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Bailout 1: Liquidity vs. solvency

Review of balance sheets. Difference between illiquidity and insolvency. Created by Sal Khan.

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  • blobby green style avatar for user sbd
    Aren't 'insolvent' and 'illiquid' the same thing - the inability to pay debts as they come due? Bankruptcy is negative equity, which is different than insolvent.
    (9 votes)
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    • leaf blue style avatar for user Darin Hagre
      They're both very similar, but there are a couple of unique differences to the terms.

      If you're illliquid, this might not be a horrible situation, but it simply means that the things you own or control cannot be traded or sold instantly and that you don't have a reserve of cash on hand. Things like a house or a car are illiquid, meaning that you can't sell them instantly without expecting to take a significant financial hit.

      On the other hand, insolvency means that you're unable to pay back your debt when it comes due.

      Let's say you operate a business with assets of $100,000 but it's tied up in all of your infrastructure... it's still worth $100,000 — but you can't sell it right away, and you won't have that money available in cash immediately. That's illiquidity.

      But now, let's say your same business has assets of $100,000 and a liability of $120,000 (stemming from a new equipment purchase). Unfortunately, you haven't been able to bring in any cash in the last six months because of whatever reason, and now you're still in debt for the full $120,000 plus 6 months worth of interest. Because you're not paying back these debts, you're insolvent.

      These are just two examples... hope this helps!
      (51 votes)
  • male robot hal style avatar for user chris
    Don't a lot of guys with negative net worth, who are balance-sheet insolvent, still soldier on? As long as they have sufficient income etc, they continue to service their debts and thus do not file for bankruptcy? If the lenders get paid, then they won't tip them into bankruptcy either.
    (4 votes)
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    • leaf blue style avatar for user Stuffe
      They are still technically bankrupt. But you are right, normally they can still carry on. The bank might not know or might calculate that they get the most back if that person doesn't declare bankruptcy and keep paying every month. But if they get into increasingly more debt every month, at some point they will be forced to declare bankruptcy.
      (10 votes)
  • blobby green style avatar for user Ben Williams
    Can annual salary count as an asset?
    (3 votes)
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    • piceratops seed style avatar for user young.benn
      Your salary only counts as an asset after you get the cash. So if you make $50k a year you cannot enter a $50k asset on your balance sheet in January. This is because you haven't performed the work necessary to earn the salary. You do that throughout the year.
      (5 votes)
  • blobby green style avatar for user 姜 思聪
    I want to know what the liquidity is? THANKS!
    (3 votes)
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    • ohnoes default style avatar for user Tejas
      Liquidity is the speed at which you can convert your assets into cash. For instance, a stock is very liquid, because you can sell that stock within a few minutes. A house is not liquid, because it takes several months to be able to sell it. The most liquid asset of all is cash itself.
      (4 votes)
  • hopper jumping style avatar for user Smart-guy
    Can someone please explain Liquidity, illiquidity, insolvency to me.
    And the difference between illiquidity, insolvency and bankcrupcy?
    (3 votes)
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  • leafers ultimate style avatar for user florah123984
    what does liquidity mean?
    (2 votes)
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  • blobby green style avatar for user Jonah Martin
    What are the 2 primary reasons for banks failures? Is it insolvency and illiquidity? Or something else?
    (2 votes)
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  • piceratops ultimate style avatar for user Dicky Wira Senjaya
    is there a video about mortgage? i dont really understand what mortgage means.. thx
    (1 vote)
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    • male robot hal style avatar for user Bam
      A mortgage is a loan given generally when you want to buy a house but cannot pay the full amount immediately. For example, a 1 million dollar house and you only have $500,000. So you need a mortgage (loan) for $500,000.
      (3 votes)
  • mr pants teal style avatar for user Max
    What exactly is the paulson bailout?
    (1 vote)
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  • aqualine sapling style avatar for user ray kasian
    how do you tell the difference between net worth and liquidity or solvency
    (1 vote)
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    • ohnoes default style avatar for user Tejas
      Net worth is assets minus liabilities. So if you can sell everything you own and use that to pay off all of your debts, then what is left over is your net worth. Solvency is the statement that you have a positive or zero net worth, i.e. you are solvent if you have a positive net worth, and insolvent if you don't.

