Debt Instruments Vs. Equity Instruments: Key Differences

Introduction

In every business around the world, finance or capital is essential for its daily running, stability and overall success. There is a term known as capital structure. This states the various ways a firm or company uses in funding its assets. The basis for the concepts and study focus on the subject of capital structure beginning with the introduction of Modigliani and Miller’s (M&M) notional model about corporate capital structure in 1958 which is considered to have created the turning point for modern day corporate finance theory.

The theory offers understanding into a firm’s capital structure decision in a capital market free of taxes, transaction costs, and other frictions. A company’s capital structure which it relies on for consecutive running has many sources but the two main sources it relies on are debt instruments also known as liabilities and equity instruments also known as assets.

This paper aims at comparing these two instruments (Debt and Equity) by explaining their key characteristics and further stating how easy or not it is to distinguish debt instruments to that of equity instruments.

What is Debt?

Debt is the sum of money borrowed by a company which it must repay and in most if not all cases with interest. This form of financing has been used over time by companies and in some cases individuals to finance their business(es). In line with the above and in addition to finance, companies also have other forms of finance which can be burrowed in form of bonds issued by the government. This only applies to companies and not individuals

What is Equity?

Ordinarily, equity is referred to as the shareholder equity (also known as shareholders’ equity) which signifies the sum of money that would be paid back to a company’s shareholders if all of the assets were liquidated and all of the company’s debt was paid off.

Debt Instruments

A debt instrument refers to a fixed income asset which enables the lender to earn a fixed interest on it apart from getting the original borrowed funds back while the borrower uses it to raise funds at a cost. This instrument also acts as a legal obligation on the borrower’s part to repay the borrowed amount alongside interests if any to the lender based on their agreement. Examples of debt instruments are; notes, bonds, debentures, loans, mortgages, leases or other arrangements made between a lender and a borrower.

Equity Instruments

As stated by Sibilkov (2009), equity allows a firm or business to acquire capital without earning liabilities. What this means is that the money gotten via equity does not have to be repaid at a particular time. The shareholders who procured shares in the firm or business plans to regain their investments from future profits. This means that companies should be able to produce returns through healthy stock valuations and dividend that meet or exceed this level to retain shareholder investment. The capital asset pricing model (CAPM) uses the risk-free percentage, the risk premium of the wider market, and the beta worth of the company’s stock to determine the expected percentage of profit or cost of equity. Usually, the cost of equity surpasses that of debt and because of this, the shareholders inure more risk than those who lend capital to companies.

Examples of equity instruments are:

• Common Stock: this is the common stock which companies sell to shareholders so as to raise money and thereby giving then (the shareholders) right over certain matters in the company.
• Preferred Stock: This form allows ownership in the company by shareholders but doesn’t give them any voting rights. These shareholders do get paid before common stockholders in case the business is liquidated.
• Retained Earnings: These are the retained gains of the company over the growing period of the company’s history which haven’t been paid back to the shareholders in the form of dividends.

In line with the above, a few important things have been noted and they are; that both debt and equity instruments provide companies and businesses with financial aid in order to operate daily to their maximum and most times when money is borrowed by businesses they are expected to be paid back with interest. Equity also offers shareholders some level of ownership in a company’s assets after all liabilities have been paid off and after all, equity is asset minus liabilities ( Assets – liabilities = Equity).

Key Characteristics of Debt Instruments

Any debt instrument funding should include the following;

• The date which the debt security was issued,
• The price at which shareholders and investors bought the security as at when issued,
• The date when the principal amount borrowed should to be repaid,
• The particular amount to be paid as at when due,
• The original due date, which is the period from when the date was issued to the final date agreed upon by the parties,
• The outstanding due date,
• The percentage of interest to be paid back on the principal sum,
• When this interest is to be paid, and
• The currency in which the above mentioned is agreed on and to be paid by the burrower.

Comparing Debt Instruments to Equity Instruments

The distinguishing factor between debt and equity instruments aren’t striking however, they are noticeable in some aspects and are important under the law. Both instruments consist of an external party by way of a bank or an investor by funding the business. With these financial instruments, the external source expects something in return. With regards to debt instrument, where a bank is the lender, it is required that repayment of the principal amount including the interest agreed upon be paid by the borrower. While in respect of equity instruments, investors expect ownership in the company, dividends and a return on their investment over time.

Earlier, when stating examples of debt instruments, a number of them mentioned will be discussed and how they differ from equity instruments.

