Limited companies may issue debenture stock or loan stock. These are long term liabilities described on the balance sheet as loan capital. They are different from share capital in the following ways.
- Shareholders are members of a company, while provides of loan capital are creditors.
- Shareholders receive dividends (appropriation of profits) whereas the holders of loan capital are entitled to a fixed rate of interest (an expense charged against revenue)
- Loan capital holders can take legal action against a company if their interest is not paid when due, whereas shareholders cannot enforce the payment of dividends.
- Debentures or loan stock are often secured on company assets, whereas shares are not.
The holder of loan capital is generally in a less risky position than the shareholder. He has greater security, although his income is fixed and cannot grow, unlike ordinary dividends. As remarked earlier, preference shares are in practice very similar to loan capital, not least because the preference dividend is normally fixed.
Advantages of rising finance by borrowing by debentures
- Debentures holders are creditors, not shareholders, and so do not affect the control of the company.
- The interest rate is fixed and a known cost.
- The interest is usually allowable for offset against the company’s corporation tax.
- If a debenture is secured as assets the interest rate will normally be lower than, say, an overdraft.
Disadvantages of rising finance by borrowing debentures
- Debenture interest must be paid, whereas directors do not need to pay shareholders a dividend.
- Dividends are appropriations of profit and do not reduce the company’s corporation tax.
- Debenture holders can force the sale of any assets used as security, if their loan is not repaid on the due date.