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An ill-informed investor can lose cash if he wagers on a stock only on the basis of the numbers flashing on a real-time stock screen. A critical analysis of the company’s financial background is always required for a better investment decision, especially at a time when the stock market is juggling myriad issues, such as soaring inflation, supply chain bottlenecks, and a hawkish monetary policy.

Often, investors evaluate a company’s performance by simply looking at its sales and earnings, which sometimes do not reveal the real picture. To be more precise, they do not tell whether a company’s fundamentals are sound enough to meet its financial obligations. Here, the coverage ratio comes into play — the higher the metric, the more efficient an enterprise will be in meeting its financial obligations.
 

Why Interest Coverage Ratio?

The interest coverage ratio is used to determine how effectively a company can pay interest charges on its debt.

Debt, which is crucial to financing operations for the majority of companies, comes at a cost called interest. Interest expense has a direct bearing on the profitability 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 = Earnings before Interest & Taxes (EBIT) divided by Interest Expense.

Interest Coverage Ratio suggests how many times the interest could be paid from earnings and gauges the margin of safety a firm has for paying interest.

An interest coverage ratio lower than one suggests that the company is unable to fulfill its interest obligations and could default on repaying debt. A company capable of generating earnings well above its interest expense can withstand financial hardships. 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.

General Mills, Inc. (GIS - Free Report), Texas Roadhouse, Inc. (TXRH - Free Report), O'Reilly Automotive, Inc. (ORLY - Free Report), and Gilead Sciences, Inc. (GILD - Free Report) boast an impressive interest coverage ratio.
 

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 with 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 four of the eight stocks that qualified for the screening:

General Mills, which manufactures and markets branded consumer foods worldwide, carries a Zacks Rank #2 and has a VGM Score of B. Its expected EPS growth rate for three-five years is 7.5%. 

The Zacks Consensus Estimate for General Mills' current financial year sales and EPS suggests growth of 2.7% and 3.8%, respectively, from the year-ago period. GIS has a trailing four-quarter earnings surprise of 6.1%, on average. The stock has rallied 31.9% in the past year.

Texas Roadhouse, which operates casual dining restaurants, carries a Zacks Rank #2 and has a VGM Score of A. The expected EPS growth rate for three-five years is 13.8%.

The Zacks Consensus Estimate for Texas Roadhouse’s current financial year for both sales and EPS suggests a growth of 16.3% from the year-ago period. Texas Roadhouse has a trailing four-quarter earnings surprise of 11.2%, on average. The stock has risen 16% in the past year.

O'Reilly Automotive, which operates as a retailer and supplier of automotive aftermarket parts, tools, supplies, equipment, and accessories, carries a Zacks Rank #2 and has a VGM Score of B. The expected EPS growth rate for three-five years is 13%.

The Zacks Consensus Estimate for O'Reilly Automotive’s current financial year sales and EPS suggests growth of 6.8% and 4.8%, respectively, from the year-ago period. ORLY has a trailing four-quarter earnings surprise of 7.5%, on average. The stock has risen 33.8% in the past year.

Gilead Sciences, a biopharmaceutical company, carries a Zacks Rank #2 and has a VGM Score of A. The expected EPS growth rate for three-five years is 15.7%.

Gilead Sciences has a trailing four-quarter earnings surprise of 0.4%, on average. The stock has appreciated 21.5% in the past year.

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