Ratio Analysis: A Relevant Tool for Emotional Fitness (Too!)

Ratio Analysis is known to students and practitioners of business, more particularly of finance, as a simple but insightful approach to measure and comparatively benchmark the state of business and operations of a firm. There are basically four ways of constructing ratios, classified as (i) coverage ratios, which are measures of a company’s ability to satisfy or meet particular obligations, (ii) return ratios, which are measures of the net benefit relative to the resources expended, (iii) turnover ratios, which are measures of the gross benefit, relative to the resources expended, and (iv) a component percentage, which is the ratio of a component of an item to the item. Wise leaders would never look at absolute numbers as indicative of performance, good or bad; ratios are vital ways to assess performance in relevant perspectives.

Specifically with reference to a company’s operating and financial performance, there are six types of ratios which constitute an essential analytical framework. These are (1) liquidity ratios, which provide information on a company’s ability to meet its short term or immediate obligations, (2) profitability ratios, which provide information on the amount of income from each rupee of sales, (3) activity ratios, which provide information on a company’s ability to manage its resources or assets efficiently, (4) leverage ratios, which provide information on the ability of a company to satisfy the fixed financing obligations, (5) investor ratios, which describe a company’s ability to satisfy shareholders investing in stock of the company, and (6) return on investment ratios, which provide information on the profits, relative to the assets deployed to produce the profits.

Universality

There is probably no analytical tool in business that is as universal as ratio analysis. Contrary to popular fixation that it is a finance oriented tool, it can be used to describe the state of affairs in respect of any type of functional performance (for example, number of exiting employees to total number of employees in an organization) or any type of physical performance (for example, units exported to total units sold). There can also be crossover ratios covering physical and financial numbers (for example, value added in rupees per employee). There are probably no absolute prescriptive levels for ratios, they being influenced by the age and market standing of the company, nature of industry, quality of management, nature of investors and the state of economy. They are, however, extremely useful as comparisons with other firms in same, similar or differentiated industries and as trends over time. Interestingly, ratio analysis can be applied to an individual’s operating and financial performance as well, equally effectively.

As an example of applicability to an individual, liquidity ratios are very insightful. Given the relatively non-liquid or volatile nature of investments that individuals tend to make, measures like quick ratios (current assets less money tied up in equities and bonds to current liabilities) are more helpful and cautionary. Similarly, those steeped in equity and investment culture must deploy profitability ratios consistently across their sectors of investment to judge their relative performance. They can utilize leverage ratios to assess their short term and long term financial viability. They can also follow a physical framework in terms of hours spent on social networking to hours spent on studies etc. The purpose of the blog post is, however, different; it seeks to adapt and apply the insightful framework of ratio analysis to analyse, judge and improve one’s emotional well-being.

Emotionalism

While emotions are a perfectly normal part of human life (even all life, considering how birds and animals are also emotive), emotionalism is an overwhelming and controlling state of mind and heart. Emotionalism may be defined as a strong or excessive appeal to emotions, either all by oneself or by one to another. It would include unwarranted expression or display of emotions in day to day settings. Emotions themselves are several but one can consider nine emotions (Nava Rasas as per Hindu fine art tradition) as core or root emotions. With certain liberty for the purposes of this post, these are tweaked and expanded as synonyms-like feelings as follows: love (also, affection or collaboration), happiness (also, optimism or energy), compassion (also, caring or pity), anger (excitement or revulsion), fear (also, anxiety or disquiet), disgust (also, revulsion or irritation), courage (also, adventurism or risk taking), wonder (also, surprise or fulfilment), serenity (also, equanimity and sobriety).

Positive leaders like Mahatma Gandhi and Nelson Mandela exemplified positive emotions such as love, happiness, compassion, courage, surprise and serenity while negative leaders like dictators feed on negative emotions like anger, fear, disgust and courage (of a different kind, though). The occurrence of emotions is not only related to personality types but the circumstances faced by the personalities. An emotionally driven person is not only overwhelmed by the above core emotions in varying degrees but also tries to dominate others through his dominant emotions. The way to avoid emotionalism is by seeking an emotional balance. This, of course, varies widely between individuals. That said, certain emotional ratios are relevant to understand one’s own emotional health better and work towards a healthy emotional balance. Six emotional ratios are presented below.

Emotional liquidity

Happiness is the most fulfilling emotion. Some people are spontaneously happy while some are happy only upon accomplishing their goals. A basal naturally spontaneous happiness level, superimposed by a variable happiness level related to goal accomplishment, is the best state. Alongside the asset of happiness, the liability of unhappiness or sadness also exists. Happiness tends to be short-lived while sadness tends to be long lasting. For example, a person who loses out on an exciting promotion is likely to be saddened (with respect to the specific promotion goal) till the next annual performance review cycle while he could still make continuous achievements, and hence derive continuous happiness, all though the year. An emotionally liquid individual has assets of happiness, optimism and energy that are several times over the sad liability of unfulfilled goals. An emotionally liquid person is one who is an energetic and optimistic seeker of happiness.

