Equity vs Debt Security: Claim, Return and Control

An equity security is an ownership claim on whatever remains once every other claimant has been settled, carrying a vote on stated matters and no promised payment at all. A debt security is a promise to pay stated amounts on stated dates, ranking ahead of equity and carrying no vote. The difference runs through four things: claim order, promised return, control, and behaviour under stress.

Two people put money into the same company on the same morning. One of them will be told, in writing, exactly how much comes back and exactly when. The other will be told nothing of the kind, and will instead be handed a claim on a quantity that does not yet exist and may never exist. Both of them now hold a security. Both of those securities can be bought and sold. And almost everything a reader gets wrong about companies afterwards traces back to treating those two positions as though they were variations on one idea rather than two genuinely different arrangements.

Three things are taken as already known: the word security in its legal sense, together with the four rights that travel with an equity share; the balance sheet, including which line on it is equity and how that line is arrived at; and the profit ladder, read from revenue down to profit after tax rather than assembled. Each of the two instruments is set out completely on its own terms first, and the two are put side by side only afterwards.

Every figure below belongs to Sarvani Coatings Limited, an invented listed maker of decorative paints and industrial coatings. The year three statements are its published spine. The fall in profit worked later is a hypothetical laid on those published opening figures.

What is an equity security, taken entirely on its own?

An equity security is an instrument that makes its holder a part owner of a company and hands that holder a claim on what is left over. Not a claim on the assets. Not a claim on the revenue. A claim on the remainder, and the remainder is what sits there once anyone ranking earlier has been paid off completely. The single word remainder carries the whole instrument, and every other property of the instrument is a consequence of it.

Take Sarvani Coatings Limited. The company has 24.00 crore equity shares of Rs 2/- face valueThe amount printed on the instrument itself, fixed when it was created. Face value is an accounting and legal reference point, not the instrument's worth and not the amount it changes hands at. each, fully paid. Holding one of those shares gives the holder a claim, and the instrument's silences matter more than its statements. The instrument does not say how much will be paid, and it does not say when. No maturityThe date on which an instrument reaches the end of its life and the amount owed under it falls due. Instruments that carry one are dated; an ordinary share carries none. is written into it, so there is no date on which the arrangement ends and the money comes back. The company is not obliged to pay the holder anything in any particular year. No promise was ever made, so paying nothing breaks nothing.

The two absences, no stated amount and no stated date, are the whole of the equity security, and every other property of the instrument is a consequence of them rather than a separate feature. Because no amount was promised, there is no ceiling on what the claim can be worth. Because no amount was promised, there is also no floor beneath it other than zero. Because nothing was promised, the holder influences the company's conduct through a vote rather than through a claim for payment. Because there is no maturity, the only way out is to sell to somebody else. Read backwards, every item on the list derives from the two blanks.

The abstraction hides how ordinary the arrangement is, so here is an everyday version. A household runs a small tailoring unit out of two rooms. The cloth supplier is owed Rs 40,000/- on the fifteenth of the month, and that figure does not move whether the month was busy or dead. The household keeps whatever is left after the supplier, the electricity board, the two people who stitch and everybody else has been paid. In a good month the household keeps a great deal. In a bad month it keeps nothing, and in a genuinely bad month somebody in the household has to find the Rs 40,000/- from elsewhere. The household is holding the equity position in its own business, and it is holding it on exactly the terms an ordinary share sets out.

What is a debt security, taken entirely on its own?

A debt security is an instrument recording a promise to pay stated amounts on stated dates. The definition ends there, and it can be written without using the word equity once. The holder is a creditor rather than a part owner. The amount is fixed when the instrument is created, the dates are fixed at the same moment, and neither moves afterwards because the company had a good year or a bad one.

Three properties come out of that promise, in the same derived way the equity properties came out of the two blanks. First, the claim is fixed, so the best outcome available to the holder is being paid exactly what was promised and not one rupee more. Second, the instrument has a couponThe periodic amount an instrument promises to pay, conventionally expressed against its face value. How coupons are set and what they imply about pricing is a subject in its own right and is covered separately. and a maturity, so there is a date on which the arrangement ends and the principal is due back. Third, the promise is enforceable rather than aspirational, so the holder needs no vote. If the company misses a payment the holder does not have to persuade a meeting of anything; the holder has a contractual right, and the terms of the instrument say what happens next.

