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 warrant superior 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 with coverage ratios — the higher these are the more efficient an enterprise will be in meeting its financial obligations. Here we have discussed one such ratio — the Interest Coverage Ratio.

Why Interest Coverage Ratio?

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

What’s the 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 21 stocks that qualified the screening:

BJ's Restaurants, Inc., which owns and operates casual dining restaurants, has a VGM Score of B and an expected EPS growth rate of 14.5% for 3-5 years. The stock carries a Zacks Rank #2.

O'Reilly Automotive, Inc., which is engaged in the retail of automotive aftermarket parts, tools, supplies, equipment and accessories, has a Zacks Rank #2 and VGM Score of B. The expected EPS growth rate for 3-5 years is 15.7%.

Amedisys, Inc., which provides health care services, has a VGM Score of A and Zacks Rank #2. Its expected EPS growth rate for 3-5 years is 18.8%.

HCA Healthcare, Inc., provides health care services, has a Zacks Rank #2 and VGM Score of A. The expected EPS growth rate for 3-5 years is currently 12.2%.

Toyota Motor Corporation, which designs, manufactures, assembles and sells passenger vehicles, minivans and commercial vehicles, and related parts, has a VGM Score of A. This Zacks Rank #2 company has an expected EPS growth rate of 5% for 3-5 years.

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