Equity is an essential aspect of capital markets; that is why I would like to write an article giving a short and general introduction.
If you are reading this blog, I am sure it is because you feel a strong passion for the world of personal finance, financial markets, or philosophy.
Understanding the security concept is vital because owning a security in a corporation is one of the most important mechanisms to build wealth in the long-term.
Anyone looking to build a solid retirement plan and build real wealth along the way should understand these essential concepts and taking advantage of them by participating in some company’s growth over time.
What Is a Security In Finance?
In finance, a security can be any proof of ownership or debt that has been assigned some specific value and could be sold.
A security is a tradable financial asset that, for the holder, is an investment that represents either an ownership stake or a debt stake in a company.
In the investment industry, there is a division among owners (equity security or stock) and lenders (bonds or debt security).
When a company or any other financial or business entity wants to issue equity security or debt security, it is called the issuer.
A equity security or debt security is a sound system that is used by entities to raise new fresh capital without having an obligation to protect the investor against bankruptcy or business default. It is a sound system that governments use to raise new capital, which allows them to increase their budget.
Owning a security in a corporation or any company is one of the most important mechanisms to build wealth in the long-term.
EQUITY Security And DEBT Security
When you talk about securities, you can divide them into equity securities and debt securities.
Stocks represent equity or ownership in a company (e.g., common stocks), and bonds represent a company’s debt, are a loan to a company (e.g., bonds and banknotes).
When any company wants to publish the combination of its total capitalization –equity and debt-, they disclose a balance sheet.
The balance sheet of a company compiles the company’s assets, liabilities, and equity.
a) assets: everything that the company owns, such as cash, accounts receivable, investments, real estate properties, inventory, etc.
b) liabilities: everything that company owes: accounts payable, long-term debt, short-debt, other obligations.
c) equity: The company’s net worth is the surplus of the value of assets over the number of liabilities.
The Net Worth of a company is calculated by abstracting all company’s liabilities from the total assets.
The basic balance sheet Equation is:
ASSETS – LIABILITIES= NET WORTH; (N=A-L).
ASSETS= LIABILITIES + NET WORTH.
Equity Security Basics
–An equity security is a share of equity interest in a financial or business entity such as capital stock, trust, or partnership.
–There are several forms of capital stock, but the most common type of equity interest is common stock.
-The holder of an Equity Security is an investor that becomes a shareholder of a company by owning a company’s share.
-One of the main characteristics of equity securities is that they do not give you any right for any interest payment (versus debt security).
-In the case of a company that files bankruptcy: after they pay out all obligations to its creditors, they share with the shareholders only the residual interest.
-Equity Securities entitles the holder to have equal votes on directors, voting rights, and other essential matters.
-Shareholders or stockholders regularly vote for and elect candidates to a board of directors (BOD) to oversee the company’s core business.
-By choosing the board of directors (BOD), the shareholders have some rights over the company’s management; however, they do not have any rights or involvement with the day-to-day business operations.
-The shareholders that own a majority of the equity can control the issuer: whatever the company owns belongs to its shareholders -business owners-.
-Equity Securities allow its holders to have capital gains, dividends, and to make profits (vs. with debt securities, the lender only receives the repayment of principal plus some interest).
Debt Security Basics
-When you as investor loan capital to an entity (corporations and governments) -issuer-, you have the right to receive regular interest payments for the use of those funds by the issuer for a fixed term, plus the principal, plus the rights to receive certain important information.
-Because you (investor), are receiving fixed interest payments for your money, this kind of debt securities can also be named fixed-income securities.
–Debt security may be protected by collateral or may not be protected.
–In the case that the debt security is not protected by insurance, it may be contractually “senior” to other unprotected debt. This means that in fact the corporation or government (issuer) files bankruptcy, their holders have priority (debt security that is not considered senior is “subordinated”).
Hybrid securities combine some of the main features of both equity securities and debt securities. Let’s mention some examples of hybrid securities:
a)Equity warrants are options issued by a company, allowing the shareholders the opportunity to purchase the company’s shares within a specific timeframe and at some special price.
b) Convertible bonds: are bonds that can be converted into company shares of common stock in the issuer (issuing company).
c) Preference shares: as the name suggests, preference shares are those company stocks whose: payments of interest, dividends, or other returns of capital can be prioritized over different types of stockholders.
As far as preferred stock is concerned, there are some difficulties when it comes to classification: technically speaking, preference shares are equity security. However, they can be considered as debt security because they act as a bond. If you are an investor who is looking for a fixed dividend rate that gives you some regular income, then preference shares are a good option.
Check out this previous article if you didn’t have the chance to read it before: Roth IRA: Check Out This Amazing Investment Tool.