Equity Shares and Preference Shares: A Comprehensive Guide (2024)

When delving into the world of finance and investments, one often encounters the terms "equity shares" and "preference shares." These financial instruments play a pivotal role in the functioning of companies and form an integral part of the capital structure. In this comprehensive guide, we will explore the intricacies of both equity shares and preference shares, shedding light on their definitions, characteristics, advantages, and disadvantages.

Equity Shares: Unraveling the Basics

Definition Equity shares, often referred to as ordinary shares, represent a form of ownership in a company. They offer a share of the company's ownership to the shareholders, who are essentially the residual owners. Equity shares entitle shareholders to participate in the company's management through voting rights.

Characteristics

• Maximum Business Risk: Equity shareholders bear the maximum risk as they are the last in line for claims on the company's income and assets.
• Long-Term Capital: Companies raise long-term capital by issuing equity shares.
• Residual Owners: These shareholders are entitled to the residual amount left after all claims on the company's income and assets are settled.
• Voting Rights: Equity shareholders can actively participate in the management of the company by exercising their voting rights.

Advantages of Equity Shares

1. Cushion for Creditors: Equity capital provides a cushion for creditors, which enhances the company's creditworthiness.
2. Boosts Confidence: It instills confidence in potential lenders and investors, as equity capital signifies the company's financial strength.
3. Attracts Risk-Tolerant Investors: Equity shares are favored by investors willing to embrace higher risks.
4. No Compulsory Dividends: Companies are not obligated to pay dividends to equity shareholders, alleviating financial burdens.
5. No Charge on Assets: Raising funds through equity shares does not encumber the company's assets.
6. Management Control: Equity shareholders can actively participate in shaping the company's decisions through their voting rights.

Disadvantages of Equity Shares

1. Not Suitable for Risk-Averse Investors: Investors seeking fixed income may find equity shares unsuitable.
2. Higher Cost: The cost of raising funds through equity shares is often higher than other sources.
3. Dilution of Earnings: Issuing additional equity shares can dilute the earnings and voting rights of existing equity shareholders.
4. Time-Consuming: The process of issuing equity shares involves various formalities and administrative delays.

Preference Shares: The Assurance of Steady Dividends

Definition Preference shares, as the name suggests, provide shareholders with a preference when it comes to receiving dividends. These shares guarantee a fixed and steady dividend payment, and their dividends take priority over those of equity shareholders.

Characteristics

• Fixed Dividends: Preference shareholders enjoy a fixed and consistent dividend payout.
• Priority in Dividend Payment: Their dividends are paid before equity shareholders receive any dividends.
• Different Types: Preference shares come in various forms, such as cumulative and non-cumulative, participating and non-participating, and convertible and non-convertible.

Types of Preference Shares

a) Cumulative and Non-Cumulative

• Cumulative Preference Shares: These shares can accumulate unpaid dividends in case they are not paid in a particular year.
• Non-Cumulative Preference Shares: Dividends not paid in a specific year are not accumulated.

b) Participating and Non-Participating

• Participating Preference Shares: These shares have the power to share in the surplus profits of the company after fixed-rate dividends on equity shares are paid.
• Non-Participating Preference Shares: These shares do not participate in surplus profits beyond fixed-rate dividends.

c) Convertible and Non-Convertible

• Convertible Preference Shares: Convertible preference shares can be converted into equity shares after a specific period.
• Non-Convertible Preference Shares: These shares cannot be converted into equity shares.

Advantages of Preference Shares

1. No Impact on Control: Preference shares do not affect the control of equity shareholders over the company's management.
2. Potential Dividend Increase: In favorable times, equity shareholders may receive higher dividends.
3. Steady Income: Preference shareholders enjoy a steady and fixed income.
4. Priority Repayment: In case of liquidation, preference shareholders have priority in receiving their capital back.
5. No Charge on Assets: Preference capital does not create a charge against the company's assets.

Disadvantages of Preference Shares

1. Higher Dividend Costs: Dividend payments on preference shares are typically higher than interest rates on debentures.
2. Dividend Regulation: Dividends on preference shares are regulated by the company's earnings.
3. Dilution of Equity Shareholder Claims: The presence of preference capital can dilute the claims of equity shareholders.
4. Non-Deductible Expense: Dividends paid to preference shareholders cannot be deducted as expenses.

In conclusion, equity shares and preference shares are essential components of a company's capital structure. They serve different purposes and cater to diverse investor preferences. Understanding these shares, their advantages, and disadvantages is crucial for making informed investment decisions. Whether you seek potential growth or a steady income stream, your choice between equity and preference shares can significantly impact your financial portfolio.