholders investing in the company.

Furthermore, these ratios allow stakeholders to analyze the financial performance of a company from multiple aspects. Usually, stakeholders prefer companies with higher profits. However, judging companies by the amount of their profit is not suitable for comparisons. Similarly, just because companies can make profits doesn’t mean they are using their assets effectively.

Therefore, asset management ratios can help with all these aspects, and much more.

Assets Management Ratios

Some of the most commonly used asset management ratios are as below.

1) Total Asset Turnover

The Total Asset Turnover is a ratio that measures the efficiency of a company in the use of all its assets to produce sales. It gives a summary of all the asset management turnover ratios. The higher the asset turnover ratio of a company is, the better and more efficient it is considered by stakeholders.

Asset turnover = Sales / Total Assets

2) Fixed Asset Turnover

The Fixed Asset Turnover is a ratio that measures the efficiency of a company in the use of only its fixed assets to produce sales. This ratio only considers the use of long-term assets as compared to short-term. While it is a type of asset turnover ratio, some stakeholders prefer only considered the fixed assets of a company to evaluate its efficiency.

Asset turnover = Sales / Fixed Assets

3) Net Working Capital Turnover

The Net Working Capital Turnover is a ratio which signifies the efficiency of a company in using its working capital. It is also a type of asset turnover ratio. However, this ratio is usually a better indicator of a company’s operations as compared to using total assets. The higher this ratio is for a company, the better it is using its working capital in generating revenues.

Net Working Capital Turnover = Sales / Net working capital

4) Inventory Turnover Ratio

Another asset management ratio that is considered critical is the Inventory Turnover Ratio. It shows how many times the company has sold and restocked its inventory within the accounting period under consideration. While a higher Inventory Turnover Ratio is preferable, if it is too high, it can also indicate a risk of stockouts. A low ratio, on the other hand, may indicate slow-moving inventory.

Inventory Turnover Ratio = Net Sales / Inventory

5) Days Sale in Inventory

Another inventory-related asset management ratio is the Days Sale in Inventory. Expressed in a number of days, it calculates the time it takes a company to sell off all its inventory. Simply put, it shows how much time it takes the company to convert stock into sales. For this ratio, the lower the number of days, the better it is.

Days Sales in Inventory = 365 (days) / Inventory turnover

Another formula to calculate the ratio is as follows.

Days Sales in Inventory = Inventory / Cost of Goods Sold x 365 days

6) Receivables Turnover

Receivables Turnover is a ratio that measures how many times a company collects its accounts receivable balances. This ratio depends on the credit policies of a company. A higher Receivables Turnover ratio means the company collects its credits promptly.

Receivables Turnover = Sales / Accounts Receivable

7) Days Sales Outstanding

The Days Sales Outstanding ratio measures the efficiency of a company in recovering its receivables. Similar to the above ratio, the DSO expresses the result in a number of days. A lower DSO means that a company is recovering its receivables in a short amount of time. Shorter receivable collection periods can also be beneficial in avoiding bad debts. Other names for this ratio are Average Collection Period or Days Sales in Receivables.

Days Sales Outstanding = Accounts Receivable / Sales x 365 days

8) Payables Turnover Ratio

Accounts payable aren’t the assets of a company. Nonetheless, they are a part of a company’s working capital management. The Payables Turnover shows how quickly a company makes payments to its suppliers for credit purchases. A high ratio means that the company pays its bills in a short amount of time. A low ratio may be an indicator of cash flow problems.

Payables Turnover Ratio = Purchases / Accounts Payable

Importance

Asset management ratios are highly significant in their importance. First of all, these ratios help determine the efficiency and effectiveness of a company. Without these ratios, making comparisons between the performance of various companies becomes complex. Similarly, asset management ratios play a significant role in helping investors in making decisions.

Similarly, these ratios can indicate the performance of a company in a specific area, for example, working capital management. Therefore, they can also help companies in controlling their assets and generating the maximum possible revenues for the limited resources they have. Asset management ratios also signify the fact that only considering a company’s revenues is not crucial. It is also critical to take its usage of assets into account.

Limitation

There are several limitations of asset management ratios as well. Most importantly, these ratios consider the revenues of a company and neglect its profits. While generating higher revenues is critical for companies, they must also weigh their profits. Generating higher revenues while lacking the capacity to convert them into profits is futile.

Similarly, these ratios consider the historical information of a company. It means investors must also consider other aspects of the business of a company along with these ratios. Furthermore, these ratios may return inaccurate result sometimes, for example, when companies have assets they don’t use anymore. Lastly, these ratios are also subject to manipulation due to their dependency on information obtained from financial statements.

