DEBTS AND EQUITY


Debts and Equity are two sources of Financing.


Debt is the obligation incurred by borrowing while Equity is the owner’s share of assets. Debt and Equity are distinguished on the basis of four distinguishing features.


These are following:


1. Maturity


2. Claim on income


· Priority to claim


· Certainty of claims


· Amount of claims


3. Claim on Assets


4. Right to voice in Management


MATURITY:


Debt and Equity can be distinguished on the basis of maturity because debt comes due i.e. it must be at some specific time decided in agreement. Various types of debts are differentiated on the basis of maturity date e.g. short term loans are matured within a year. Intermediate term loans are matured in 1 to 10 years while long term loans in more than 10 years. The amount paid on maturity date is called maturity amount and is equal to actual amount plus interest on loan.


Principle amount= Rs. 1000


Interest Rate= 8% annually


Maturity= one year


Rs. 1000+80= Rs.1080


So Rs. 1080/- will be retuned to the bank on maturity date.





If firm is unable to repay the debt on maturity date, the creditor can seal the assets of firm or even force the liquidation of the company.


Equity has no date of maturity. Owner invests in the business to get the profit. There is no agreement on that his initial investment will be refunded.


The investment of owner (i.e. equity) can be regained on the liquidation of company or partnership or by selling the share he has got. Still the chances of regaining the original initial investment depend on the fortune of company and his bargaining ability.


CLAIM ON INCOME:


Another feature which differentiates debt from equity is claim on income. There are three aspects of claim on income that distinguish debt from equity are:



o Priority to claim:
When a firm or company earns income the first priority is given to the claims of creditors. After paying the obligations to creditors, if BOD decide to distribute dividend then preferred stockholders have right to collect the dividend. The claims of preferred stockholders (or limited partners in pak.) are preferred over common stockholders or residual owners. In some cases preferred stockholders check the working capital if it is in a good position (i.e. as agreed or decided), then dividend can be distributed among residual owners otherwise not.



o Certainty of Claim:
If the company has promised to pay the interest on the debt, it must pay the interest regardless of the level of earnings. In case of failure it may face legal action from a part of creditor. The interest payments are fixed charge i.e. they have fixed percentage i.e. 2% or 3% etc. in this way preferred shares are like debts. But the difference btw preferred shares and debts is that unlike creditor, preferred stockholders have no legal right to claim on assets.


Payment to the owners is called withdrawal in case of sole proprietorship or partnership and dividend in case of Joint Stock Company. Whether the share is preferred or common the company does not promise to pay any interest so it is the main difference btw debt and equity.



o Amount of Claim:
Debts have always fixed percentage of interest which is to be paid on them e.g. a company borrows loans from a bank. The interest the company will pay on that amount will be fixed at 5% or 6% regardless of the profit earned by the company.


On the other hand the equity has not fixed percentage although the preferred share holders get a fixed amount as dividend yet the common stockholders who are actual owners of co. do not earn fix dividend. Their income varies year to year depending upon the earning power of the co.


CLAIM ON ASSETS:


Banks and other institutions raise loans so that they can earn profit. They never want to liquidate a company. But in certain situations co. is unable to earn profit; it rather incurs continuous loss, so in order to remove its debts directors have to dissolve it. In such cases the assets of co. are liquidated to pay the creditors and owners.


The first priority to claim on assets is of creditors who raise loans to company. There are two types of loans:



o Secured Loans: These loans for which some security is kept e.g. loans on mortgage. The creditors who provide