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 called interest coverage 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 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 profits of a company. 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 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 13 stocks that qualified the screening:
America's Car-Mart, Inc. (CRMT - Free Report) , an automotive retailer, has a VGM Score of A and an expected EPS growth rate of 8.4% for three-five years. The stock currently sports a Zacks Rank #1. You can see the complete list of today’s Zacks #1 Rank stocks here.
Rush Enterprises, Inc. (RUSHA - Free Report) , which operates as an integrated retailer of commercial vehicles and related services in the United States, has a VGM Score of A and an expected EPS growth rate of 15% for three-five years. The stock carries a Zacks Rank #2.
Sprouts Farmers Market, Inc. (SFM - Free Report) , which provides fresh, natural and organic food products, has a VGM Score of A and an expected EPS growth rate of 9.2% for three-five years. The stock carries a Zacks Rank #2.
KB Home (KBH - Free Report) , which operates as a homebuilding company in the United States, has a Zacks Rank #2 and a VGM Score of B. The expected EPS growth rate for three-five years currently stands at 8.8%.
O'Reilly Automotive, Inc. (ORLY - Free Report) , engaged in the retail of automotive aftermarket parts, tools, supplies, equipment, and accessories, has a Zacks Rank #2 and a VGM Score of B. The expected EPS growth rate for three-five years is currently 14.6%.
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Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
Disclosure: Performance information for Zacks’ portfolios and strategies are available at: https://www.zacks.com/performance.