Skip to main content

Households temporarily short of cash to cover their bills have a Liquidity issue and may need to briefly borrow money. Households that owe more than they own may face a more serious Solvency issue.

A liquidity issue is a temporary cash flow problem that prevents a household from covering financial obligations such as rent, car and credit card payments, utility bills, mortgages, etc. Consider a household with most of its funds tied up in long-term investments that experiences an unexpected drop in income or unforeseen expenditure. This could trigger a temporary liquidity issue. If the household’s income and assets outweigh its long-term financial liabilities, then there is little risk in a short-term loan to tide it over. However, if the opposite is true and the household’s long-term financial liabilities vastly exceed its income and assets, this could signify a more serious Solvency issue. This could require debt restructuring or even bankruptcy.

Liquidity Issues

Temporary liquidity issues can often be resolved with household cash (or cash equivalents), leveraging credit cards, short-term bank loans, drawing down savings, selling assets or using them as collateral to borrow funds, boosting income, or cutting expenses. Several simple liquidity ratios have been developed to help gauge a household’s ability to meet short-term financial obligations.

1. Cash ratio {Total cash and cash equivalents/Total current liabilities} Measures a household’s ability to service its current liabilities using cash on hand and cash equivalents (i.e. checking accounts, and other highly liquid assets that can be rapidly converted to cash). A Cash ratio of 0.2 or higher generally signals that a household has sufficient cash and cash equivalents on hand to service current financial liabilities.

2. Current ratio {Total current assets/Total current liabilities} Measures a household’s ability to pay off its current liabilities using cash, cash equivalents, and assets that can be converted to cash within a year, including a household’s inventory. Household inventories typically include Furniture, Major Appliances, Electronics, Clothing, Jewelry, Art and Antiques, Tools, Sports and Recreation Equipment, Vehicles, and other valuables. A Current ratio greater than or equal to 1 generally signals that a household has sufficient assets, including inventory, to cover current liabilities.

3. Quick ratio {(Total current assets – Inventory)/Total current liabilities} In contrast to the Current ratio, the Quick ratio subtracts household inventory from current assets which is appropriate if major inventory items cannot be rapidly converted to cash. Much like the Current ratio, a Quick ratio greater than or equal to 1 signals that a household has sufficient liquid assets to cover current liabilities.

All three ratios may be used by lenders to assess a household’s short-term liquidity position. Note that Current and Quick ratios incorporate a broader range of assets that may offer a more comprehensive picture of overall household financial liquidity. Liquidity ratios can also be used by households. For example, whereas too low a liquidity ratio may warn lenders that a household is carrying too much debt, too high a liquidity ratio could signal households they hold too much cash capable of generating higher returns.

Solvency Issues

Solvency issues can arise when a household takes on so much debt their combined income and assets cannot cover their long-term financial obligations. Various strategies exist to address solvency issues. These include working with creditors to restructure debts (cutting interest rates or extending repayment terms), selling assets, boosting income, cutting expenses, seeking financial assistance (government loans, grants, etc.), and as a last resort declaring bankruptcy. Several simple ratios have been developed to help gauge a household’s solvency risk.

1. Debt-to-Asset ratio {Total debt/Total assets} Measures the proportion of household assets financed by debt, calculated by dividing total household debt by its total assets. Total debt includes all outstanding debts, such as mortgages, car loans, credit card balances, and personal loans. Total assets include major possessions, such as property, investments, and savings. A low ratio is desirable since it indicates a household is not as highly leveraged, or owns more than it owes (i.e. has more equity than debt).

2. Debt-to-Income ratio {Total debt payments/Total income} Measures a household’s ability to manage its debt payments relative to income, calculated by dividing total debt payments by total income. Total debt payments include all monthly debt payments, such as mortgage and car loan payments, minimum credit card payments, etc. Total income includes all sources of income, such as wages, salaries, bonuses, and investment income. Too high a ratio could indicate a household may not have sufficient disposable income to pay off its debts.

3. Savings ratio {Total savings/Total income} Measures the percentage of income a household saves, calculated by dividing total savings by total income. Total savings include all money set aside for the future, such as emergency funds, retirement savings, and other long-term investments. A high savings ratio may indicate a household is able to set aside enough money to meet future financial needs.

4. Net Worth {Assets – Liabilities} Measures a household’s assets minus its liabilities, calculated by subtracting total liabilities and any debts owed from the value of its assets. Liabilities can include mortgages, car loans, credit card and other debts. Assets can include primary residences, investment properties, vehicles, savings accounts, retirement accounts, and other investments. The higher a household’s net worth, the more likely it can service its debts over time. While Debt-to-Asset and Debt-to-Income ratios offer a more comprehensive picture of debt burdens, Savings ratios may reveal a household’s capacity to build wealth over time. Note that if a household enjoys a stable income and has a solid repayment plan (e.g. a fixed vs. variable interest rate), then high Debt-to-income or Debt-to-asset ratios may not necessarily indicate financial distress. Similarly, a low Savings ratio will not signal a solvency risk if households have other sources of long-term financial security, such as pensions or retirement savings.


Households that face a Liquidity issue risk not meeting their short-term financial obligations. Households that face a more serious Solvency issue risk not meeting long-term financial obligations. Temporary Liquidity issues can result from a variety of factors including Drops in Income or Job loss (due to Illness, disability, or business conditions), Unexpected expenses, Credit constraints, etc. Longer-term Solvency issues can emerge from many of the same factors, as well as Property Problems (house poor” or underwater/upside-down mortgages), Insufficient Retirement Savings, Inadequate Insurance, etc. Regardless of which factors impact a household, they could face a Solvency risk if their total debt outstrips their income and assets.

Lenders consider a variety of factors to determine the risk of issuing short-term loans to households facing Liquidity issues, or longer-term loans to those facing Solvency issues. Key factors include Income, Expenses, Employment history, Debt-to-income and the other ratios, Cash reserves (including emergency funds), Savings and Assets, Credit history (paying bills on time and managing debt responsibly), Purpose of the loan (e.g. necessary or discretionary), Collateral available, etc. Companies such as that collect and analyze data on many of these factors can help lenders set more suitable loan terms, and households better evaluate their borrowing capacity.

Francois Melese, Ph.D.

Author Francois Melese, Ph.D.

More posts by Francois Melese, Ph.D.