What is the Liquidity Ratio?

What is the Liquidity Ratio?

The notion of liquidity is exceptionally important in all financial markets, as traders/investors want to understand how many chances they have to buy and sell a certain asset by the market price. While diving into the notion of liquidity, a trader/investor faces a diversity of forms; this is why it is a challenging task to understand all the levels of liquidity.

The liquidity ratio is among the terms the hardest to understand for newcomer traders/investors; this is why the explanation from the very beginning is mandatory.

Liquidity ratio: definition and ways to calculate this index

First and foremost, a trader needs to understand what the liquidity ratio means. This accounting formula discloses a company’s ability to cover its short-term obligations within a certain period (month, quarter, year).

There are three types of liquidity ratios:

  • Current liquidity ratio (CLR). Such an index is among the simplest to calculate, as traders need to divide a company’s assets by its liabilities. This calculation enables a trader/investor to understand a company’s financial health without deep diving into assets under management.
  • Acid-test liquidity ratio (ATLR). This index discloses a company’s ability to cover short-term liabilities. ATLR focuses on cash-based assets, not on less liquid ones.
  • Cash liquidity ratio (CLR). This index is mainly used by lending companies to understand whether a company is able to pay off its debts or not.
What is the most common formula to calculate a company’s liquidity ratio? The current liquidity ratio is an index used to understand financial health. For instance, a certain company has assets worth $30 million, while the liabilities are equal to $10 million. In this case, the LR index is 3.0, showing a company’s financial health is rather good. When the index is more than 1, traders and investors may use a company’s assets to gain profits.

Liquidity ratio and the Forex market

The Forex market is a sector with an average daily turnover of about $7 trillion; this is why it seems to be challenging to apply the liquidity ratio to this market.

On the other hand, traders may access the daily turnover of a certain trading pair to compare it with the overall volume of the order book. When a trader deals with no liquidity provider, the depth of its order book is rather limited, as a brokerage company relies on the demand and supply of signed-up brokers only.

As for brokers that have applied to Tier 1 LPs, their ratio is extremely high – Tier 1 providers connect a company to the largest banks and funds. For instance, the overall EUR/USD daily turnover is $1.17 trillion, and the USD/CAD daily trading volumes equal $275 billion. This said reliable LPs make your order book exceptionally deep, executing all bid and ask orders within milliseconds.

How to find a reliable liquidity provider, as there are many companies that belong to the Tier 1 category? The most trustworthy companies mix innovations with their personal revolutionary products, offering a wide range of high-end solutions to fuel your business. B2Broker is among the leading companies that offer liquidity for diverse financial instruments.