We often judge a company based on its sales and earnings. However, these metrics may not be sufficient on their own. A stock might get a boost if these figures rise year over year or surpass estimates in a particular quarter, offering a lucrative opportunity for short-term investors to cash in. Relying solely on sales and earnings numbers may not yield the desired long-term returns. For those seeking sustainable investment growth, a deeper dive into the company’s financial health and stability is essential.

A critical analysis of a company’s financial background is a prerequisite for an informed investment decision. Coverage ratios, which assess whether a company is robust enough to meet its financial obligations, play a crucial role in this analysis. A higher ratio generally indicates a stronger financial position. This article focuses on the Interest Coverage Ratio, a key indicator used to evaluate a company's ability to pay interest on its debt, ensuring that the company is not over-leveraged and can comfortably meet its interest obligations from its operating earnings.

Interest Coverage Ratio is equal to Earnings before Interest & Taxes (EBIT) divided by Interest Expense. Kennametal Inc. (KMT Quick QuoteKMT - Free Report) , Tapestry, Inc. (TPR Quick QuoteTPR - Free Report) , Ralph Lauren Corporation (RL Quick QuoteRL - Free Report) and Celestica Inc. (CLS Quick QuoteCLS - Free Report) have impressive interest coverage ratios.

Why Interest Coverage Ratio?

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

Debt, which is crucial for most companies to finance operations, comes at a cost called interest. Interest expense has a direct bearing on a company's profitability, and its creditworthiness depends on how effectively it meets interest obligations. Therefore, the interest coverage ratio is one of the important criteria to factor in before making any investment decision. 

The interest coverage ratio suggests the number of times the interest could be paid from earnings and 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 hardships. One should also track the company’s past performance to determine whether the interest coverage ratio has improved or worsened over 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 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 four of the nine stocks that qualified the screening:

Kennametal, a global leader in metal cutting solutions, sports a Zacks Rank #1 and has a VGM Score of B. KMT has a trailing four-quarter earnings surprise of 35.4%, on average. You can see the complete list of today’s Zacks #1 Rank stocks here.

The Zacks Consensus Estimate for Kennametal’s current financial-year sales and EPS indicates growth of 13% and 81.3%, respectively, from the year-ago period. The stock has soared 97.9% over the past year. 

Tapestry, a house of iconic accessories and lifestyle brands, carries a Zacks Rank #2. The company has a trailing four-quarter earnings surprise of 12.8%, on average. 

The Zacks Consensus Estimate for Tapestry’s current financial-year sales and EPS implies growth of 11.2% and 26.5%, respectively, from the year-ago period. TPR has a VGM Score of B. The stock has soared 114% over the past year. 

Ralph Lauren Corporation, which designs, markets and distributes lifestyle products, carries a Zacks Rank #2. The company has a trailing four-quarter earnings surprise of 9.7%, on average. 

The Zacks Consensus Estimate for Ralph Lauren’s current financial-year sales and EPS implies growth of 12.4% and 31.8%, respectively, from the year-ago period. RL has a VGM Score of B. The stock has surged 70.4% over the past year. 

Celestica, a global leader in data center infrastructure and advanced technology solutions, carries a Zacks Rank #2. The company has a trailing four-quarter earnings surprise of 9.1%, on average. 

The Zacks Consensus Estimate for Celestica’s current financial-year sales and EPS implies growth of 39.2% and 47.8%, respectively, from the year-ago period. RL has a VGM Score of B. The stock has soared 336% over the past year.