Debt versus equity in detail — loans, bonds and shares
The answer
Debt is a contract: fixed payments, a fixed end date, no ownership, and first claim on the money. Equity is a partnership: no payments owed, no end date, full ownership, and last claim on the money. Everything else — bank loans, debentures, bonds, rights issues, placements — is a variation on those 2 sentences.
Why this costs you money
Two things happen quietly, and both cost long-term shareholders more than any market crash.
The first is dilution you never noticed. You bought shares 4 years ago. Profit is up 40%. Your shares have barely moved, and you blame the market. What actually happened is that the share count went up 45%, so profit per share went nowhere. Your slice was cut thinner each year through placements, employee stock options and convertible instruments. None of it appeared as bad news. Every announcement was framed as an achievement.
The second is the interest bill you never checked. A company you own reports a profit before tax of ₹400 crore and pays ₹340 crore of interest. It is profitable. It is also 1 poor quarter away from being unable to pay its lenders, and when that happens the lenders, not the shareholders, decide what comes next.
Both are visible in a company's own published accounts, in about 3 minutes each. Almost nobody looks, because both live in the parts of a report nobody reads.
How it works
The debt side
When a company borrows, 4 things are agreed: how much, at what rate, when the money comes back, and what happens if it does not. That fourth item is where the real power sits, and it is the part investors skip.
Secured debt is backed by named assets — a factory, a fleet, a set of receivables. If the company fails to pay, the lender can take them. That second route to repayment is why secured lenders accept a lower interest rate. Unsecured debt is backed only by the promise: higher rate, weaker position in the queue.
Covenants are conditions attached to the loan. "Debt must stay below 3 times earnings." "The promoter must retain at least 51%." Breaking one is a breach, and a breach usually allows the lender to demand all the money back immediately, even if every payment has been made on time. This is how a company that has never missed a payment can lose control of itself in a week.
Debt comes in 3 practical shapes:
- Bank loans. Negotiated privately with 1 bank or a group of banks. Flexible, renegotiable, and dependent on a small number of relationships.
- Bonds and debentures. A loan divided into many small pieces and sold to many lenders. Harder to renegotiate, because you would have to persuade thousands of holders. Cheaper for a strong borrower, unavailable to a weak one.
- Commercial paper. Very short-term borrowing, usually under a year. Cheap and dangerous, because it must be continuously replaced. A company funding long-lived assets with commercial paper is betting that lenders will still be there next month.
The equity side
When a company issues shares, only 1 thing is agreed: the buyer becomes an owner. There is no rate, no date and no security, because there is no promise.
What the buyer gets is a proportional claim. If a company has 100 crore shares and issues 20 crore more, everybody who was there before now owns a smaller fraction of the same company. That is dilution, and it is arithmetic, not opinion.
Dilution is not automatically bad. This is the sentence most investors get wrong.
Dilution hurts you only if the money raised earns less than the business already earns.
If a company owning 100 crore of assets earning 20% issues shares to buy another 100 crore of assets that also earn 20%, your slice halved and the pie doubled. You are where you started. If the new assets earn 5%, you are worse off. If they earn 35%, you are better off.
So the question is never "did they dilute me". It is "what did they buy with it".
Why a founder ever chooses equity
Debt looks cheaper. Interest rates are lower than the return a good business earns, and interest is deductible against tax. So why does anybody sell shares?
- Debt has to be serviced from cash the company does not yet have. A new business with no earnings cannot pay interest, and no lender will fund it. Equity is the only money available to a company whose profits are in the future.
- Debt removes the right to be wrong. With equity, a bad year makes shareholders unhappy. With debt, a bad year can end the company. Founders trade away ownership to buy the freedom to survive a mistake.
- Equity buys more than money. A serious investor brings customers, discipline and a name other people trust. A bank brings a payment schedule.
What it tells you, and what it does not
The mix of debt and equity tells you how the value of the company will be split if things go well, and who decides if things go badly.
It does not tell you whether the debt is affordable. A company with ₹10,000 crore of debt and ₹8,000 crore of annual operating profit is comfortable. A company with ₹2,000 crore of debt and ₹150 crore of operating profit is not. Absolute debt levels are almost meaningless without the earnings beside them.
It does not tell you when the debt is due. ₹5,000 crore repayable across 10 years is a different company from ₹5,000 crore repayable in 14 months. The maturity schedule is in the notes to the accounts, and it is the single most useful page nobody reads.
