The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Funko, Inc. (NASDAQ:FNKO) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Funko Carry?

As you can see below, Funko had US$177.6m of debt at September 2021, down from US$208.1m a year prior. On the flip side, it has US$93.2m in cash leading to net debt of about US$84.3m.

How Healthy Is Funko’s Balance Sheet?

According to the last reported balance sheet, Funko had liabilities of US$243.7m due within 12 months, and liabilities of US$297.4m due beyond 12 months. On the other hand, it had cash of US$93.2m and US$153.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$294.1m.

This deficit isn’t so bad because Funko is worth US$947.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Funko’s net debt is only 0.64 times its EBITDA. And its EBIT easily covers its interest expense, being 10.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Funko grew its EBIT by 531% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Funko can strengthen its balance sheet over time.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Funko actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

The good news is that Funko’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, Funko seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start.