Zacks Investment Research | Jun 21, 2016 07:26AM ET
A layman might get himself trapped if he decides to pick a stock only by looking at its shooting numbers in a real-time stock screen. A critical analysis of the company’s financial background is always required for a better investment decision.
Often investors evaluate a company’s performance by simply looking at its sales and earnings, which sometimes do not reveal the true picture. To be more precise, they do not tell whether a company’s fundamentals are sound enough to meet its financial obligations. Here the role of coverage ratios comes to play — the higher these are the more efficient an enterprise will be in meeting its financial obligations.
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 financing operations for a majority of companies, 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. The "Interest Coverage Ratio” suggests how many times the interest could be paid from earnings and also gauges the margin of safety a firm possesses 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 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 Zacks Investment Research
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