We often judge a company on the basis of its sales and earnings numbers. These, however, may not be enough. Sometimes, a stock gets a boost if these numbers climb year over year or surpass estimates in a particular quarter. This will definitely be a great opportunity for an investor with a shorter horizon to cash in on. But if you seek long-term returns, investments backed only by sales and earnings numbers may not yield the desired results.

A critical analysis of a company’s financial background is a prerequisite for an informed investment decision. Here, coverage ratios that determine whether a company is sound enough to meet its financial obligations play a crucial role. The higher the ratio, the better it is. The focus of this article is on “Interest Coverage,” which is one such ratio.

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

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 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 its creditworthiness depends on how effectively it meets interest obligations. Therefore, Interest Coverage Ratio is one of the important criteria to factor in before making any investment decision.

Interest Coverage Ratio suggests the number of times the interest could be paid from earnings and 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 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 20 stocks that qualified the screening:

EMCOR Group, Inc. (EME - Free Report), which provides electrical and mechanical construction and facilities services, has a VGM Score of B and an expected EPS growth rate 15% for 3-5 years. The stock currently sports a Zacks Rank #1. 

CBRE Group, Inc. (CBRE  - Free Report), a commercial real estate services and investment company, has a Zacks Rank #2 and a VGM Score of A. The expected EPS growth rate for 3-5 years is currently 13%.

Arrow Electronics, Inc. (ARW - Free Report), which provides products, services and solutions to industrial and commercial users of electronic components and enterprise computing, has a Zacks Rank #2 and a VGM Score of A. The expected EPS growth rate for 3-5 years is currently 10.1%.

Steel Dynamics, Inc. (STLD  - Free Report), which is engaged in the steel products manufacturing and metals recycling businesses, has a Zacks Rank #1 and a VGM Score of B. The expected EPS growth rate for 3-5 years currently stands at 12%.

CMS Energy Corporation (CMS  - Free Report), which operates as an energy company, has a Zacks Rank #2 and a VGM Score of B. The expected EPS growth rate for 3-5 years currently stands at 6.3%.