A debt security therefore does its work through the contract rather than through membership, and that is why the instrument confers no vote without leaving its holder powerless. Instead of a vote it carries terms, and the terms usually include a covenantA promise about how the borrower will behave while the money is outstanding, written into the loan or the instrument. Breaching one gives the lender a right to act. The mechanics of covenant drafting are covered separately. or several: undertakings about how much more the company may borrow, what it may sell, what ratios it must keep. Covenants are enforced by the instrument, not by a meeting.

Sarvani Coatings' own borrowings show the shape at a size a reader can hold. Total borrowings at the close of year three stood at Rs 240 crore. Rs 150 crore of that is classified short term and Rs 90 crore long term, and the year's finance cost came to Rs 21 crore. A date is hiding inside that classification. Read it carefully. The Rs 150 crore classified as short term is short term precisely because it falls due inside twelve months. Somebody has written down a day on which that money must be found. Nobody has written down any such day against the Rs 1,486 crore of net worth sitting above it.

Who is paid first, and out of what?

The two definitions are now on the table, so the contrasting can begin, and the first axis is the order in which claims are settled. Sarvani Coatings ended year three with net worth of Rs 1,486 crore, borrowings of Rs 240 crore and trade payables of Rs 356 crore. Adding the second and third of those gives Rs 596 crore of claims sitting ahead of the shareholders. Net worth is itself nothing but the assets with those Rs 596 crore taken off, so assets must come to Rs 2,082 crore.

The word ahead is doing something precise here and it is worth slowing down on. Ahead does not mean the lenders are paid sooner in the ordinary course of business, though they often are. Ahead means that in a winding upThe legal process of ending a company, turning what it has into money and settling claims against it in a set order. The order, and who sets it, is a matter of law rather than of agreement., when everything is turned into money and the claims are settled, the shareholders receive nothing at all until the prior claims have been settled in full. Not a proportionate share alongside them. Nothing, and then everything above the line.

A residual claim is only meaningful when something else is prior to it. The ordering is not a convention that grew up around these instruments; the ordering is what defines them. Strip the prior claims away and there is no remainder to be a claim on, only the whole thing. A company funded entirely by shareholders still has shareholders with a residual claim in form: the trade payables and the tax due are prior claims too, and a residual claim measured after nothing at all is a contradiction rather than a special case.

Look at the drawing again and notice what is unusual about the top band. The two lower bands were fixed by somebody signing something. Rs 356 crore is owed to suppliers because invoices say so. Rs 240 crore is owed to lenders because loan documents say so. The Rs 1,486 crore on top was never agreed with anybody. The Rs 1,486 crore is a subtraction, recomputed every time the column changes height. An equity holder does not hold an amount; an equity holder holds the arithmetic operation that produces an amount.

What does each side actually get promised?

The second axis is the return, and it is the axis where the two instruments look least like each other. A debt holder's best possible outcome is being paid in full, on time, exactly as promised. There is no version of events in which Sarvani Coatings has a spectacular year and its lenders receive more than the amount written on the instrument. Their upside is bounded by the promise itself, and the promise was fixed before anybody knew how the year would go.

Their downside is not the mirror of that. If things go badly enough the promise is not kept, and the holder recovers whatever the prior position on the claim ladder yields rather than the promised amount. So a debt security offers a small, capped gain against a large, uncapped-in-practice loss, and that asymmetry is the entire reason lenders behave the way they do. The only side of the distribution where a lender's outcome varies is the bad side, so lenders spend their attention on the ways things can go wrong.

An equity holder has the opposite shape. No amount was promised, so no amount caps the claim and the upside has no ceiling. The holder cannot be called on for more than they put in, so the downside stops at total loss. Set the two payoff shapes side by side and they are near mirror images, one with a lid on top and nothing underneath, the other with a floor underneath and nothing on top, and how each kind of holder behaves comes out of that geometry rather than out of anything about the holders themselves.

Set that against Sarvani Coatings' published year three ladder and the shapes stop being abstract. Earnings before interest and tax (EBIT) were Rs 354 crore. Other income added Rs 38 crore. The finance cost took Rs 21 crore, leaving profit before tax of Rs 371 crore, on which the tax charge was Rs 93 crore, an effective tax rateThe tax charge in the accounts expressed as a proportion of profit before tax. The effective rate reflects what was actually charged. The rate set out in the tax law is a different figure. of 25.1 per cent. Profit after tax was Rs 278 crore and earnings per share Rs 11.58/-. The Rs 21 crore finance cost is the figure to keep in mind through three quite different years.

