Sources of Business Finance

Equity Shares and Preference Shares

You’ve heard the term ‘shares’ certainly. You might have the basic idea of what a share is as the definition is in the word itself. But did you know that every shareholder is actually a part owner of the company? Let’s understand the basics about equity shares and preference shares.

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Equity Shares

Equity shares are also known as ordinary shares. They are the form of fractional or part ownership in which the shareholder, as a fractional owner, takes the maximum business risk. The holders of Equity shares are members of the company and have voting rights. Equity shares are the vital source for raising long-term capital.

Equity shares represent the ownership of a company and capital raised by the issue of such shares is known as ownership capital or owner’s funds. They are the foundation for the creation of a company.

Equity shareholders are paid on the basis of earnings of the company and do not get a fixed dividend. They are referred to as ‘residual owners’. They receive what is left after all other claims on the company’s income and assets have been settled. Through their right to vote, these shareholders have a right to participate in the management of the company.

Now let’s understand what motivates the company to raise them:

Merits of Equity Shares

Equity Shares and Preference Shares

(Source: elearnmarkets)

  • Equity capital is the foundation of the capital of a company. It stands last in the list of claims and it provides a cushion for creditors.
  • Equity capital provides creditworthiness to the company and confidence to prospective loan providers.
  • Investors who are willing to take a bigger risk for higher returns prefer equity shares.
  • There is no burden on the company, as payment of dividend to the equity shareholders is not compulsory.
  • Equity issue raises funds without creating any charge on the assets of the company.
  • Voting rights of equity shareholders make them have democratic control over the management of the company

Now let’s understand what limits the company from raising them:

Limitations of Equity Shares

  • Investors who prefer steady income may not prefer equity shares.
  • The cost of equity shares is higher than the cost of raising funds through other sources.
  • The issue of additional equity shares dilutes the voting power and earnings of existing equity shareholders.
  • Many formalities and procedural delays are involved and they are time-consuming processes

Read about Debentures here.

Preference Shares

Preference shares are the shares which promise the holder a fixed dividend, whose payment takes priority over that of ordinary share dividends. Capital raised by the issue of preference shares is called preference share capital.

The preference shareholders are in superior position over equity shareholders in two ways: first, receiving a fixed rate of dividend, out of the profits of the company, before any dividend is declared for equity shareholder and second, receiving their capital after the claims of the company’s creditors have been settled, at the time of liquidation. In short, the preference shareholders have a preferential claim over dividend and repayment of capital as compared to equity shareholders.

Dividends are payable only at the discretion of the directors and only out of profit after tax, to that extent, these resemble equity shares. Preference resemble debentures as both bear fixed rate of return to the holder. Thus, preference shares have some characteristics of both equity shares and debentures.

Preference shareholders generally do not enjoy any voting rights. In certain cases, holders of preference shares may claim voting rights if the dividends are not paid for two years or more on cumulative preference shares and three years or more on non-cumulative preference shares. But what are cumulative and non-cumulative preference shares? They are classified below:

Types of Preference Shares

1. Cumulative and Non-Cumulative:

The preference shares that have the right to collect unpaid dividends in the future years, in case the same is not paid during a year are known as cumulative preference shares. Non-cumulative shares, the dividend is not accumulated if it is not paid in a particular year.

2. Participating and Non-Participating:

Preference shares which have a right to participate in the extra surplus of a company shares which after dividend at a certain rate has been paid on equity shares are called participating preference shares. These non-participating preference shares do not enjoy such rights of participation in the profits of the company.

3. Convertible and Non-Convertible:

Preference shares that can be converted into equity shares within a specified period of time are known as convertible preference shares. Non-convertible shares are such that cannot be converted into equity shares. intervals say six months or one year.

Now let’s understand what motivates the company to raise them:

Merits of Preference Shares

  • It does not affect the control of equity shareholders over the management as preference shareholders don’t have voting rights.
  • Payment of fixed rate of dividend to preference shares may make a company to announce higher rates of dividend for the equity shareholders in good times.
  • Preference shares have reasonably steady income in the form of fixed rate of return and safety of the investment.
  • Also, they are suitable for those investors who want a fixed rate of return with low risk.
  • Preference shareholders have a preferential right of repayment over equity shareholders in the event of liquidation or bankruptcy of a company.
  • Preference capital does not create any sort of charge against the assets of a company.

Limitations of Preference Shares

  • The rate of dividend on preference shares is generally higher than the rate of interest on debentures.
  • The Dividend on these shares is to be paid only when the company earns a profit, there is no assured return for the investors.
  • Preference shares are not preferred by those investors who are willing to take a risk and are interested in higher returns;
  • Preference capital dilutes the claims of equity shareholders over assets of the company.
  • The dividend paid is not deductible from profits as an expense. Thus, there is no tax saving as in the case of interest on loans.

Solved Question for You

Q: Equity shareholders are
(a) Owners of the company
(b) Partners of the company
(c) Executives of the company
(d) Guardian of the company

Answer: The correct option is “A”. Equity falls under Owners Fund and not Borrowed Funds. So every person that holds even one equity share is a part owner of the company. This is why they do not have a fixed return to the shareholders. Returns will depend on the performance of the company