A layman can end up losing bucks if he decides to pick a stock only on the basis of numbers flashing on a real-time stock screen. A critical analysis of the company’s financial background is essential for a better investment decision.

Often investors evaluate a company’s performance by simply looking at its sales and earnings, which sometimes do not reveal the real picture. To be more precise, they do not tell whether a company’s fundamentals are sound enough to meet its financial obligations. Here, the role of coverage ratios comes into play — the higher these are the more efficient an enterprise will be in meeting its financial obligations.

Why Interest Coverage Ratio?

Interest Coverage Ratio is used to determine how effectively a company can pay the interest charges on its debt.

Debt, which is crucial to financing operations for a majority of companies, comes at a cost called interest. Interest expense has a direct bearing on the profitability of a company. And the company’s creditworthiness depends on how effectively it meets its interest obligations. Therefore, Interest Coverage Ratio is one of the important criteria to factor in before making any investment decision.

Interest Coverage Ratio = Earnings before Interest & Taxes (EBIT) divided by Interest Expense.

The Interest Coverage Ratio suggests how many times the interest could be paid from earnings and also gauges the margin of safety a firm has for paying interest.

An interest coverage ratio lower than one suggests that the company is unable to fulfill its interest obligations, and could default on repaying debt. A company that is capable of generating earnings well above its interest expense can withstand financial hardships. Definitely one should also track the company’s past performance to determine whether the interest coverage ratio has improved or worsened over a period of time.

The Winning Strategy

Apart from having an Interest Coverage ratio that is more than the industry average, adding a favorable Zacks Rank and a VGM Score of “A” or “B” to your search criteria should lead to better results.

Interest Coverage Ratio greater than X-Industry Median

Price greater than or equal to 5: The stocks must all be trading at a minimum of $5 or higher.

5-Year Historical EPS Growth (%) greater than X-Industry Median: Stocks that have a strong EPS growth history.

Projected EPS Growth (%) greater than X-Industry Median: This is the projected EPS growth over the next three to five years. This shows that the stock has near-term earnings growth potential.

Average 20-Day Volume greater than 100,000: A substantial trading volume ensures that the stock is easily tradable.

Zacks Rank less than or equal to 2: Zacks Rank #1 (Strong Buy) or 2 (Buy) stocks are known to outperform irrespective of the market environment.

VGM Score of less than or equal to B: Our research shows that stocks with a VGM Score of ‘A’ or ‘B’ when combined with a Zacks Rank #1 or 2 offer the best upside potential. 

Here are five of the 17 stocks that qualified the screening:

Build-A-Bear Workshop, Inc. (BBW - Free Report) , which operates as a specialty retailer of plush animals and related products, has a VGM score of “B” and an expected EPS growth rate of 22.5% for 3–5 years. The stock currently flaunts a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.

The Marcus Corporation (MCS - Free Report) , which owns and operates movie theatres, and hotels and resorts, has a Zacks Rank #1 and a VGM score of “B”. The expected EPS growth rate for 3–5 years is currently pegged at 15%.

Sprouts Farmers Market, Inc. (SFM - Free Report) , which provides fresh, natural and organic food, has a VGM score of “B” with an expected EPS growth rate of 11.7% for 3–5 years. The stock carries a Zacks Rank #2.

Grand Canyon Education, Inc. (LOPE - Free Report) , which provides post secondary education services, has a VGM score of “B” and an expected EPS growth rate of 10.8% for 3–5 years. The stock currently carries a Zacks Rank #2.

UnitedHealth Group Incorporated (UNH - Free Report) , a diversified health and well-being company, has a Zacks Rank #2 and a VGM score of “A”. The expected EPS growth rate for 3–5 years is currently pegged at 13.4%.