And a rising share count does not always mean shareholders were harmed. Shares issued to buy a good business, or in a rights issue you were invited to join, are not the same event as shares handed to institutions at a discount.
The decision rule
Judge debt by whether it is covered, and equity by what it bought.
For debt: divide operating profit by the interest bill. If that number is above 4, the debt is comfortable. If it is between 2 and 4, the company has no room for a bad year. If it is below 1.5, the lenders are effectively in charge already.
For equity: compare the share count today with 4 years ago. If the share count grew and profit per share grew faster, the dilution was worth it. If the share count grew and profit per share did not, you funded something that did not work.
Unless the company is a bank or a lender, in which case both tests need different measures, because borrowing money is what a bank sells.
Try this now
Five minutes, 1 company you own, 1 annual report. This measures both doors at once.
- Search for "[company name] annual report" and open the most recent PDF from the company's own website. Every listed company publishes one free. In India you can also find it under Financials on the exchange website.
- Find the Statement of Profit and Loss. Write down 2 lines: Profit before tax and Finance costs (in the United States this line is called Interest expense).
- Add them together. That is roughly the company's operating profit before interest. Divide it by the finance costs.
(Profit before tax + Finance costs) ÷ Finance costs = interest coverage. - Now find the share count. Look at the front of the Balance Sheet for Equity share capital, or find weighted average number of shares in the earnings-per-share note. Write down this year's figure and the figure from 4 years ago. Older annual reports are on the same website.
- Calculate the change in the share count over those 4 years, as a percentage.
What you should see. Two numbers that together describe how this company is funded and what it has cost you.
An interest coverage above 6 usually means debt is not a live issue for this company. Between 2 and 4, one bad year matters. Below 1.5, read the auditor's report before you do anything else.
On the share count, a rise of less than 2% over 4 years is normal — that is employee stock options and nothing more. A rise of 15% or more means real dilution happened, and you should be able to name what the company bought with the money. If you cannot name it, that is the finding.
A company with no borrowings at all will show a very small finance cost or none. Step 3 will produce a huge number or an error. That is the correct answer: debt is not this company's risk. Go and do step 4 anyway, because equity dilution usually is.
Three real cases
1. IL&FS, September 2018 (India) — short-term debt, long-term assets Infrastructure Leasing and Financial Services funded roads, tunnels and other projects that would take decades to pay back. It funded them substantially with short-term borrowing that had to be replaced constantly. In September 2018 it began missing payments. Its credit rating fell from the highest grade to default within weeks. The company had not become a bad business overnight. It had simply reached a month in which the lenders declined to lend again. Credit dried up across Indian non-bank lenders for more than a year afterwards, and companies with no connection to IL&FS found their own borrowing costs rising.
2. Apple, 30 April 2013 (United States) — borrowing while holding a fortune Apple sold $17 billion of bonds, the largest corporate bond sale ever completed at that point. At the time it held well over $100 billion in cash. It borrowed anyway. Most of the cash sat outside the United States and bringing it home would have triggered a large tax bill, while borrowing was cheap and the interest was deductible. The lesson is that a company raising debt is not necessarily short of money. Sometimes debt is simply the cheaper of 2 ways to reach the same rupee.
3. Suzlon Energy, 2012 to 2025 (India) — dilution as a survival mechanism The wind turbine maker had roughly 1.93 billion shares outstanding in 2012. Through a decade of debt restructuring, conversions of loans into shares, and placements to institutions, that count rose to about 13.9 billion by 2025. An investor who bought in 2012 and never sold saw their ownership fall to roughly one-seventh of what it was, without selling a single share. The company survived. That survival was paid for entirely by the people who already owned it. This is what happens when a company runs out of debt capacity and equity becomes the only door left.
The question that resolves it
A novice reads a fundraising announcement and asks: is the company borrowing too much?
An expert asks: what happens in the worst 12 months this business can plausibly have?
Take the company's weakest year in the last decade and apply that operating profit to today's interest bill. If it still covers, the debt is fine. If it does not, the debt is a bet that the weak year will not repeat.
What would make this wrong
If the mix of debt and equity did not matter, companies with identical operations would fail at identical rates regardless of financing. They do not. Every credit cycle produces a list of failures, and borrowing predicts that list far better than product quality does.
The honest limits are 3.
First, interest coverage uses reported profit, and reported profit can be managed. A company can capitalise costs, revalue assets or recognise revenue early. The cash flow statement is harder to arrange, and interest actually paid appears there.
