Debt v/s equity is something you’ll hear quite often in finance, but the minute someone starts talking about it at full length your reaction might be something like this:
Don’t worry we are going to simplify these concepts with an example:
You want to buy a gorgeous dress from Versace but you cannot afford it by yourself. Your friend also wants the dress but she doesn’t want it as badly as you do.
Now you don’t have the money but you desperately need and want the dress.
You have 3 options :
Option 1: Borrow money for the dress from your friend and pay her later in installments with interest.
Option 2: Ask your friend to chip-in a little money for the outfit and in return allow her to wear the dress occasionally.
Option 3: Borrow some money from your parents for the dress and if your friend wants the dress too she can give you some money with the condition that she can wear it sometimes.
Option one is debt, option two is equity and option three is a mix of both debt and equity.
So debt and equity are the 2 ways companies fund their business.
Note: All companies have some amount of equity which is the money contributed by the founder to the business.
Meaning of debt in technical terms: Debt is the amount of money borrowed by one party from another. Debt is used by many companies to make large purchases for their business improvement.
For e.g. A designer has an order of 10,000 dresses for which she needs lots of material. But she doesn’t have enough money to buy the material. So she takes a loan for buying the material and after all her dresses are sold she can repay the loan with interest. A debt arrangement gives the borrowing party permission to borrow money under the condition that it is to be paid back at a later date, usually with interest.
Meaning of equity in technical terms: It is referred as the net amount of funds invested in a business by its owners along with any profits that were reinvested back in the business. The equity concept can also refer to different options available to others providing them an ownership in the business.
For e.g. A fashion designer needs money for international expansion of her business, so she looks for good investors. Anita wants to invest in a fashion brand because she has the knowledge on fashion but not the skills required to start designing herself. So she gives money to the designer for expansion with the condition that the designer shares a part of her profits with Anita in proportion to the money she invests. The designer agrees and gives her ownership rights by giving her shares of the company.
Debt v/s Equity which is Better?
Debt: Common types of debt are loans and credit. The benefit of debt is that it allows a business to use a small amount of money and grow it into a much larger sum, leading to more rapid growth in the business which might otherwise not be possible. This in financial terms means ‘Leveraging’
So next time someone says this company has more debt than equity then you can say: it is highly leveraged.
In addition, payments on debt are generally tax-deductible. The downside of debt financing is the payment of interest, meaning the total amount borrowed exceeds the initial sum. In addition, payments on debt must be made regardless of whether the business is making any profit or no. For smaller or newer businesses, this can be especially dangerous.
Equity: The main benefit of equity financing is that funds need not be repaid. However, equity financing is not a no-strings-attached solution. People who provide the funds in equity are called as shareholders as they own a share in the company. They contribute funds to the company with the understanding that they then own a small stake in the business and thus when the business makes a profit they will also get a part of it. At the same time, they also know that if the business is making a loss then they too stand to make a loss.
Since this risk is involved the cost of equity is much higher than the cost of debt.
How should a company ideally divide the debt to equity ratio?
Debt/Equity Ratio is a ratio used to measure how much a company has borrowed in comparison to how much is owned by shareholders,
The formula for calculating D/E ratios can be represented in the following way:
Debt/Equity Ratio = Total Liabilities (Loans, credit basically borrowed money) / Shareholders' Equity (Money contributed by owners and people who want a stake in the company)
The result may often be expressed as a number or as a percentage.
When this number is less than 1, it indicates that the company’s has borrowed less money. That, typically, would be an ideal ratio. However, it’s common for large, well-established companies to have Debt-to-Equity ratios exceeding 1 because they rather borrow money and repay it instead of parting with ownership of their company.
In a nutshell difference between Debt & Equity:
|Basis for comparison||Debt||Equity|
|Meaning||Funds owned by the company given to them from another company/individual.||Funds raised by the company by issuing shares is known as equity.|
|What is it?||Loan funds||Own funds|
|Term||Comparatively short term||Long term proprietors|
|Status of holders||Lenders||Proprietors/Owners/Shareholders|
|Types or Forms||Term loan, debentures, bonds, etc..||Shares and stocks|
|Nature of return||Fixed & regular||Variable & Irregular|
|Collateral||If the debt is a loan taken then collateral is needed but funds can be raised otherwise also.||Not required|
That was the basics of debt v/s equity, if you have any questions feel free to ask us and we will demystify it for you!