In our previous article, we saw the importance of working capital in keeping the wheels of the business running for day-to-day operations. This is the micro view of the business for its financial viability and survival. However, there is also a macro aspect where finances are needed for its larger objectives, like growth and expansion. The two important pillars for such finances are the shares and debentures. Check out this blog to know the meaning of these terms and their importance for a company as well as investors.
Shares are the capital of the company, i.e., the ownership of the company represented in the form of units. When investors buy shares of a company, they become part owners with the right to vote and the right to earn profits from the company distributed in the form of dividends. Companies can raise capital by issuing shares instead of external debt. This will help in reducing the dependence on external funds for achieving the business goals, but may lead to dilution of ownership with the consistent issue of shares. The key features of shares include,
Shareholders get the right to ownership along with the right to share in profits.
The value of shares can fluctuate due to many internal and external factors, like the company's financials, changes or competition in the industry, etc.
Shareholders have the voting rights in the meetings.
Shareholders also have limited liability to the extent of their shareholding.
Shareholders can also trade or liquidate their holdings in the open market or at the time of IPO, as the case may be.
The shares of a company are typically classified into two broad categories. The distinction between these types of shares is essentially in the nature of the profit sharing and the ownership rights bestowed on the shareholders. The details of these types of shares are mentioned below.
Equity shares are also known as the common shares of the company. These shares are issued at the time of listing of the company on the stock exchange or subsequently, depending on the need for capital. Equity shareholders are also known as the true owners of the company and have the right to a share in the company's profits, which are distributed from the free reserves. Shareholders can thus have returns from their investment in the form of dividends (share in profits) or in the form of capital gains (profits from the sale of their investment in the company). However, despite being the true owners of the company, equity shareholders have the last right to get any return on their investment at the time of the company’s liquidation. Investment in equity shares is thus known to be a high-risk, high-reward situation.
Preference shares are privileged shares of a company that allow a preference in the right to share profit over common or equity shareholders. One of the most distinct features of preference shares is the consistency in the distribution of dividends compared to equity shareholders. This dividend is also paid at a fixed rate, unlike that on the equity shares, making them a good option for investors looking to invest in a company but also looking for consistent returns. Preference shareholders do not get voting rights in company matters but have a higher right or a first right to return on their investment at the time of the company’s liquidation. A company can issue different types of preference shares depending on its capital needs and objectives. The types of preference shares include,
These shares secure the right of the shareholders to receive dividends on their investment. If dividends are not issued in a year, they are included with the subsequent year’s dividend and paid to the shareholders.
These shares are the opposite of cumulative preference shares, where the dividends not paid for any year are foregone and the company is not obligated to pay the same in the following year.
Convertible preference shares are where the shareholders have the right to convert their shares into common shares at the time of redemption or the agreed period, as mentioned at the time of issue of shares. This allows them to be part of the equity shareholder base and be the true owners of the company.
Non-convertible shares are shares that do not carry any privilege of conversion to equity shares, unlike convertible shares.
The company has to declare the type of preference shares at the time of its issue to ensure full disclosure at the time of investment as per SEBI norms for ‘Issue of Share Capital’.
While shares are known as the owner's funds, debentures are the external funds needed by a company to meet its objectives. It is like a loan or borrowing used by companies to raise money from the public at large or institutional investors. When an investor buys a debenture of a company, they are not considered its owner but a lender to the company. Debentures are issued for a fixed maturity period and allow the debenture holder to earn interest on their investment at a fixed rate. This interest is a mandatory obligation for the company, with any default leading to a negative impact on their credit rating or creditworthiness. Upon maturity of these debentures, they are redeemed by the company, i.e., the debenture holders are paid their original investment back at an agreed-upon rate (which can be at a discount, at par or at a premium) as agreed upon at the time of issue of debentures. Debentures are thus a safer investment option for investors and institutions looking to invest or lend funds, respectively, but prefer a limited risk. The key features of debentures include,
Fixed interest on investment at fixed intervals
Defined maturity date for redemption of debentures
No ownership of the company with investment in debentures
Binding legal obligation to pay interest and the original investment amount upon maturity.
Secured form of investment with credit ratings to back the quality of investment.
A company can issue many types of debentures with distinct features. Some of the common types of debentures issued by companies are explained below.
Secured debentures are backed by the assets of the company. This means if the company fails to pay the interest or return your money, you have the legal right to claim certain company assets like property, machinery, or equipment. These assets act as ‘security’ or a guarantee, making secured debentures less risky for investors.
Unsecured debentures, also known as naked debentures, do not have any asset backing. These are based only on the company’s creditworthiness and trust. Thus, if the company goes bankrupt, unsecured debenture holders do not have the first right on any company assets and may not get their money back. Companies usually offer higher interest rates on these types of debentures to make up for the extra risk and attract investors.
Convertible debentures are special debentures that can be converted into equity shares of the company after a certain period or under certain conditions. This means, instead of getting the initial investment back, investors become shareholders in the company. This type of debenture is useful for investors who want fixed returns at first and potential growth later through shares.
There are two types of convertible debentures:
Fully Convertible - The entire amount is converted into shares.
Partly Convertible - Only part of the debenture is converted while the rest is repaid in cash.
Non-convertible debentures stay as loans till maturity. They cannot be converted into shares and are pure debt instruments. Since they do not offer the benefit of future ownership, companies usually offer higher interest rates to make them attractive to investors. NCDs are quite popular in India, especially among investors who want fixed and safe returns. Investors can buy NCDs from financial companies like Tata Capital, L&T Finance, etc., during public issues or from the stock market.
Redeemable debentures come with a fixed maturity date. The company promises to repay the principal amount to the investor after a certain period, like 3 years, 5 years, or 10 years. These are the most common types of debentures in India, where the company pays interest periodically (monthly, quarterly, or annually), and the debentures are redeemed after the agreed time.
Irredeemable debentures do not have a fixed maturity date. This means the company is not legally bound to return the principal on a specific date. The company can continue paying interest for a long time, and may choose to repay the amount at its own wish.
Shares and debentures are essentially the two sides of long-term financing, a company needs to meet its long-term objectives and thrive. The key differences between shares and debentures are explained below.
A choice between shares and debentures is like a choice between apples and oranges. They cater to two different classes of investor groups where the risk perception is quite varied and along with the returns expectations. Thus, there is no better choice between shares and debentures; rather, the choice depends on your personal goals, risk level, and income needs. Shares may be a better option for those looking for long-term growth and willing to take some risk, as they offer the chance for higher returns and part ownership in the company. However, share prices can fluctuate, making them less stable. Debentures, on the other hand, are more suitable for investors who prefer safety and regular fixed income. They are less risky and provide steady interest, making them ideal for retired individuals or those seeking stable returns. The ideal way to go is to have a mix of both, i.e., shares for growth and debentures for security
Shares and debentures are two important ways for companies to raise money and for people to invest. Shares make investors a part-owner of the company and give them a chance to earn through dividends and price growth, but they come with higher risk. Debentures are like loans given to companies and offer a fixed, regular interest and are usually safer, especially if secured by company assets. While shares are good for those who can take some risk for higher returns, debentures are better for investors looking for steady income with lower risk. Thus, understanding the differences between them helps you choose the right option based on goals, safety needs, and income expectations.
We have discussed a fundamental topic in this article to help investors understand the finer details of these balance sheet line items. Let us know if you have any queries on this topic, and also if you want to see such a detailed discussion on other line items of financial statements in our upcoming blog.
Till then, Happy Reading!
Read More: Difference Between Large-Cap, Mid-cap and Small-cap Stocks - How to Choose?
Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
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