The green block on the left is the same Rs 21 crore in all three bars. The block is more than a quarter of the whole pot in the hypothetical bad year, about one rupee in nineteen in the published year, and about one rupee in twenty-six in the hypothetical good one. Nothing about the lenders' position improved; the pot grew around a fixed block. A promise looks like that from the outside, and the fixed block is the reason a lender's attention goes almost entirely to the left hand bar.

Which holder has more say in what happens next?

Asked who has more control over a company, a shareholder or a lender, most readers answer quickly and are usually wrong. The shareholder is a part owner and has a vote, so the shareholder must have the say. The reasoning is sound about the legal position and unreliable about the practical one, and the gap between the two is one of the more useful distinctions between the instruments.

Start with what a vote actually is. A vote is a right to be counted, once a year at the annual meeting and occasionally at a meeting called in between, on the matters that are put to the meeting. Not on every matter. On the matters put. A shareholder cannot vote on next quarter's pricing, on whether to commission the coatings line sitting in capital work in progress at Rs 118 crore, or on how much to spend on advertising. Pricing, capital spending and advertising are management decisions, and the vote does not reach them.

Then there is arithmetic on top of that. Sarvani Coatings' promoter and promoter group hold 52.4 per cent. The free floatShares sitting outside the promoter group's holding, and so the slice genuinely available to change hands. How it gets measured, and what it then feeds into, is covered separately. is the other 47.6 per cent. So even if every single shareholder outside the promoter group voted together, on every resolution, they would still be outvoted on any matter decided by a simple majority. For a shareholder outside the promoter group at this company, the vote is a genuine right whose practical effect on any ordinary resolution is nil, and pretending otherwise is the commonest overstatement made about shareholder control.

Now the lender. A lender has no vote at all and cannot attend the meeting. A lender has instead a set of covenants, tested against the company's own numbers and tested on a schedule rather than once a year. If a covenant is breached, the lender acquires a right there and then. The right is contractual rather than constitutional, so it needs no majority, no meeting and no agenda item. Sarvani Coatings' covenants, whatever they are, sit in loan documents rather than in the published statements, so the mechanism is known to exist and its terms are not.

None of that makes lenders powerful in some general sense, and it is worth saying plainly what it does and does not support. A lender's influence is narrow: it reaches the things the covenant names and nothing else, and it is only triggered when a test fails. A shareholder's influence is broad in principle and thinly exercised in practice. Say the word part owner and it sounds as though control comes attached. Control does not come attached in the way the word implies. The shareholder's right arrives on a schedule and only works in numbers. The lender's right is live all year and works alone.

What do the four differences look like set beside each other?

The three axes worked so far, claim order, promised return and control, are joined by a fourth worked out in detail below: how each instrument behaves when the company's results move. Putting all four in one place is useful because the commonest analytical error with these two instruments is holding one axis in mind and forgetting the other three.

The bottom row of the two panels, read together, contains the sharpest single fact about the two instruments. Over the same two years, the same company, the same trading, the same everything: the equity claim per share nearly doubled and the amount going to the lenders fell. The two movements are not a coincidence of one company's history but what the two instruments were designed to do, and either one would have looked the same in reverse had the years gone the other way.

What happened to each claim when Sarvani Coatings did well?

Year one to year three was a good stretch for Sarvani Coatings Limited by any reading of the ladder. Revenue rose from Rs 1,840 crore to Rs 2,415 crore. Earnings before interest and tax rose from Rs 190 crore to Rs 354 crore. Profit before tax rose from Rs 191 crore to Rs 371 crore, an improvement of Rs 180 crore. Profit after tax rose from Rs 143 crore to Rs 278 crore, and earnings per share from Rs 5.96/- to Rs 11.58/-, a rise of about 94 per cent.

A bridge shows where each rupee of an improvement came from and who it went to. Now put the Rs 180 crore improvement in profit before tax through one.

The sliver is the point. Across two years in which Sarvani Coatings' profit after tax rose by Rs 135 crore, the amount flowing to its lenders did not rise at all; it fell by Rs 5 crore, from Rs 26 crore to Rs 21 crore. The lenders did not do badly. The lenders were paid exactly what they were promised, every year, and being paid in full is the best outcome their instrument permits. But they were spectators to the growth, by construction, and no amount of good news could have changed that.

Rebase both series to 100 in year one and the divergence becomes impossible to miss, and it also removes the scale problem that makes the waterfall sliver hard to see.