1. Bonds. Bonds can be described as loans given to companies and organizations including corporations, cities, and national governments. A singular bond is an enormous piece of loan and this is due to the fact that these organizations need financial support from more than one source. In my view this type of debt instrument is different from equity instruments because the government is not an investor or shareholder in this case and the money borrowed will subsequently be paid back whether the burrower makes profit or not. It is also key to note that these monies will be paid back with interest in most cases.
2. Debentures. This is another form of debt instrument which is similar to bonds and usually utilised in long term loans without the backing of a security. What this means is that if the borrower doesn’t pay the loan back on time to the lender, there is no form of asset belonging to that the lender can hold on to pending the time the loan will be repaid. Similar to bonds, debentures are also recorded in an indenture. An indenture is a legally binding agreement between bond issuers and bondholders and this agreement outlines the important aspects of a debt offering such as the due date to repay the loan, the timing of interest or coupon payments and the method of interest calculation among others. It is also key to note that both companies and governments are able to issue debentures. In my opinion, what differentiates this from an equity instrument just that that of bonds is that the money borrowed will have to be paid back mostly in instalment because as stated before, it’s a huge loan. Another distinguishing element is that when a debenture is issued, it has no shares in the company and therefore owns no part of the business or company.
3. Loans. This is the most direct form of financing in corporate finance. This is a contract between the lender and the borrower of the loan where by the lender releases funds or money to the borrower to utilize in exchange for a fixed or unfixed interest rate as well as the principal amount within a stipulated time. Because funding is the key element in businesses, it is the most common form of debt instrument used worldwide. Just like other forms of debt instruments, this differs from equity instruments because by lending money to the borrower, the lender has no rights to claim to the business his/her money is funding. This means that whether a profit or loss is made by the business, the lender is still entitled to his principal amount given to the burrower including interest. This also means that repayment of the loan is not subject to the outcome of the business.
4. Mortgages. A mortgage is another form of debt instrument which is secured by a collateral usually in the form of real estate (a piece of land or property). It can also be described as the transfer of interest in property from the borrower to the lender for as security for a loan and this right reverts back to the borrower upon repayment of the loan. Mortgages is a legal instrument used both by corporate entities and private persons to make huge real estate acquisitions without making payment for the entire purchase price up front. Over time, the borrower repays the loan inclusive of the interest on it until ownership of the property is transferred to him or her. Mortgages can as well be described as ‘liens against property’ or ‘claims on property.” In a situation where the borrower defaults in paying the mortgage, the lender has the right to foreclose. This particular debt instrument is different from equity instruments because unlike that of equity, there is no funding of a business here, it is just funding mainly to purchase real estate in land or developed land. Another main difference is in the nature of transferred right. In equity instruments, there are usually securities and no transfer of rights as opposed to debt instruments where security is usually required.
5. Leases. This form of debt instrument is quite direct and simple. Largely, in the accounting framework, SSAP 21 and IAS 17 explains an operating lease to mean ‘a lease other than a finance lease’. A funding lease is a way of providing. In essence, a leasing organization, owner or a lessor acquires the asset for the user usually known as the lessee and gives it out in rent for an agreed period of time. This invariably means that the lessee is in possession of the asset and has right over it until the rent which has been paid for expires. In line with the above, a simple example of a lease instrument in finance can be described as- when a private person or company rents or pays for the lease of a property in order to sell their goods, services or both. This class of debt instrument is different from equity instruments because when rent is paid to the lessor, there has been temporary exchange of rights to the lessee. This is called a possessory right and not absolute because a purchase of the asset was not made rather it was a mere lease. In other words, unlike equity instruments where an investor or lender of finance becomes a shareholder, a lessor is just a provider and in most cases, owner of the asset being used to acquire more profit for the business by the lessee.

From the statements written above and in my opinion, the main distinguishing features of equity instruments from debt instruments are as follows;

• The external body in form of organizations or private persons who facilitate financial support in debt instruments are called lenders while those in equity instruments are called investors or shareholders.
• Debt instruments involve borrowing of capital from a lender by a private person or an organisation to facilitate or run a business. This loan can be for a short or long period of time. An equity instrument on the other hand gives not only aids businesses but also gives the investor or lender of money some level of right over the business. It is the right that makes the investor a shareholder.
• When a loan is obtained by a borrower as a debt instrument, the business for which loan was taken to finance may or may not yield profit. In this situation, the lender has no concern with the outcome of the business as long as the money is paid back with interest or as agreed by the parties. This is not the case in respect of equity instruments as returns of the investment to the lender (investor) is subject to the outcome of the purpose it was used for.
• Because debt instruments are not subject to how well or how bad the business its financing is doing, there is usually little or no risk involved because as afore mentioned, repayment of loans aren’t affected by the outcome of the business. On the other hand, equity instruments are risky and can only be positive where the business yields profit. If the business yields a loss, nothing will be paid to investors because they have equitable rights in the business being financed by them.
• When debt instruments are used to finance a business, ownership is not transferred to the lender. In other words, the lender doesn’t own a share of the business and thereby doesn’t get to become a shareholder. The agreement comes to an end when the principal amount along with the agreed interest rate is paid off. In debt instruments, once money is invested into a business, the investor automatically owns shares in the business and therefore has a certain level of right over the business.
• It can also be inferred that in debt instruments, the cost of capital is simple while the cost of equity instrument is complex
• When lending money to a borrower in debt instruments, it may or may not be secured. What this means is that where a default has been made in repaying the loan, the lender has a right to recover his or her loans through the asset to be used in lieu of repayment of the loan. However, in equity instruments, there is no need for security because the lender automatically becomes a shareholder and returns will be made based on the success of the business.

In my view, even though both debt and equity instruments serve as financial aid in making the running of a business easier, they both have their essential features and differences which justifies their purpose. As earlier mentioned in this paper, there are some forms of financial instruments best suited for organisations and then there are those best suited for private persons or individuals.

Conclusion

Overall, this paper has attempted to break down both debt and equity instruments, explained what they are, how and when they are used and going further to state who uses these instruments. The principal parties have also been mentioned, their roles as well as their gains. In essence, the paper has attempted to distinguish equity instruments from debt instruments as much as possible and in addition stating how easy or not it is to separate both instruments.