You can simply arrive at a decision to “Buy” or “Sell” a particular stock by looking at its sales and earnings numbers. But such a strategy does not always guarantee returns. A critical analysis of the company’s financial background is always required for a better investment decision. 

A company’s fundamentals should be sound enough to meet its financial obligations. This can be judged through coverage ratios — the higher these are the more efficient an enterprise will be in meeting its financial obligations. The focus of this article is on Interest Coverage which is one such ratio.

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 very important for most of the companies to finance operations, 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.

Formula: Interest Coverage Ratio = Earnings before Interest & Taxes (EBIT) divided by Interest Expense. Interest Coverage Ratio suggests the number of times the interest could be paid from earnings and also gauges the margin of safety a firm carries for paying interest.

An interest coverage ratio lower than 1.0 implies that the company is unable to fulfill its interest obligations, and could default in repaying debt. A company that is capable of generating earnings well above its interest expense can withstand financial hardship. 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 seven of the 25 stocks that qualified the screening:

Sanmina Corporation (SANM - Snapshot Report) , the provider of integrated manufacturing solutions, components, products and repair, and logistics, has a Zacks Rank #1 and a VGM score of “B”. The expected EPS growth rate for 3–5 years currently stands at 17.5%.

Orchids Paper Products Company (TIS - Snapshot Report) , the manufacturer and seller of tissue products, has a Zacks Rank #1 and a VGM score of “B”. The expected EPS growth rate for 3–5 years currently stands at 14.3%.

Lowe's Companies, Inc. (LOW - Analyst Report) , a home improvement retailer has a Zacks Rank #2 and a VGM score of “A”. The expected EPS growth rate for 3–5 years currently stands at 15.6%.

Steel Dynamics Inc. (STLD - Snapshot Report) the manufacturer and seller of steel products has a Zacks Rank #2 and a VGM score of “A”. The expected EPS growth rate for 3–5 years is currently 28%.

Vail Resorts Inc. (MTN - Snapshot Report) , which through its subsidiaries operates mountain resorts and urban ski areas, has a Zacks Rank #2 and a VGM score of “A”. The expected EPS growth rate for 3–5 years is presently 14.1%.

Euronet Worldwide, Inc. (EEFT - Snapshot Report) , the provider of payment and transaction processing and distribution solutions to financial institutions, retailers and individual consumers, has a Zacks Rank #2 and a VGM score of “A”. The expected EPS growth rate for 3–5 years is pegged at 14.8%.

O'Reilly Automotive Inc. (ORLY - Analyst Report) , retailer of automotive aftermarket parts, tools, supplies, equipment, and accessories, has a Zacks Rank #2 and a VGM score of “A”. The expected EPS growth rate for 3–5 years is pegged at 15.3%.