Equity vs Debt (debentures): what’s better for business?

Welcome to Motivational Banker! I’m your friend Aastik Dave and today we will look into difference between Equity and Debt using examples.

When starting a business, understanding the sources of finance is crucial. There are primarily two types of funds: short-term and long-term. 

In business, there are mainly two sources: capital and debt. Capital itself can be divided into two main types: equity share capital and preference share capital. Debt can be understood as a loan or debenture.

You can watch the below video to understand the concept or go through the blog to read in details.

Difference Between Capital and Debt

To understand the difference between capital and debt in simple terms:

Equity Share Capital

• Ownership: This is the money invested in the business by shareholders and is seen as ownership in the business.
• Voting Rights: Shareholders have voting rights in company decisions.
• Dividends: Dividends are paid after all obligations are met and depend on the company’s profitability.

Preference Share Capital

• Priority: Shareholders receive dividends first but have limited voting rights.
• Fixed Dividends: Dividends are fixed and paid before equity shareholders.

Debentures (Debt)

• Loan: This is a loan that the business must repay with interest.
• Interest Payment: Interest must be paid regardless of profit.

Understanding Through an Example

Let’s assume a business has 5000 equity shares, each priced at ₹100, so the total equity share capital would be ₹5 lakhs. Similarly, if there are 3000 preference shares each priced at ₹100, the preference share capital would be ₹3 lakhs. If there are 2000 debentures of ₹100 each, the debenture capital would be ₹2 lakhs.

Thus, the total capital investment in the business would be ₹10 lakhs, comprising:

• ₹5 lakhs in equity share capital
• ₹3 lakhs in preference share capital
• ₹2 lakhs in debentures

Business Profit and Fund Distribution

The business income or profit is referred to as “Earnings Before Interest and Taxes” (EBIT). Let’s say the business earned ₹1,00,000.

1. Interest Payment: First, the business must pay the interest on debentures. For example, if there is a 10% interest on ₹2 lakhs of debentures, ₹20,000 must be paid as interest.
2. Tax Payment: Out of the remaining ₹80,000, if the tax rate is 50%, ₹40,000 will go towards taxes, leaving ₹40,000.
3. Preference Dividend: Next, preference shareholders are paid their 12% dividend. For ₹3 lakhs, this would be ₹36,000.
4. Equity Dividend: The remaining ₹4,000 will be distributed among equity shareholders. If there is no profit, equity shareholders will receive nothing.

Choosing the Right Source of Funds

Low Profit Situation

If the business is earning low profits and cannot even cover loan interest, it’s better to arrange funds through partnership and equity shares.

High Profit Situation

If the business is earning good profits and can cover more than the loan interest, taking a loan can be beneficial as the profit remaining after interest payment will be yours.

Conclusion

The key takeaway is to choose the source of funds based on the business’s profitability. If the business income is low, arranging funds through equity shares is advisable. However, if the business is earning well, taking a loan can be advantageous as the profit remaining after paying interest will stay with the business owners.

Thus, wisely choosing the source of funds is essential for the success of the business. I hope you now understand the methods to arrange funds and the differences between them.

This blog is to help students preparing for JAIIB and CAIIB exams understand the difference and strategic uses of debt and equity capital.

Topics-

• Debt vs Equity Capital
• Business Finance
• Equity Share Capital
• Preference Share Capital
• Debentures
• Earnings Before Interest and Taxes (EBIT)
• Business Profit Distribution
• Source of Funds
• Low Profit Business Strategy
• High Profit Business Strategy