      Liquidity, on the other hand, measures how easily you can sell your assets. Homes tend to be very illiquid assets, because they take months to sell. On the other hand, stocks and bonds tend to be very liquid assets, as you can probably sell all of the ones you own in an instant. Cash is the most liquid asset, since it has already been sold.
      (2 votes)

Video transcript

In the next series of videos, I'm going to give my best attempt at trying to get a handle on the bailout and the financial crisis. So I'm going to try to explain different concepts in more than one way. Then I think hopefully it'll all sink in. But the big picture really is that there's a lot of fancy terminology being thrown around, but the underlying concepts really aren't that fancy. So I think a good place to start is just with the idea of the balance sheet. And you could watch some of the videos that I did before the whole financial mess on the balance sheet and that'll give you good primer, but it doesn't hurt to review it here. So a balance sheet is just a snapshot of what you have and what you owe and the difference between, and the difference between is kind of like your wealth. So if I just had a personal balance sheet, I could write my assets. They mean what you think they mean. These are things that will give you future benefit. So let's say I have $1,000 cash. Let's say I have a $100,000 house. Let's say I have a $10,000 car. And let's say everything else, I'll call it other, my furniture, my TV and everything else, is another $5,000. So those would be my assets. And so what are my total assets? It's $101,000, $111,000, $116,000. Well, it would be great if we lived in a world of only assets. But, unfortunately, let's say that I had liabilities as well. So liabilities. And a liability is what you think it means. It means something that you have to give future economic benefit for. You're kind of on the hook for something. And so let's say, my liabilities, I have a $20,000 student loan. And let's say on that house, unfortunately, I don't own it outright. Let's say that I have an $80,000 mortgage on that house, so essentially I borrowed $80,000 from the bank. And let's throw some credit card debt in there. Just to make this realistic relative to I think a lot of households out there, let's say that there's $5,000 of credit card debt, although for most households right now, this house is a lot more and this mortgage is a lot more. But anyway, I won't make social commentary. This is just to explain what a balance sheet is. So what is left over for me? What is my assets minus my liability? Let's calculate our total liabilities. So this is total assets. I'll use an A colon. So what are my total liabilities? 20 plus 80 plus 5, so it's $105,000. $105,000 total liabilities. So the difference between these two, my assets minus my liabilities, this is essentially my net worth. If I just liquidated everything tomorrow, if I sold all of this and paid off all this, this is what I would be left standing with. That's my net worth. Or you could view that as that is my equity. You often hear equity in the context of a house. In the context of a house, it's just the asset of the house minus the liability, but I'm talking about in the context of my personal balance sheet, not that these are the actual numbers. I don't want to give away too much about my life just yet. But anyway, so what is that number here? So my equity, and I'll do that in green since if it's positive it's a good number. My equity is $116,000 minus is $105,000. So what is that? That's $11,000. That's my equity. So there's a couple of things to think about here. You'll meet people with a $100,000 house or a $1 million house, and they say, oh, I am worth $1 million. And you're like, well, you're not really worth $1 million unless you own that house outright and you could actually sell that house for $1 million. It's not what you paid for it. It's what the market is willing to give for it. But your real net worth is your assets minus all of your liabilities. So in this case, your net worth is actually $11,000, not $116,000. And this is another important thing to think about. Assets are always equal to liabilities plus equity. That just comes out of the definition of what equity is. Equity was assets minus liabilities. If you take an MBA, they'll write it down, and it looks like an equation, but it's assets is equal to liabilities plus equity. But that's almost by definition that that's going to be true. So what can we do with this? How does this help us? Well, there's a couple of ways that we can think about this. First of all, what happens if my liabilities are larger than my assets? So if I owe the world more than the world owes me? Well, then this number is going to be negative. And if this number is negative, then there's no really good reason for me, maybe to preserve my credit score, but other than that, if we take that out of the equation, there's no good reason for me to continue living this existence. If my liabilities are greater than my assets, let's think about that situation. Let's say that my house is only worth $100,000, but for whatever reason, I owe $120,000 to the bank. Let's say maybe I originally