Conclusion

Asset management ratios are necessary for the evaluation of the efficiency and effectiveness of a company. These ratios indicate how well a company uses its assets in generating revenues. The purpose of these ratios depends on the user. Asset management ratios are of significant importance, although they may have some limitations.

How to improve return on capital employed?

Return on capital:

Return on capital or return on equity invested or capital employed is the percentage return on investment. The return is generated from the profit the business makes from its activities. This is the formula for calculation of return on capital employed:

Return on Capital Employed is calculated by Earning Before Interest and Tax / Capital Employed

To understand how we can improve the return we generate from the capital employed, it is also important to look at what we’re investing in. Investments can be stocks, bonds, mutual funds, real estate or interest-bearing accounts, etc.

Some investments are much riskier than others while some investments yield a much greater return than others. Most investors prefer more return and less risk.

How to improve return on capital employed?

Now moving on to how we can improve our return we yield on our investments- there are multiple ways to do so. Let take a look at the most effective ways.

  1. Reduce costs and increase sales: By reducing costs, sales value will increase and greater sales will lead to more profit being generated. This can’t be done simply by spending less but finding out about the nature of each cost and how it affects the selling price and profits. Lowering the selling price won’t be the only solution if costs aren’t being reduced too. But higher sales don’t necessarily mean higher profits or higher returns. By reducing costs, the company can become more efficient too if they try to find areas where unnecessary costs are being generated. This will lead to operational efficiency as well. We need to analyze how much percentage change the reduction of each cost brings in the sales and evaluate the percentage increase in profits due to the reduction in cost percentage. Hence, the combination of lower costs and higher sales will provide a better return on capital.
  2. Disposal of assets: Selling off surplus assets and inefficient assets that don’t generate much revenue or increase costs can also improve your return on capital employed. Assets that cost more than they generally are of no use to any business. For example, a production company should sell off the machine that has outlived its efficient days. This way there will be less capital employed and more returns leading to a better return on capital employed percentage.
  3. Level of operation: The scale at which the business operates is also very important to look at while talking about return on capital. If the business is small scale, it will have high fixed costs and the return will be lower. However, if the business is high scale and increasing the volume can reduce fixed costs, the business should be doing so in order to maximize profits. This is also known as economies of scale.
  4. Debt financing: Furthermore, the company should try to finance its business through debt financing rather than equity financing. Equity financing dilutes shareholders holding since the number of shareholder increases meaning the net profit would be distributed among a higher number of investors.

Conclusion:

A perfect combination of all these ways can lead to a better return. Many things go overlooked in business and to have the maximum return generated on all the capital invested, a company should analyze each and every aspect of its business.

Return on capital employed tells the shareholders the value of a company and how profitable the company is. A higher return is obviously better but we can’t judge the value and performance of a company by looking at just one figure.

The trends of many ratios over the years and across the industry has to be taken into consideration.

Just generating lots of profit with no actual efficient operations taking place in the business will lead to a greater return, but when taking the bigger picture into account, it is a loss for business because of the inefficiency.

How to improve quick ratio?

Quick Ratio:

Quick ratio can best the best determinant of liquidity measures within a company. As a matter of fact, it can be seen as a measure to validate the organization’s ability to meet its day to day expenses and other short-term liabilities like accounts payable and accrued interest expenses.

In this article, we will discuss the ways how a company could use to improve the quick ratio when the calculation shows that ratio performance is not meet the expectation of company management.

Formula:

The quick ratio or acid-test ratio can be calculated through the following formula:

(Current assets – inventory) / Current Liabilities

How to improve quick ratio?

Often the greatest organizations are faced with the greatest challenges pertaining to liquidity, to an extent where they are often forced to shut down.

Therefore, given the overall importance of ensuring liquidity within the firm, it is really rudimentary for organizations, regardless of their size to ensure that they follow certain protocols to improve their quick ratio.

  1. Increasing Sales and Inventory Turnover: There is no doubt to the fact that Sales and Inventory Turnover are some of the greatest determinants to gauge business standing. However, in order to improve the liquid resources your business has in hand, it gets pivotal to increase the sales for your company. In return, this will increase inventory turnover. Having greater turnover means greater cash in hand for the company, and hence, greater sales.
  2. Improving Invoice Collection Period: Long-term Debts extended to clients are often one of the biggest reason for a company’s inability to meet its expenses. As a result, it often gets challenging to manage cash, and despite the fact that one might have greater sales and assets (long-term debtors), the liquidity position might get gruesome. It also increases the company’s exposure towards risk, because of the chance of clients defaulting on those debt gets higher, and significantly increases the probability of increased bad debts for the company. Therefore, by giving long-debtors discounts in order to attract them to pay early, your organization can quickly convert long term assets into cash, thereby increasing the liquidity you have at your disposal.
  3. Paying off liabilities quickly: Current liabilities tend to have an inverse relationship with quick ratio, which should, therefore, be decreased. This can be achieved by ensuring that you are able to pay back liabilities in due time.
  4. Discarding unproductive assets: Often in an organization, the corporation has certain assets lined up which do not generate any considerable revenue for the company. These assets need to be identified and then discarded in order to get cash against those assets. This cash can then be taken for short term liquidity of the company, hence improving the quick ratio of the company.
  5. Drawings: As far as drawings are concerned, it can be seen that drawings from business owners should also be prioritized and kept at a minimum. If your business is a partnership, then there should be strict preventions to ensure that there are no withdrawals in the form of drawings, because that just takes a heavy toll on the existing cash in the company.

