Differences between debt and equity | 2022

Not all the differences between debt and equity are obvious or easy to understand. Both are sources of financing for a company, but they come from different sources and their implications also differ.

In this article, then, we will explain what are the key points that allow us to distinguish between debt and net worth.

But first, we must define each concept. The debt is a payment obligation that a natural or legal person has with a third party. That is, we are basically referring to a loan or credit. For example, a financing that a company obtains from the bank.

On the other hand, net worth corresponds to all those elements that constitute the company’s own financing. These are mainly the company’s own funds which refer to share capital (partners’ contribution), reserves (from retained earnings and other sources), etc. In simple, they are the resources that belong to the same company.

Differences between debt and equity at source

The differences between debt and net worth occur, first, in terms of their origin or provenance. The debt corresponds to third parties, that is, individuals or legal entities that are not part of the company. For example, a bank or those private investors who acquire a bond issued by the company.

Instead, net worth corresponds to the company’s own resources. As we explained previously, they are contributions from the partners or have come from the profits generated by the firm’s own economic activity.

Differences in the form of remuneration

As you should know, loans generate interest and this is the financial expense that the company assumes with its creditor. Thus, the way in which financing is paid through debt is by returning it, but not only the amount initially received (the principal of a loan), but also interest.

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On the other hand, when the financing is through equity, the remuneration is with the payment of dividends. This, if the company decides not to retain the profits, but to distribute them among the partners.

Differences in tax implications

Interest paid on acquired debts is a tax shield for the company. After deducting them, the amount on which the Corporation Tax (IS) or Income Tax (IR) is estimated decreases.

On the other hand, this does not happen in the case of equity, since the dividends are distributed after paying the IS. It should be noted, however, that what may be subject to tax is dividend income. That is to say, if a person receives dividends, he would pay a tribute for this income of money. The tax rate will depend on the country. Likewise, if the partner that receives the dividends is another company, the rules vary because the idea is that he does not pay twice the IS or IR. Again, everything is subject to each regulatory framework.

What we can conclude is that the debt generates financial expenses that reduce the tax base, reducing the tax to be paid by the company, and can improve the company’s cash flow statement. However, with net worth the above does not happen. To understand it better, we can see the following example:

Let’s analyze the case of the company YZI, which presents the following income statement in its last fiscal year.

income statement Value in US dollars
Net income or sales 40,500
-Sale costs 30,000
Gross margin 10,500
-General, personnel and administrative expenses 7,500
EBITDA 3,000
– Amortization expenses and provisions 1,000
Earnings Before Interest and Taxes (BAIT) or EBIT 2,000
+ Extraordinary income 200
– Extraordinary expenses 400
Ordinary result 1,800
+ Financial income
– Financial expenses 200
Earnings Before Taxes (BAT) or EBT 1,600
– Corporation tax (25%) 400

Financial expenses are the interests produced by a debt acquired by the firm for the purchase of machinery. Now, let’s imagine that instead of requesting a loan, the company had resorted to its own resources to obtain the fixed asset.

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In that case, assuming that the other data does not vary, the BAT would be equal to the ordinary result and the IS would be calculated on US$ 1,800.

1,800 x (25%) = $450

The tax shield generated by interest would be:

(1,800 – 1,600) x (25%) = $50

As we can see, by paying the interest on the debt, the firm’s net profit falls. Consequently, the taxes paid to the treasury also fall.

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