What is the difference between equity and debt financing? Is it better to finance a business such as a hospital using equity that you have or debt financing?  

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jpgwolf37 eNotes educator| Certified Educator

Equity financing describes a process by which investors put in cash or cash equivalents to buy shares in a company. If an investor were to purchase fifty percent of the shares of a hospital, that shareholder would own fifty percent of the profits of the company. If the hospital were to bring in one hundred million dollars ($100,000,000) in revenue during the next year, and the total operating expenses of the hospital over the course of that same year were to equal fifty million ($50,000,000), then the equity investor would get half of that profit, which would equal twenty-five million dollars ($25,000,000).

On the other hand, if the hospital were to lose money the next year, and make no profit, then the equity investor would get no money, because there would be no profit to split. However, an equity investor who owns fifty percent of a company would have certain voting rights, and could force the hospital to make changes to its operations in order to maximize profit in future years. Even so, the equity investor has far less power than the debt investor. That is because our legal system prioritizes debt over equity.

A debt investor would not buy stock in your hypothetical hospital, but would instead by bonds issued by your company. These bonds, unlike equity, give the debt investor collateral, and because these bonds are treated as loans, the investor also gets a guaranteed return on that investment every year. That return is based on the interest that the bonds yield. The riskier the investment, the higher the yield (or annual interest rate) the investor can demand. 

This point is extraordinarily important, because while equity investors can get wiped out (lose everything they invested) if the company they invest in goes under, a debt investor gets to pocket fixed yearly interest payments regardless of how profitable the company is. In the event of the company going bankrupt, these debt investors also would get the building, the land, the MRI and X-Ray machines, as well as any other tangible or intangible items of worth that could be sold off to pay those debt investors back.

In this hypothetical hospital situation, that would mean that if a debt investor put up half the capital to buy the hospital, say fifty million dollars ($50,000,000), the hospital management would have to use its profits first to pay the interest on those bonds, which are loans, every year or every quarter, or perhaps even every month.

As for what kind of investor (equity or debt) most companies prefer, the answer is usually equity, because equity investors don't need to be paid unless the company makes a profit. Also, equity investors have less leverage in the case of bankruptcy. In other words, it is far easier to walk away from one’s obligations to equity investors than it is to walk away from one’s obligations to debt holders.