Understanding Basic Investment Classifications: Debt and Equity

We often hear a number of terms or Jargons associated with investments. With Growing importance of investments, the awareness about these terms or Jargons is also catching up gradually. One would probably feel as an odd one out if he is unable to understand these commonly used terms. The purpose of this article is to reach out to those people who are interested in knowing the terms – Debt & Equity, what they mean and finally how are these two different from each other as an avenue of investment.

Even before we try to understand what these terms mean, it is important for us to understand that any investment made by any investor would fall into either Debt or Equity or a combination of both. With complex investment products overcrowding the investment zone, there have been many products which are neither purely equity nor purely debt. To add to the trouble, Insurance (which is not an investment but a risk hedging mechanism) also has been clubbed in various forms such as Market linked policies and ULIPS etc. This makes it difficult for a layman to get clarity on what their investment comprises of – Debt/ Equity/ Combination/ Insurance/ Commodity and the list is endless with innovation of newer ideas and products.

What is Debt?

Debt is a borrowing by a corporate or a government to meet the fund requirements for its different projects. When the government/ corporate needs funds, it will borrow from individuals/ Institutions. These individuals and institutions are the investors who lend their money to the governments/ corporate to earn an income in the form of interest from the money lent to the borrowers. As and when the time period for which money has been borrowed comes to an end, the principal amount is returned to the lender along with dues in the form of Interest. The interest may be payable at once at the maturity or as a regular payment throughout the time period for which investment has been made but here we are not concerned with those aspects. We stick to understanding of the concept of Debt. It is clear from this process, What is borrowing for the government/ Corporate is investment for the individual/ institutional lenders. So whenever we talk of debt being raised, it means that there are two entities namely lender and borrower and the company raising debt is the borrower and the investor is the lender. Debt investments are characterized by regular and fair income. Debt entails a lower level of risk as these are secured loans and the borrower has to pay off the debt before paying other liabilities. Thus there is a low level of risk for the lender (Investor)

What is Equity?

Equity refers to ownership. The words Share/ Stock/ Scrips/ Equity are interchangeably used quite often in the investment community. So you need not be confused on hearing these terms. These terms are more or less synonymous. Equity as an investment means ownership of a share or a number of shares of a company. When there is an individual or institution who invests money in the equity shares of a company, he actually buys out a part of the company equivalent to the proportion of shares held by him. He has a right to vote in the Annual General Meetings and has a share in the earnings of the business to the extent of shares held by him. This can be compared to a venture wherein a person has funds to be invested but does not actively manage the business. Rather he provides funds to a capable entrepreneur.

Comparison : Debt & Equity

Point of Comparison	Debt	Equity
Risk	Low	High
Return Volatility	Stable	Highly Volatile
Form of Income	Interest	Dividend
Investor’s Position	Lender to the firm	Owner of share of the firm