Emotional viability

Life is difficult and challenging, especially if one sets for himself or herself higher order goals that are not easily achievable. Usually, aspiration or goal motivates one to attempt achievement. Yet, one is beset by fear of failure or anxiety of slippage vis-à-vis the goals. The counteracting force for this fear is courage, peppered by a bit of adventurism and risk taking. The ratio of one’s courage to one’s fear has to be a significant number for one to be emotionally viable. Additionally, another ratio reinforces one’s emotional viability; it is the ratio of one’s affectionate emotions to one’s revulsion hot points. An ability to naturally be loving, affectionate and collaborative overcomes the tendency to be repelled by negatively surprising or irritatingly disgusting developments that one encounters. The former, if endowed in a person in a rich measure, helps him or her to achieve and sustain emotional viability. 

Emotional turnover

Everyday activities bring their own joys and disappointments even as most daily chores tend to be emotion-neutral. That said, just as one saves money for anticipated and unanticipated expenses, one must accumulate an inventory of happiness that can compensate for sharp spikes in unhappiness. Happiness needs to be viewed not as a momentary pleasure but an accumulation of good moments and memories that keeps one’s ship of life well protected when buffeted by sudden storms. Ideally, at any point of time one should be in a position to have happiness that outlasts disappointments of two quarters. It is more particularly true for corporate executives who battle the assessment rigour of corporate quarterly performance by the Street every quarter and also for the layman who is perplexed by loss of market capitalization or spike in inflation every quarter!   

Emotional leverage

Amongst all financial leverage ratios, debt-equity ratio is the most meaningful and popular indicator of financial health and stability of a firm. Investors and financial institutions provide capital to companies to develop as equity and debt respectively. The higher the proportion of debt the higher the leverage. Individuals have their own emotional debt-equity ratio as well. The broader society encourages individual development through two instruments - trust and goodwill. Trust is situational and contextual and, much like debt, needs periodic servicing, Defaults could lead to poor rating of individuals. In contrast, an individual in his or her lifetime can gain goodwill through successive positive actions. Much like equity or risk capital, goodwill remains undented despite occasional minor issues. Like debt-equity ratio being ideal at 1:1 for optimal leverage, an equal proportion of trust and goodwill bestows serenity on an individual.

Emotional return

Businesses cannot be expected to provide usurious returns continuously; eventually firms converge towards an industry average rate of return. The businesses are measured by earnings per share (EPS) and by return on total investment (ROI). In a loose sense, earnings are nothing but revenues less expenditure. The nine emotions comprise the positive emotions (PEs) of love, happiness, compassion and serenity, and non-positive or negative emotions of surprise, anger and disgust (NEs). The difference of PEs over NEs represents the net positive emotion (NPE) of an individual. This is modified with multiplication by the emotional viability index (EVI) of courage divided by fear (C/F). An EVI which is a natural number greater than 1 enhances the NPE of an individual. The net emotional return for an individual thus is a clear arithmetic of differently classified emotions as discussed herein.

Reservoir and dam

We have seen that emotions are complex feelings and spontaneous expressions at play but also have an intriguing and inspiring arithmetic. Emotional ratio analysis as outlined in this blog post is a tool for every individual to understand his or her own emotional profile and to achieve favourable emotional ratios. For that to happen, we need to understand two other characteristics of emotions as follows.

The first is that contrary to a common misunderstanding, emotions are not transient or fleeting feelings and expressions that are triggered by isolated events. Emotions tend to accumulate and are triggered into flow by individual triggers. Emotional reservoirs are a fact of life for every individual, however much one may deny. It is this characteristic that would enable one draw up emotional statements for a period and also as at the end of a period, much like income statement and balance sheet, respectively. While this being subjective, the analogy helps one semi-quantify one’s emotional income and expenditure as well as emotional assets and liabilities.

The second is that while all emotions are like rivers flowing into, and as, reservoirs of different capacities depending on one’s emotional propensities, there is one emotion - serenity - that would act as a dam to all the other eight emotions. With age, experience, maturity and wisdom, one is able to build higher heights of serenity that can check the inevitable build-up of emotional reservoirs that happens over time. Serenity discriminates in terms of moderating any overflow of emotions. Serenity is the master emotion that one needs to develop to be able to achieve an enhanced NPE. Serenity is also the quintessential ultimate emotion that arises from a healthy fusion of one’s body, mind, heart and soul.    

Posted by Dr CB Rao on April 25, 2015