The two instruments are blurred most often at one particular contrast. In year three Sarvani Coatings paid a dividend of Rs 96 crore, being Rs 4.00/- a share, and it paid finance costs of Rs 21 crore. Both are cash leaving the company and going to a holder of a security. The two payments are not the same kind of event. The Rs 21 crore was owed; had the board decided against paying it, that would have been a default with consequences written into the loan documents. The Rs 96 crore was declared; had the board decided against paying it, nothing would have been breached and no holder would have had a claim for it. A dividend is a decision and interest is an obligation, and the fact that both arrive as money in a bank account is precisely what makes them easy to confuse.

What would happen to each claim if profit collapsed?

Everything so far has been worked on a company doing well. The instruments show their difference far more sharply in the other direction, so here is a hypothetical, clearly labelled as one, laid on Sarvani Coatings' published opening figures. Suppose earnings before interest and tax fell from the published Rs 354 crore to Rs 40 crore, a fall of Rs 314 crore. Nothing else changes: other income stays at Rs 38 crore, borrowings stay at Rs 240 crore, the finance cost stays at Rs 21 crore. A fall of that size is uncommon, and the difference between the two instruments is clearest at the uncommon end.

Work the ladder. Available to meet the promise is Rs 40 crore plus Rs 38 crore, or Rs 78 crore. The promise does not scale with the year, so the lenders take their Rs 21 crore first, in full, exactly as before. Profit before tax is therefore Rs 57 crore, the tax charge at 25.1 per cent is about Rs 14 crore, and profit after tax is about Rs 43 crore against the published Rs 278 crore. Earnings per share falls from Rs 11.58/- to about Rs 1.78/-.

Two readings come out of that, and the second is the one people skip. The first: between the two securities, the equity claim absorbs the entire movement. The lenders' Rs 21 crore is identical before and after. The second, and more precise: the tax charge falls as profit falls and takes 25.1 per cent of the movement with it, so the equity claim does not absorb the whole Rs 314 crore. The equity claim absorbs 74.9 per cent, exactly one less the effective tax rate. The relationship is an identity rather than a coincidence, holding whenever the tax charge is a flat proportion of profit before tax and nothing else in the ladder moves. Saying the equity claim takes the whole of the fall is true about the two securities and false about the arithmetic, and stating which of the two is meant is the difference between a careful reading and a slogan.

Notice what has happened to interest coverEarnings before interest and tax divided by the finance cost, so a count of how many times over the year's earnings would meet the year's interest bill. A cover ratio and its uses are covered separately. as well. On the published figures Sarvani Coatings earned close to seventeen times its finance cost. In the hypothetical it earns under two times, and the Rs 21 crore that was a rounding error against Rs 354 crore is now taking more than half of what the company earned. Nothing about the borrowings changed. The denominator was never the problem; the numerator moved.

Where does the line between the two instruments stop being clean?

Everything above has treated equity and debt as two well separated things, and for a reader learning the distinction that is the right way to meet them. The clean separation is not the whole truth, and a reader who stops there is unprepared for the first instrument that does not fit.

Real instruments are drafted, and whoever drafts one can put in whichever features they want. An instrument can carry a fixed payment and a share in the upside. Another can rank ahead of ordinary shares and behind the lenders. A third can carry a vote only in stated circumstances, such as when its own payment has been missed. A fourth can start as a promise and convert into an ownership claim on a stated event. None of those is a trick; each is a response to somebody wanting something a clean instrument at either end does not provide.

Treat the two definitions above as the far ends of a spectrum rather than as the only two places an instrument can sit: the ends are where the ideas are clearest, and a great deal of actual drafting happens somewhere in between them. There is a further complication worth naming and not solving here: how such an instrument is classified in the accounts does not always match how it behaves commercially, and the classification question has an accounting answer that is covered separately.

A household version, so the middle of the range does not feel exotic. A cousin needs Rs 6,00,000/- for a shop. One arrangement: the money is lent, she pays Rs 12,000/- a month for five years, and if the shop does brilliantly the payment is still Rs 12,000/- a month. Another: the money goes in as a partner's stake, taking a third of whatever is left after everything, and taking nothing at all in a bad year. Now a third, and it is the one people actually agree over tea: she pays Rs 8,000/- a month, and if the shop is still going in five years the person who put the money in gets a fifth of it. The third arrangement is neither of the first two, it is completely sensible, and it sits exactly in the middle of the range.