Meaning of Equity and Debt Instruments
Financial markets involve the trading of many financial instruments, also known as Securities. These financial instruments include shares, debentures, bonds, deposits and so on. These financial instruments may represent either ownership or a debt in favour of the investor. Some instruments may even represent both, debt and potential ownership which may be realised at a future date. On this basis, such instruments or securities may be classified as Equity or Debt Instruments/Securities.
As shown in the chart above, Financial Instruments can be
classified into 3 basic categories, which are discussed as follows:
·
Equity Instruments
Equity Securities are
representative of an ownership share in the favour of the investor. These are
in the form of Shares, which according to the Companies Act, 2013 simply means
a share in the share capital of a corporate body. The investors who hold such
Equity Instruments are not liable to any repayment, but have a right to their
share of profits, which are distributed to them as dividends. Repayment may
happen only in case a company is wound up, and funds are left after fulfilling
all other liabilities. Equity Instruments can be divided into Equity Shares and
Preference Shares, as specified under section 43 of the Companies Act, 2013,
and also seen in the figure given above.
Equity Shares carry
with them certain advantages, mainly being the right to vote and participate in
the affairs of a company. Its main disadvantage however, is that there is no
fixed rate of return or dividends prescribed. This makes it a high risk – high
reward investment, as the return can be very high if the company does well, but
can also be negligible, is the company does not manage to do that well.
Preference Shares on
the other hand do not carry voting rights, except on matters directly
concerning the preference shareholders. However, the main advantage of
preference shares is that the rate of return is fixed, as preference dividend
is distributed at a fixed rate when the company is making profits. Further,
preference shareholders also have a preferential right to receive dividends
over equity shareholders, and to repayment in case of winding up of the company
as well. This makes it a low-risk investment. However, the fixed rate of return
is generally lower than the dividend distributed to equity shareholder in case
of profits.
·
Debt Instruments
These instruments,
instead of giving ownership to the investor, create a debtor-creditor
relationship between the investor and the company. The company is put into the
position of a debtor who borrows money from the investor, who is put into the
shoes of a creditor. As a result, the amount invested is repaid by the company
according to stipulated terms and with interest. No ownership or voting rights
are provided to the investors in this case. Lastly, these Debt Instruments may
also carry a charge over an asset in case of default by the company. Thus, it
is possible to have both, secured and unsecured debt instruments. Debt
Instruments include debentures, bonds, public deposits, treasury bills, etc.
·
Hybrid Instruments
These kinds of
instruments carry the characteristics of both, equity and debt instruments. The
most common example of such an instrument are convertible debentures.
These kinds of debentures can be converted into preference or equity shares on
the expiry of a certain period of time. Another type of convertible security,
though within the realm of only equity instruments are convertible preference
shares. These preference shares are convertible into equity shares on a certain
future date, and an option may also be provided to the investor. These kinds of
securities give the investors more options, and often more comfortable ones, to
attract more investment. For example, a person may invest into convertible
debentures at the beginning, and seeing the performance of the company, can
benefit from their conversion into equity instruments at a later date.
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