Every company needs money for survival and growth. There are two modes in which companies finance capital: equity and debt capital. Debt capital is the money that a company raises by ways of loans. The persons who loan the money are considered as the creditors of the company. Equity capital is raised by issuing shares to the persons who invest their money in the company. These investors are called the company’s shareholders. There are two types of shares: preference and equity. Brave investors buy equity shares, as they usually provide higher returns as compared to preference shares when the company makes profits. Preference shareholders get priority in the payments over equity shareholders.
The creditors of the company loan their money with an agreement that they would be paid interest on the said amount periodically. This interest income is to be paid to them irrespective of whether or not the company makes profits. Also, when a company winds up, it is legally obligated to repay its creditors’ funds. Preference shareholders always get preferential treatment over the common shareholders with regards to discharge of dividend payments and payments that are made in the event of liquidation of the company. Dividends are paid only when the company earns profits and, after keeping aside a sum for sustenance and expansion purposes, distributes the remaining amount to the shareholders.
Preference shareholders get dividends every quarter that the business makes profits. Creditors usually receive interests every quarter whether or not the company makes profits. The dividend rate and the interest rates are predetermined and set at the time the company procures the funds. Credit rating agencies review and rate the safety and volatility features of both the debt funds and the preference shares.
Both these investment forms are safer and more secure in comparison to equity shares. The creditors have a legal claim on the assets of the organization in the event of nonpayment of dues. The preference shareholders get preferential treatment over and above the common stockholders for payments.
Debt capital is classified under two main heads: secured and unsecured loans. Secured debt is one in which the company provides to its creditors a collateral. This collateral assures the creditor that they have a claim on company's assets in case their money is not repaid on the pre-specified date. Unsecured loans do not give an security cover. These are obtained on the basis of the goodwill that the company has. Examples of debt capital include debentures, bonds, commercial papers and letters of credit.
There are several types of preference shares that companies issue. The convertible preference shares are first type. Here, the shareholder is at all points in time given the option to convert his preference shares into equity shares of the company. The second kind is fixed-rate preferred stock. Here, at the time of issuing the shares, the company determines the rate of the dividend for the entire lifetime of the stock. The last type is the participating preference shares. The owners of these shares are given the opportunity to get more dividend than the predetermined rate. This happens in the event the company makes mammoth profits and there is a scope of receiving more.
Debt capital does not represent ownership in the company. Though the creditors have loaned large sums of their money to the company, they have no stake in the company. Preference shareholders though are the owners of the company have no voting rights. In other words, they are only the owners on paper and have no say in the working of the organization.