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