“Discuss if the Debt is better in Capital Structure or Equity.”

To understand what is better Debt vs Equity in Capital Structure of a Company, firstly, we need to understand what is Capital Structure then Debt and Equity. Let’s discuss them in details:

Capital Structure:

Capital Structure of the Company is the composition of the Company’s permanent or long-term capital, which consist of a combination of Debt and Equity. A healthy proportion of Equity and Debt Capital is an indication of financial fitness.

The Capital Structure is the careful selection of Equity and Debt that a Business uses to finance its Assets and Long terms Investment for Facility Enhancement or Investment in a new venture. The Capital Structure is the mix between Owner’s Fund and Borrowed funds. 

It is expressed below:

FUNDS = Owner’s funds + Borrowed funds.

Owner’s funds = Equity share capital + Preference share capital + reserves and surpluses + retained earnings = EQUITY

Borrowed funds = Loans + Debentures + Public deposits = DEBT

Debt:

Borrowings in a company are called Debt, to be repaid over a period you agreed on a Fixed Rate of Interest. The Debt can be in the form of Loans, Debentures, Bonds or Credits. Debt Financing allows Business to Leverage a small amount of money into a much larger sum, enabling more rapid growth than might otherwise be possible.

Equity:

Equity is an Owners Fund, or in other words, to raise Equity, part of share/stock is sold to the Investor. The main benefit of Equity is that funds should not be repaid. In this case, the stockholders get the Dividend and Profit as their return, and they have voting right in the Company.

Difference between Debt and Equity:

The Difference Between Debt and Equity and their comparison is shown below:

Differences

DEBT

EQUITY

Meaning

Funds owed by the company towards another party is known as Debt.

Funds raised by the company by issuing shares is known as Equity.

Purpose of Funding

This is a Loan Fund

This is Owner’s Funds

Obligation to pay

Has an Obligation to Pay

Has Ownership right

Terms of Payment

Comparatively short term or defined term

Investment is for Long term

Status of holders

Lenders

Shareholders

Risk

Low Risk

High Risk

Types of Instruments

Term loan, Debentures, Bonds etc.

Shares and Stocks.

Return on Investment

Rate of Interest charged

Dividend & Profits

Nature of return

Fixed and regular

Variable and irregular

Collateral

Essential to secure loans, but funds can be raised otherwise also.

Not required

Debt Vs Equity, which is better as Capital Structure:

Debt is one of the two main ways companies can raise capital in the capital markets. Companies like to issue debt because of tax advantages. Interest payments are tax-deductible. The mortgage also allows a company or business to retain ownership, unlike equity. Additionally, in times of low-interest rates, debt is abundant and easy to access.

Equity is more expensive than debt, especially when interest rates are low. However, unlike a mortgage, capital does not need to be paid back if earnings decline. On the other hand, equity represents a claim on the future earnings of the company as a part-owner.

Debt-to-Equity Ratio as a Measure of Capital Structure:

Debt and equity both form the part of the Balance sheet. The use of Debt and Equity is mainly done to Invest or Purchase of Assets. When Companies use more debt, then equity to finance its Assets have a high Leverage Ratio and aggressive capital structure. The high Leverage Ratio or Aggressive Capital Structure may lead to a higher growth rate. In contrast, the convective capital structure may lead to lower growth rates.

Therefore the Goal of Company Management is to find the optimal mix or combination of Debt and Equity. It can be considered as Capital Structure. It is the goal of company management to find the optimal mix of debt and equity, also referred to as the Optimal capital structure.

Analysts use the Debt to Equity (D/E) ratio to compare capital structure. Companies should consider both Debt and Equity as part of their corporate strategies for Capital Structuring.

Conclusion:

All the companies need to maintain a balance between Debt and Equity funds. The ideal debt-equity ratio is 2:1, i.e. equity should always be twice of the debt, only then it can be assumed that the company can cover its losses adequately.

About the Author

BankReed Admin

Banking Professional with 16 Years of Experience. The idea to start this Blogging Site is to Create Awareness about the Banking and Financial Services.

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