Second, off-balance-sheet obligations exist. Operating leases, guarantees given to subsidiaries and commitments to suppliers can all behave exactly like debt without appearing in the debt line. Guarantees to group companies hide easily, particularly in India where group structures are complex.
Third, share count is not the whole dilution story. Convertible bonds, warrants and unexercised employee options are shares that do not exist yet and will. Diluted earnings per share accounts for these, which is why it is the number worth using.
In India
Debt. Bank lending dominates. Most Indian companies of any size have a consortium of banks rather than a bond programme. Loan rates are usually linked to an external benchmark such as the repo rate, so a change in RBI policy moves company interest bills within months.
The public debt instrument is the debenture, and the version investors meet is the non-convertible debenture (NCD) — a bond that never turns into shares. NCDs are issued under SEBI's rules for non-convertible securities. Every issue must carry a credit rating from an agency such as CRISIL, ICRA or CARE, and must have a debenture trustee whose job is to act for holders if things go wrong.
Two Indian facts change how you read all of this.
- Over 98% of Indian corporate bond issuance is by private placement, sold to a small number of institutions rather than offered publicly. The corporate bond market is real but it is not very public and it barely trades once issued.
- Retail investors can buy listed NCDs directly, in small amounts, through the same demat account they use for shares. Public NCD issues are advertised like IPOs. This is genuinely accessible in a way that individual corporate bonds are not in most countries.
Equity. Rights issues, QIPs and preferential allotments are the 3 routes a listed Indian company uses after its IPO. Pricing of QIPs and preferential issues is governed by SEBI formulas based on recent traded prices, which limits how cheaply a company can sell new shares to insiders. Preferential allotments carry a lock-in period.
When it fails. The Insolvency and Bankruptcy Code, 2016 sets the order and the clock. Financial creditors form a committee and vote on a resolution plan. Across resolved cases, financial creditors have recovered roughly a third of their admitted claims on average. Equity holders sit below all of them, and in most resolved cases receive nothing.
In the United States
Debt. The corporate bond market is the main event. A large American company raises debt by issuing bonds to institutions worldwide, often in a single day, without involving a bank as a lender at all.
Every bond carries a rating from Moody's, S&P or Fitch, and the market splits sharply at 1 line.
- Investment grade — rated BBB− or higher. Pension funds and insurers can hold it. Borrowing costs are low.
- High yield, also called junk — rated BB+ or lower. A narrower set of buyers, and much higher interest rates.
Crossing that line downwards is expensive, and is often what a company is protecting when it chooses equity over debt.
Two other American features matter. Rule 144A allows a fast bond sale to large institutions without full public registration, which is why US bond deals can be arranged in hours. Revolving credit facilities are pre-agreed bank borrowing limits a company can draw and repay at will — a safety net that costs a fee even when unused.
Equity. Follow-on offerings, shelf registrations and at-the-market programmes. An at-the-market programme lets a company sell new shares into the open market gradually, with no announcement on any given day. Dilution can therefore happen continuously and silently, disclosed only in the quarterly filing.
When it fails. Chapter 11 lets a company keep operating while it renegotiates with creditors. The order of the queue is the same, and shareholders are usually wiped out — though occasionally, when asset values recover during the process, they are not.
Where they differ, and what that tells you
The divergence is the depth of the lending market, and it changes what a debt number means.
An American company with a strong balance sheet has 2 fully independent sources of debt: banks and the bond market. If banks retreat, bonds are still available. If the bond market shuts, the revolving credit facility is already agreed. The company chooses.
An Indian company of the same quality usually has 1 source: banks. The bond market exists, is growing, and is mostly closed to anything below the highest credit ratings. A company rated below the top grades in India often cannot issue bonds at any price.
What that tells you is a question to ask before you buy a debt-heavy Indian company.
Ask: if its banks stopped lending next quarter, what would this company do? If the answer is "issue bonds", it has 2 doors. If the answer is "sell assets" or "issue shares at whatever price it can get", it has 1 door, and you are the fallback funding.
There is a second consequence, and it favours the Indian investor. In India, listed NCDs are sold to individuals in small amounts, so you can read the rating, the maturity schedule and the interest rate of a company's actual borrowing before you buy its shares. In the United States, individual corporate bonds are largely an institutional product and retail access is mostly through funds. The Indian retail investor has a clearer view of the debt side of the companies they own — and almost never uses it.
Carry this
- Debt is a contract with a date. Equity is a partnership with no date.
- Operating profit divided by interest is the number that says whether debt is a problem. Below 2, it is.
- Dilution hurts only if the money raised earns less than the business already earns. Ask what they bought.