The explanation for equity and debt capital is clear because there is a clear dividing line between the two forms of capital. In simple terms, debt capital describes debt and includes any capital for which there is a possibility of repayment. Lenders are not involved in profits or losses but receive a defined interest for a defined period.
Equity providers invest part of their private wealth in a company and are therefore directly involved in it. Equity providers are generally involved in profits and losses.
Comparison of equity and debt
debt ratio participating interest Lenders of the outside capital are not liable. Shareholders are liable at least with the contribution, possibly also with private assets. Remuneration through interest. Remuneration through participation in profit and loss. No participation by lenders. Partners are entitled for participation. Limited in time. Unlimited, termination possible. Borrowing costs are tax deductible. Equity interest is not tax deductible. The main interest is the repayment of the capital. The main interest is the positive development.
Advantages of equity
By participating in the profit of companies, the return is also higher than with debt. In contrast, this is of course available much longer, practically unlimited because there is no interest on it. A high equity ratio can also translate into more favorable credit terms. Banks value higher equity as collateral, which can lower lending rates. Thanks to the generally more favorable loan terms, mezzanine capital pays off, especially in crowdinvesting.
Disadvantages of equity
Equity providers are entitled to co-determination depending on the degree of the capital share and this means less flexibility when making decisions if this is not contractually limited. Profits must also be shared with other equity investors depending on the capital share.
Advantages of debt
Lenders have no right to profit sharing and no say in decisions. Interest payments to lenders can be tax deductible as expenses.
Disadvantages of debt
The obligation to repay the interest and the loan installments exist in both good and difficult economic situations. Failure to service the credit rate can result in bankruptcy.
Special forms of debt
Hybrid forms of equity, that means a mixed form between equity and debt capital are summarized in mezzanine capital.
- Subordinated loan is debt capital that only needs to be repaid after senior creditors have been satisfied. This type of debt is particularly suitable for financing real estate projects, since banks add mezzanine capital to equity, which can significantly improve the conditions for a loan.
- In the event of a conditional repayment obligation upon liquidation, profit participation rights are also classified as equity and are recognized as equity in banks.
- Silent societies are characterized by the nature of an obligation and are considered as debt.
- Hybrid bonds are subordinated corporate bonds with either a very long or unlimited term. Since they are bonds, they are clearly classified as debt.
- Shareholder loans are formally borrowed capital and are classified as subordinated receivables in an insolvency procedure, economically, however, the shareholder loan is treated as equity.
The debt ratio provides information about the proportion of debt financing in relation to total financing. Despite a good economic situation, high debt ratios reduce the company’s profits through higher interest expenses (repayment of the loan).
Real estate financing has a very high debt ratio of 72% on average, since the lenders can secure themselves with a mortgage.