bought the house with a no-money down payment for $120,000. And now I'm honest with myself. I'm like the value has gone down. It's only worth $100,000 now. So I'm in the situation where you could say I'm upside down in my mortgage. Well, one, you could say there's no incentive for me to continue paying this house. An even bigger picture, if I now look at my balance sheet, what are my liabilities now? My liabilities would be $145,000. And my equity would be my assets minus my liabilities. So $116,000 minus $45,000, what is that? Minus $29,000. I'll do that in red. That's a bad number for your equity. So in this situation, there's really no reason for me to continue living like the way I am, at least financially. As long as you're breathing, there's no reason not to continue breathing. But you wouldn't want to live like this financially anymore, so there's no reason not to go seek bankruptcy protection. And bankruptcy protection is admitting I am insolvent, which means that there's no way that I'm going to be able to unwind all of my liabilities. Courts protect me. My lenders can't come back after me. Everything is going to be erased. They're going to take all my assets, all my liabilities, and they're essentially going to take these and divide them up amongst the people that I owe stuff to. So that's bankruptcy. That's insolvency. And I want to highlight the word insolvency because that's a word that we're going touch on when we actually talk about the credit crisis. And that is opposed illiquidity. So what is illiquidity? So insolvency means there's no reason for you to continue with this type of a financial situation. You're bankrupt. You go get bankruptcy protection. That's insolvency. Illiquidity is a different situation. Illiquidity says no, I actually do have positive equity. So let me go back to the original circumstance. It really was I only owe $80,000 on the house, so my liabilities really are only $105,000. So I really do have a positive equity of $11,000. So this isn't insolvency anymore. So I'm going to describe what illiquidity means to you. Or to me, in this case, because this is my balance sheet. So let's say that my wife comes to me and says we need to pay our child's tuition. It is $5,000 for the upcoming year. I need to pay $5,000 in tuition. Actually, let me take a better situation because if I'm talking about tuition, it should have shown up on liabilities. Let's say that I have to make a $5,000 payment on my student loan. So I have some kind of weird student loan, where $5,000 comes due all of a sudden. So I have to make a $5,000 payment on the student loan. Let me do that in red. Make $5,000 payment. And it could be for anything, but let's say it's to satisfy part of one of these liabilities. So if you look at my equity, if you look at my assets minus my liabilities, I clearly have $11,000. I'm worth $11,000. And if I could liquidate all my assets and all my liabilities overnight, I would have $11,000 in cash, and then I could pay that $5,000. In fact, in the process of doing it, I would have paid that $5,000. But in this circumstance, if I just look at my situation, let's say that student loan payment is due tomorrow. I only have $1,000 of cash. I only have $1,000 maybe sitting in my checking account. So I can't make that $5,000 payment just with my cash. And then I look at everything else, and I'm like, boy, can unload any of these assets overnight? Well, a house, absolutely not. There's no way I'm going to be able to unload my house tomorrow. Maybe I could find someone who would buy it for $50,000 tomorrow, but that wouldn't help my situation. Then my equity would go negative again. So that won't help. I can't sell my car overnight. Maybe I could sell it at a super low price for $4,000, just to kind of make this payment, but I don't want to do that either. And same thing, your furniture, you'd have to go on Craigslist and take pictures of it. You couldn't do it. So this is a situation where you are having a liquidity crisis. You are illiquid, but you're not insolvent. You have a positive net worth, assuming that you're not lying about what's going on in your balance sheet. And that's another issue. So how do you get past a liquidity crisis like this? Well, someone has to give you-- we could call it a bridge loan because they're giving you a financial bridge from here to where you need to go. Or they're giving you a bridge that essentially buys you time. Let's say your dad says, OK, Sal, or my dad, I guess, I'll give you a $5,000 loan for the next two months. And over the next two months, I expect you to find some other source of cash. Maybe sell your car, buy a cheaper car, sell some of your furniture or something. So that is a loan to prevent a liquidity crisis. And that loan wouldn't be a bad idea because if this person isn't lying about their balance sheet, or I'm not lying about my balance sheet, then I actually am good for the money. On the other hand, that loan be a bad idea if I had insolvency because it would just be throwing good money after bad. I'm not able to pay my current loans, and you're just giving me another loan that I wouldn't be able to pay. Anyway, I'm out of time. I'll see you in the next video.