Conclusion:

In addition to the features listed above, it can further be stated that the best manner to ensure that your company has an improved quick ratio is to ensure that there are strategies and plans decided which can ensure that there are sufficient funds and paybacks to facilitate the working capital of the business.

By investing less in inventory (adopting policies like Just in Time), you can ensure that you do not have a lot of money tied up in inventory.

Similarly, by ensuring that you are able to keep your credit limits in check for long term debtors, your business can have sufficient cash on hand to be able to manage the day to day expenses in a viable manner.

It is absolutely crucial that one does a holistic analysis of the Current Assets and Liabilities for the company so that it is easy to analyze which aspect needs to be highlighted and taken care of.

Importance and limitation of debt to equity ratio

Introduction:

Debt to equity ratio is computed by dividing the total liabilities of the company by shareholders’ equity. This ratio is represented in percentage and reflects the liquidity of the company i.e. how much of the debt owed by the company is used to finance the assets as compared to the equity.

The investors and especially the potential equity shareholders always use this ratio to assess company financing strategy since they are concerning about to profit that could deliver to them after paid to creditors, banks, as well as treasury shareholders.

Before moving to the discussion the limitation and advantages of debt to equity ratio, now let see the formula first,

The formula:

Debt to equity = Total liabilities / Total shareholders’ equity

A high debt/equity ratio is usually a red flag indicating that in the case of solvency the company will go bankrupt with not enough equity to cover the debts. A low debt/equity ratio indicates lower risk since the debt is lesser than the available equity.

A debt-to-equity ratio is an important part of ratio analysis performed under financial analysis. It is included under gearing ratios along with time interest earned ratio, debt ratio, and equity ratio.

Gearing ratios are a metric used to demonstrate the funding of an entity’s operations i.e. whether it was covered through debt or the investment made by shareholders.

An ideal debt/equity ratio is around 1:1 which means equity must be equal to liabilities; however, the optimal ratio depends more on the type of industry and may vary from industry to industry.

The following is the discussion of key importance and limitation of debt to equity ratio:

Importance of debt to equity ratio:

Debt to equity ratio is particularly significant for the financial analysis of a company. A list of points explaining the importance of the debt/equity ratio is mentioned below:

  • Debt to equity ratio is an important tool used in financial analysis to enable potential investors to examine the health of a company. A high debt to equity ratio is an indication of low liquidity. It means that the entity is unable to finance its obligations through the cash and reserves and is dependent on the creditors. The probabilities of the entity to go bankruptcy are high. It is a sign that new investors their money in.
  • Debt to equity ratio also helps in understanding shareholder’s earning. A high debt implies that high interests are paid by the company which reduces profits significantly. A decrease in profit is a decrease in dividends paid to the ordinary shareholders.
  • Debt to equity ratio is used by lenders and creditors as well when a small business applies for the loan. It signifies the entity’s credit trustworthiness and how regular they are in regards to payment of installments.
  • It is helpful for management to demonstrate the competition in the market. Debt to equity ratio can help the entity understand its performance against the competitors. This may help the management in making improvised decisions to reach the ideal debt/equity ratio.

Limitations of debt to equity ratio:

  • Debt/equity ratio may misguide the potential investors as well since a low debt to equity ratio can be a result of the company not appropriately financing the assets with the debt obtained. This is an indication of technical inefficiency which would result in lower returns even if the debt/equity ratio is low.
  • The optimal debt/equity ratio that is 1:1 can’t be widely used for all the industries out there. A capital-intensive entity may have a high debt/equity ratio indicating that net assets have been regularly maintained and financed through the debts obtained which would increase returns in the future due to higher production. However, a low-capital industry doesn’t need to invest in factories and types of equipment hence its optimal ratio should be around 1:1. This is one of the major limitations of the debt/equity ratio since it can only compare similar companies’ financial performance.
  • Debt to equity ratio requires context to understand. A person who isn’t well versed with accounting may not be able to defer the terminologies mentioned in the balance sheet. A clear understanding of the terms equity and liabilities is required to understand the concept and objective of the debt/equity ratio.