Debt vs Equity | Equity vs Debt
Debt and equity are both forms of obtaining finance for corporate activities and day to day running of businesses. Debt and equity are distinguished from each other based on their specific financial characteristics as well as the different sources from which either is obtained. It is necessary to distinguish between debt and equity as the financial implications to the company of holding debt or equity are quite distinct. The following article is an explanation of the two forms of financing and the impacts that these pose on a firm.
Equity is commonly obtained by organisations through the issue of shares. Equity is a form of ownership in the firm and equity holders are known as the ‘owners’ of the firm and its assets. Equity may act as a safety buffer for a firm and a firm should hold enough equity to cover its debt. Incorporating financial ratios such as the debt-to-equity or gearing ratio, a firm should have twice as much equity as debt to cushion against losses or liquidation. The advantage to a firm of obtaining funds through equity is that there are no interest payments to be made as the holder of equity is also an owner of the firm. However, the disadvantage stands that dividend payments made to equity holders are not tax deductible.
Debt is usually obtained through selling financial instruments such as bonds and debentures to investors or by obtaining loans and other forms of credit from lending institutions. Debt financing can be effective for firms that do not possess the required funds to pursue a project. It can offer corporations a higher potential for growth. However, debt can become a burden to a firm since interest and principal repayments must be made to lenders and a firm may have to provide assurance to the lender of their ability to repay through the pledging of a security as collateral.
What is the difference between Debt and Equity?
Debt and equity are both forms of finance that provide funding for businesses, and avenues for obtaining such finance usually stem through external sources. The providers of equity financing are known as shareholders, whereas providers of debt financing are known as debenture holders, bondholders, lenders, and investors. The difference between providers of debt finance and equity finance is that, debt finance companies such as banks do not wish to become a part of your business, and do not wish to share the risk included in business activities. However, providers of equity finance become partners to the business with decision making power through voting rights and share the willingness to take risks in order to obtain higher returns and growth opportunities. It is also a key point to note that debt financing is cheaper than equity financing since they entail a tax shield for the interest payments on debt.
In a Nutshell, Debt vs Equity
• Equity financing is a form of ownership in the organisation through the purchase of shares in the firm. Providers of equity finance are willing to share in the risks of operating unlike providers of debt who only wish to profit through the lending of finance to the institution.
• Debt financing entails borrowing funds from financial institutions and individuals through obtaining loans, issuing bonds and other financial instruments. In obtaining debt finance, an organisation must repay the principal amount along with the interest repayments, which may become a burden to the borrowing firm. However, debt finance is cheaper than equity finance due to the tax shields available through interest payments.
• A firm must ensure that they posses adequate equity to cushion against losses. In terms of the gearing ratio, a firm must have a ratio of 2:1, where debt held is only half as much as the equity in the firm.
• It is essential to note that a firm cannot operate solely on either equity or debt, since equity is essential to act as the financial backbone of the firm while debt financing is essential for obtaining additional funds for growth and expansion.