Equity vs Debt Securities
Any firm that is planning on starting up a new business or expanding into new business ventures requires adequate capital to do so. This is the point at which the company’s top managers are faced with a decision on their hands, as to whether they should go forward and obtain equity capital or consider the option of using debt capital. In order to raise debt capital or equity capital securities are issued; which are called debt securities and equity securities. While both debt securities and equity securities can help raise capital, there are advantages and disadvantages in both. The following article takes a closer look at each form of capital and compares their similarities and differences.
What are Equity Securities?
Equity securities are stock sold by a firm on a stock exchange. These shares of equity held by the shareholders of the firm represent ownership in the firm and its assets. This ownership is, however, temporary and will be passed onto another investor once the shares are sold. There are quite a number of advantages in holding equity securities.
Unlike debt securities, no interest payments are made as the holder of equity is also an owner of the firm. Equity may act as a safety buffer for a firm and a firm should hold enough equity to cover its debt. However, there is also a considerable risk in share price fluctuation as the value of shares can appreciate over time and the shareholder might be able to sell their shares at a capital gain (higher price than the price at which shares were bought) or the share prices may fall, and the shareholder may suffer a capital loss.
What are Debt Securities?
Debt capital can be raised through debt securities such as bonds, certificates of deposit, preferred stock, government and municipal bonds, etc. A debt instrument will be issued by the borrower (the firm/government) to the lender (the investor) where the terms of the debt will be defined such as rate of interest, maturity date, date that the debt security will be renewed, amount borrowed, etc. The interest of a debt security will depend on the level of risk of the borrowing, or the repayment risk of the borrower. Government bonds usually have a low (risk free) interest rate, since it is a belief in economics that a country’s government cannot default.
Further to this, debt securities such as bonds are also given a rating called a bond rating, which are provided by independent ratings firms such as Moody’s and Fitch and Standard and Poor’s, which evaluates the borrower’s ability to meet their obligations. These ratings range from AAA (high quality investment grade) to D (bonds in default). The disadvantages of debt securities are the risk that the company will not be able to meet its debt obligations, and since bonds are sensitive to interest rate changes, the value of the bond may fluctuate with time. Furthermore, a company that holds excessive amounts of debt maybe at risk as the capital buffer may not be sufficient to cushion against unexpected losses.
What is the difference between Equity and Debt Securities?
Both debt and equity securities offer firms an avenue to obtain capital for its operations. However, these two forms of securities are quite different to one another. Equity securities offer the shareholder ownership in the business while debt securities act as a loan. Equity securities do not have a period of ‘expiry’ and can be held or sold off at any time, but debt securities have a date of maturity in which the borrowed funds are returned to the bondholder. Debt securities pay the debt holders interest payments while shareholders get paid dividends; however, sometimes dividends may not be paid, whereas interest payments are mandatory.
Summary:
Equity Securities vs Debt Securities
• Debt capital can be raised through debt securities such as bonds, certificates of deposit, preferred stock, government and municipal bonds, etc.
• The disadvantages of debt securities are the risk that the company will not be able to meet its debt obligations, and since bonds are sensitive to interest rate changes, the value of the bond may fluctuate with time.
• Equity securities are stock sold by a firm on a stock exchange. These shares of equity held by the shareholders of the firm represent ownership in the firm and its assets.
• Unlike debt securities, no interest payments are made for equity securities as the holder of equity is also an owner of the firm.