E28 Debt vs. Equity

What is the difference between debt and equity?

What does it mean to invest in debt schemes or equity schemes?

What are the upside and downside associated with these?

In this episode, Anmol helps you understand about these in the simplest way!

Are there any burning questions giving you sleepless nights? Write to us at anmol@7prosper.com

Disclaimer: This podcast is for educational purposes only. Anything said should not be construed as advice. If you're interested in our financial planning service, visit us at: https://bit.ly/3hhe8Bi

Transcript:
Hi. I am Anmol Gupta from the show "Money Ki Baat".
In today's episode I'm going to talk about Debt and Equity.


The spelling of Debt is D-E-B-T in which 'B' is silent due to which it is pronounced as 'Det'. But it is more important to understand what is Debt and Equity. It is important for you to understand Debt and Equity because whenever you invest in any scheme, that scheme either belongs to a Debt or an Equity category or it can also be hybrid.


So if you understand the upside and downside nature of Debt, and similarly if you understand the upside and downside nature of Equity, it will be very easier for you to analyse a scheme whether it matches your requirement or not.

Let's talk about "Debt". Debt means loan. I can give you two simple examples of Debt.
First, when you borrow money from your bank in the form of loan.
Second, when you give loan to the bank in the form of Fixed Deposit or Recurring Deposit.


When you take loan from the bank, you promise them to pay back the money along with some interest, right?


Similarly, in the second case, when you deposit money in your bank in the form of Fixed Deposit or Recurring Deposit, you are giving loan to the bank. In return the bank promises to pay you back the money along with some interest.


Both the situations are similar. However, the borrower and the lender got swapped. In both cases, there is a borrower and a lender.
When you are taking loan from the bank, the bank is your lender and you are the borrower.
When you are giving loan to the bank in the form of FD or RD, you are the lender and the bank is your borrower.


In both cases, the lender gets some interest from the borrower for lending his or her money, right?
And this interest is fixed.


When you take loan from the bank, they ask for 10-12% interest normally, right?
When you lend money to the bank, when you open Fixed or Recurring Deposit account in the bank, the bank promises you an interest of 5-6%, right?


Let's consider an example, you want to start a business. You want to run your business for which you need money. You need investments for your business. If you approach your bank to seek investments for your business, and you borrow 1,00,000/- to invest in your business and the bank agrees to pay you along with the condition that you have to return that money after 1 year with 10% Interest rate.

Now you start running your business and the 1,00,000/- that you had borrowed from the bank doubles in a year. which implies that you made a profit of 1,00,000/- in a year. However, the bank will still ask you to return 1,10,000/- after a year.

Suppose, you invest that money in your business and you suffer a loss of 50,000/-. Even in that situation, the bank will expect you to pay back 1,10,000/-.
Your business making profit or loss will make no difference to the bank. All that bank is concerned about is, whether it will get back the principal along with it's interest or not.


Similarly, when you open FD or RD with a bank, all that you are concerned about is, whether you are getting back the interest that had been promised by the bank.
You will not be concerned about where the bank had invested your money. Even if the bank earns a profit of 25% on investing your money, you will be only concerned about the 5-6% return that was promised to you by the bank.

It might have also happened that the bank suffered a loss on investing your money. You will not be concerned about that loss, right? You will still expect the bank to pay back the interest that was promised to you.


In Debt, a lender's downside is always covered. Lender is promised a fixed interest rate. The lender will get the fixed interest rate that was promised by the borrower, right?

But what is the disadvantage? Like I said, even if your business earns a profit of 1,00,000/-, and you earned 100% profit in a year, the bank is still getting 10% of it, right?

Therefore, upside in Debt is capped as well.

If borrower makes a lot of profit using that money, but the lender doesn't get its share instead he or she will get a fixed interest rate only, then downside gets covered but upside stays capped.

Hence, this is Debt.


Now we'll talk about Equity.

Suppose, you want money to run your business but you don't want to approach a bank for it because you'll have to pay the bank even if you suffer a loss. If you earn profit, then you will not face any problem in returning money to the bank.


But businesses are very risky. You would not want to encounter a situation in which you have to pay the bank by hook or crook despite your business suffering a loss.
In such a situation, you may approach an investor and offer him to buy ownership of your business in the form of Equity and if your business makes a profit, then you will give a share of your profit to him or her, and if it suffers a loss then he or she will have to share the losses too, right?


For example, I invest in your business instead of the bank. You and I invest 1,00,000/- each. Then we get 50% share of Equity each, which means we both get 50% ownership of the company. If this business makes a profit of 1,00,000/-, then each one of us will get 50,000/- each.
However, if this business suffers a loss of 50,000/-, then we will distribute the losses among us as well which means both of us will suffer a loss of 25,000/- each.


In this case, as an investor, I am getting complete advantage of the upside. If your business earned 100% profit, then I am enjoying a share of that profit as well. But, then its downside is that I'll have to bear the losses as well. If the business makes losses, then even I take that risk with you. So that's why it is called Equity,


Fairness, It is a fair deal between both of us. If the business makes profit, we'll share the profits and if the business suffers loss, we'll share the losses.


This is fundamental difference between Debt and Equity.
Examples of Debt Investments are Fixed Deposit, Recurring Deposit, PPF, in which you give loan to the Government in return of which you are promised a fixed rate of interest, PF, Post Office Deposits.


When companies borrow money from individuals or from other companies, they are known as Bonds. In such cases, different small companies are lent money and they promise some interest in return. They are called Bonds or sometimes, they are also called Debentures. These are the types of Debt investments which promises a fixed rate of interest.


And equity means shares. When you purchase a share of a company, you are purchasing the ownership of the company. You get a profit if the company earns profit or else you have to share the losses if the company suffers a loss.


So, I hope guys, I have made myself clear about Debt and Equity. And using the concept of Debt and Equity, I will explain you more about various type of schemes.


So stay tuned to Money Ki Baat and do hit the subscribe button to stay updated with the upcoming episodes. Thank You.

Keep prospering with other episodes!