Equity and Liabilities

Equity and liabilities (or debt capital) are elementary terms used in corporate financing.

These types of capital represent two different forms of participation for investors. Together, debt and equity form the assets of a company.

When financing a company, equity and debt capital each have advantages and disadvantages for the company as well as for investors.

Equity – Definition

Equity is capital provided to a company by its shareholders (equity providers). It is, therefore, a means of financing the company. It is the part of a company's assets that remains after all debts and liabilities have been deducted. Equity includes bank balances, shares, and real estate.

When a company is founded, equity is generated by cash or contributions in kind from the shareholders. According to the German Stock Corporation Act (Aktiengesetz, AktG), the equity of a stock corporation (AG) must amount to at least EUR 50,000. A limited liability company (GmbH) must have at least EUR 25,000. This is stipulated by law.

Through their investment, the shareholders provide the company with equity capital for an indefinite period of time. They cannot withdraw their shares prematurely from the company. Equity capital can be generated in various ways by existing companies, including through a capital increase.

In order to increase the equity capital of a company, the shareholders sell shares in the company to outside investors and consequently also make them shareholders of the company. Equity capital is the counterpart to debt capital in the balance sheet.

Debt capital – Definition

Debt refers to all financial resources made available to a company by outsiders. These include funds from loans and credits that the company has to repay with interest. Provisions are also considered in addition to outstanding liabilities.

This capital is only provided by the creditors on a temporary basis. In return, the lender can count on interest and repayment. This capital share of the enterprise thus belongs to external investors and not to the owners.

A distinction is made between short-term, medium-term and long-term debt capital. It indicates the period until which the capital is available to the company.

Equity and debt capital – Differences

These types of capital differ significantly for investors.

In the case of equity capital, the investor has a direct interest in the company and is, therefore, a shareholder of the company. In the case of debt capital, however, the investor does not participate directly in the company. Instead, he or she benefits only indirectly through interest payments or possibly agreed on profit participation rights and sale proceeds.

Equity capital entitles the investor to receive information about the company as well as the possibility of influencing the management by having a say. Lenders of debt capital usually do not have these advantages either.

Equity – Advantages and Disadvantages

The argument for an investment in a company's equity capital is the higher profit. Equity is an important economic factor for the company because it is available for an unlimited period of time.

The possession of sufficient equity is essential for companies since the possession of too much borrowed money can be an obstacle to the further development of the company. A high proportion of equity capital speaks for economic stability and entrepreneurial independence from external capital providers.

As a rule, equity capital generates higher returns than debt capital. This is expressed in the ratio of return on equity. Therefore, equity is the preferred form of investment for venture capital companies and business angels. It is easier for companies with sufficient equity to obtain cheaper loans from banks than for companies financed by borrowed capital, i.e. with more debt.

A high level of equity means that companies have less chance of being hit by losses. It is easier for companies to face higher risks.

The shareholders' co-determination rights can have a restrictive effect on entrepreneurs or existing investors. As they have a direct stake in the company, they participate in its success. However, they also bear the risk of a possible loss. Therefore, equity investors are particularly interested in the success of the company.

This formula is used to calculate the equity ratio:

Equity ratio = (equity / total capital) * 100

The equity ratio should be at least 20 percent. A low ratio could mean financial difficulties for the company.

Debt capital – Advantages and Disadvantages

The fact that profits do not have to be shared with the lenders speaks in favor of debt capital.

Interest can also be deducted from taxes.

With debt capital, however, the capital is only available for a limited period of time. Even if a company has problems, the money has to be repaid to the creditors with interest. Furthermore, the providers of this type of capital assume no liability. They have no say in the management of the company.

In the event of possible insolvency, the claims of the lenders are dealt with first, followed by the investors with equity capital.

The following formula is suitable for determining the proportion of debt capital (debt capital ratio) in the company:

Debt ratio (in percent) = (debt capital (short, medium or long-term) / total capital) x 100

Ideally, the debt ratio should be less than 50 percent.

When calculating the debt ratio, it should always be noted that if the debt ratio is low, this indicates that the company is financially independent.

Investors can use the debt ratio to find out about the stability of a company and its financial structure. It is used to calculate the ratio of debt to equity.

Which form of capital do you prefer? Let us know in the comments below!