While sales and earnings figures can offer short-term investment opportunities, a deeper dive into a company’s financial health is essential for sustainable long-term growth. One critical factor to consider is the interest coverage ratio. This ratio assesses a company’s ability to meet its interest obligations from its operating earnings, providing insights into its financial stability and leverage.
Understanding the Interest Coverage Ratio
The interest coverage ratio is calculated by dividing a company’s earnings before interest and taxes (EBIT) by its interest expense. A higher ratio signifies a stronger financial position, indicating the company can comfortably cover its interest payments. A ratio below 1.0 suggests the company struggles to meet its interest obligations and may face default risks.
Why is the Interest Coverage Ratio Important?
Debt plays a crucial role in financing operations for most companies, but it comes with an interest cost. This interest expense directly impacts a company’s profitability, and its ability to meet interest obligations is a significant factor in its creditworthiness.
Identifying Potential Investment Opportunities
Beyond simply having an interest coverage ratio higher than the industry average, consider incorporating additional factors into your investment strategy. This can include a favorable Zacks Rank (a ranking system that predicts future stock price performance) and a VGM Score (a composite grade based on Value, Growth, and Momentum).
A Winning Strategy:
1.
Interest Coverage Ratio greater than X-Industry Median:
Focus on companies that exhibit a stronger ability to cover their interest expenses compared to their peers.2.
Price greater than or equal to $5:
Look for stocks with a minimum price of $5 or higher, ensuring they are liquid and readily tradable.3.
5-Year Historical EPS Growth (%) greater than X-Industry Median:
Seek companies with a history of strong earnings per share growth, demonstrating a track record of success.4.
Projected EPS Growth (%) greater than X-Industry Median:
Identify stocks with promising near-term earnings growth potential, indicating future profitability.5.
Average 20-Day Volume greater than 100,000:
Ensure the stock is actively traded, enabling smooth buying and selling transactions.6.
Zacks Rank less than or equal to 2:
Prioritize Zacks Rank #1 (Strong Buy) or #2 (Buy) stocks, which historically outperform the market.7.
VGM Score of less than or equal to B:
Combine Zacks Rank #1 or #2 with a VGM Score of A or B, as research indicates these stocks offer the best upside potential.Success Stories:
Four companies, Sterling Infrastructure, H&R Block, Leidos Holdings, and Stride, stand out as examples of companies with impressive interest coverage ratios that have demonstrated strong performance. They each possess a Zacks Rank #1 or #2 and a VGM Score of A or B, aligning with the outlined investment strategy. These companies have all shown significant growth in their stock prices in the past year, indicating their potential for continued success.
