Debt vs Equity: The difference between these relationships
Yesterday Michael Fischer differentiated between providers of capital and users of capital. Today he explains the two ways in which these groups interact: through the exchange of debt and the exchange of equity.
Equity and Debt (5:57)
When a provider of capital loans money to a user of capital, it's a debt transaction. When he owns a portion of the user of capital, it's an equity transaction.
In debt relationships, the user of capital provides a fixed return to the provider of capital. If you buy a government bond (effectively giving the government a loan), it pays you a fixed amount of money. Likewise, when you incur credit card debt, you pay the bank a fixed percentage.
Individual investors commonly lend money to large users of capital — such as governments and corporations — by purchasing bonds. When an investor buys a bond, he is basically loaning money to the entity that issued the bond.
But in equity relationships the return is not fixed. Because the provider of capital in this case actually owns a part of the user of capital, the returns are based on how effectively the user is able to generate profit.
When we buy individual stocks (or mutual funds), we are buying ownership interest in large corporations. We have a tiny portion of equity of specific users of capital. As these companies earn profits (we hope), we receive returns in the form of dividends or increased share prices.
Michael will cover the specifics of stocks and bonds later in this series.
I found a page at Dynamic Capital (a venture capital firm) that explains the differences between debt and equity financing form the perspective of users of capital. I've blatantly stolen this table from their article:
Similar explanations of the difference between debt and equity can be found here and here.