Differences between Debt and Equity Capital

What is Debt Capital?

Debt Capital is the money that a company raises through borrowing from individuals or institutions, and they must repay the entire amount after a specific time interval. They are a cheaper and low-risk alternative for getting finances when compared to equity capital.

Debt Capital is either secured or unsecured. Secured Debt is a loan that the company takes by pledging its assets. It allows the lender to sell that asset and recover its money if it does not repay within a fixed duration. Unsecured Debt is a borrowing made by the company without pledging any assets as security.

There are three kinds of Debt Capital – Term Loans, Debentures and Bonds. Here is a brief description of the three terms:

  • Term Loans – Banks provide Term Loans to companies at a fixed/floating interest rate (according to the loan agreement). These secured loans have a fixed repayment schedule.
  • Debentures – Debenture is a debt instrument issued by a company to the general public. They can be secured or unsecured, and the principal amount is repayable after a fixed time interval.
  • Bonds – A bond is a fixed income instrument issued by the government or a company to the general public. They have a fixed date of maturity post which the issuer pays back the principal amount to the investor along with interest.

What is Equity Capital?

Equity Capital is the total amount of funds invested by the owners in their business. The equity of a company gets divided into several units, and each unit is called a share. The owners can sell some of these shares to the general public to raise funds. The shares are of two types – Equity shares and Preference shares. Here is a brief description of the two terms:

  • Equity Shares – These are ordinary shares of a company that the owners sell in the open market. Investors purchase these shares and become stakeholders in the organisation with ownership rights. They hold voting rights to select the company’s management. They get a percentage of the company’s profits, but only after preference shareholders get their dividend.
  • Preference Shares – Preference shares allow shareholders to receive dividends before equity shareholders. They are entitled to a fixed rate of compensation whenever the company declares a dividend. They also have the right to claim repayment of capital if the company dissolves.

Differences between Debt and Equity Capital

The main differences between Debt and Equity Capital are as follows:

Debt Capital Equity Capital
Definition
Debt Capital is the borrowing of funds from individuals and organisations for a fixed tenure. Equity capital is the funds raised by the company in exchange for ownership rights for the investors.
Role
Debt Capital is a liability for the company that they have to pay back within a fixed tenure. Equity Capital is an asset for the company that they show in the books as the entity’s funds.
Duration
Debt Capital is a short term loan for the organisation. Equity Capital is a relatively longer-term fund for the company.
Status of the Lender
A debt financier is a creditor for the organisation. A shareholder is the owner of the company.
Types
Debt Capital is of three types:

  • Term Loans
  • Debentures
  • Bonds
Equity Capital is of two types:

  • Equity Shares
  • Preference Shares
Risk of the Investor
Debt Capital is a low-risk investment Equity Capital is a high-risk investment
Payoff
The lender of Debt Capital gets interest income along with the principal amount. Shareholders get dividends/profits on their shares.
Security
Debt Capital is either secured (against the surety of an asset) or unsecured. Equity Capital is unsecured since the shareholders get ownership rights.

Conclusion

Companies need financing regularly to run their operations successfully. There are several differences between Debt and Equity Capital, but companies need both these instruments to raise funds.

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