If you glance through a company’s balance sheet, you’re bound to encounter the two terms- ‘shares’ and ‘debentures’. The terms are also used when one discusses Debt Financing and Equity Financing to raise capital.
To understand why they find a spot in the balance sheet of a company and what they signify, one must understand what they mean.
That is exactly what the motive of this write-up is. Know about the 10 key differences between shares and debentures, put succinctly.
What are shares?
One could say that shares are units of ownership in a company.
Each company requires capital to start a business and keep its wheel running. To acquire the desired capital, a company divides the ownership of the company into a number of units, each having a value in the local denomination.
The company then invites investors to buy those units to gain a stake in the company proportional to the capital they are willing to invest. The individuals or entities in possession of those shares are called shareholders of the company.
For example, if a company has an authorised capital of INR 10,00,000, it can divide this value into small units of INR 10 rupees each.
This means that the company can raise upto INR 10,00,000 by issuing 1,00,000 shares (10,00,000/10).
Now, if the company desires to raise all of its authorised capital by issuing shares, and an investor buys 10,000 shares, they would be a shareholder with 10% ownership of the company [(10,000/1,00,000)*100)].
Why would somebody want to be a shareholder?
The simple reason for that is to gain ownership of the company. If a company is projected to make good profits and grow in size, so would its valuation. This means, the amount invested in the company is going to give the investor returns.
Along with that, whenever the company makes a good profit, it can decide to give its shareholders a dividend (think of it like a bonus).
From an accounting perspective, the capital raised by issuing shares is a liability for the company because the company as an entity owes that money to the shareholders.
Suggested Read: Business Loan vs Equity Financing: Which one is better for your business?
What are debentures?
Debentures are debt instruments used by companies to raise capital. They are usually unsecured, ie. not backed by collateral. However, there exists secured debentures as well where a charge is created against the company’s assets in case of a default.
A company usually in need of capital and willing to go for debt financing issues debentures at a coupon rate (an interest which must be paid on the debenture regularly). Thus, a debenture could be considered a loan, which is divided into units and raised by several lenders.
The individual or entity in possession of a debenture is called a debenture holder.
The debentures are issued for a time period and are redeemed at maturity. Upon maturity, the company usually buys back the debentures at the issued price, thus giving back the debenture holders their principal amount.
In some cases, the debentures may not be bought back but instead converted into equity (shares), giving debenture holders ownership in the company. Those debentures are called convertible debentures.
From an accounting perspective, debentures are considered a liability for a company because the company is essentially taking a loan at a specified interest rate from debenture holders and must pay it back at the time of maturity.
Suggested Read: What is Debt Financing, Types and How does it Works?
What’s the difference between shares and debentures?
Despite both the instruments being used to raise capital, they have some underlying differences which define the contours of their usage.
Nature
While the shareholders are considered owners of a company, the debenture holders are considered creditors of a company.
Voting rights
As the shareholders are considered the owners of a company, they have voting rights in a board meeting which the debenture holders lack. Debenture holders do not partake in a company’s management functions.
Risk
The risk involved in shares is more than that of debentures. In case a company goes bankrupt and liquidates its assets, the debenture holders are paid before shareholders because of being considered creditors. Once all the creditors are paid, the leftover assets are distributed amongst the shareholders in proportion to their shareholding.
Interest payment
While the debenture holders receive interest irrespective of whether a company makes a profit or books loss, shareholders are not entitled to any interest on their shareholding. Shareholders receive a dividend, which is discretionary and not fixed. It may be distributed if the company makes a profit.
Conversion
While convertible debentures can be converted into shares or equity, shares cannot be converted into debentures. Conversion of shares only takes place within the equity capital itself, ie. preferential shares can be converted into equity shares and vice versa.
Trust deed
While no Trust deed is required while issuing shares, a trust deed is required while issuing debentures. It is an instrument that is used to appoint a debenture trustee for upholding the interest of the debenture holders.
Shares vs Debentures: Key Differences
| Criteria for differentiation | Shares | Debentures |
| Status | Owners. | Creditors. |
| Voting rights | Shareholders have voting rights. | Debenture holders do not have voting rights. |
| Liquidation risk | Paid after all creditors are paid, or may not get paid at all. | Paid before shareholders. |
| Interest | Not entitled to an interest. May get a dividend if the company makes a profit. | Entitled to an interest that must be paid irrespective of profit or loss. |
| Conversion | Cannot be converted into debentures. | Convertible debentures can be converted into shares. |
| Repayment | Shares are not repaid during the life of a company (can only be sold). | Repaid upon expiry of the tenure. |
| Trust deed | No Trust deed is required. | A Trust deed is required. |
| Liquidity | More liquid than debentures. | Less liquid than shares. |
| Treatment of interest/dividend in P/L Statement | The dividend on shares is paid from the profit. | Interest on debentures is paid from the income. |
| Tax benefits | There are no tax benefits in distributing dividends to shareholders. | Since interest on debenture is paid before the calculation of profit, a company decreases its tax liability by paying interest. |
Conclusion
While both shares and debentures are used by companies to shore up capital, their implications vary because of various differences in these instruments. These differences not only define the relationship of the company with the investor of these instruments, but also have different tax implications. Thus, determining whether a company wishes to go for Debt financing or Equity financing depends upon the weightage it attaches to these differences.
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FAQs
Why is Shareholders’ Equity considered a liability?
The Shareholders’ Equity is considered a liability for a company because it is the capital raised by issuing shares and the company owes this money to the shareholders.
Are debentures less risky than shares?
Yes, debentures are less risky than shares because the debenture holders receive an interest irrespective of whether the company makes a profit or not. At the same time, if the company goes bankrupt and is liquidated, the debenture holders are paid before shareholders because they’re considered creditors.
Do you receive an interest on debentures?
Yes. While generally, one receives interest on debentures, a company may also issue a zero coupon rate debenture which has no specified interest rate. In such cases, the debenture is issued at a discount and the difference between the discount and the price at the time of redemption is considered the interest.
What are the three differences between shares and debentures?
Three key differences between shares and debentures are-
- While shares give voting rights to the shareholder, debentures do not give any voting rights to debenture holders.
- Interest paid on debentures has tax benefits but dividend paid on shares has no tax benefit.
- Shares give a stake in the ownership of an enterprise while debentures make the debenture holders creditors of the firm.
Is debenture a type of share?
No, debenture is not a type of share since shares give the shareholder a stake in the ownership of an enterprise while debenture makes the debenture holder a creditor. So debenture is a type of debt instrument, while share is not.
