The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our financial statements and the accompanying notes included elsewhere in this Report. The forward-looking statements include statements that reflect management's beliefs, plans, objectives, goals, expectations, anticipations and intentions with respect to our future development plans, capital resources and requirements, results of operations, and future business performance. Our actual results could differ materially from those anticipated in the forward-looking statements included in this discussion as a result of certain factors, including, but not limited to, those discussed in the section entitled "Information Regarding Forward-Looking Statements" immediately preceding Part I of this Report.

Overview

Electromed, Inc. ("we," "us," "Electromed" or the "Company") was incorporated in 1992. We are engaged in the business of providing innovative airway clearance products applying High Frequency Chest Wall Oscillation ("HFCWO") technologies in pulmonary care for patients of all ages.

We manufacture, market and sell products that provide HFCWO, including the SmartVest® Airway Clearance System ("SmartVest System") and related products, to patients with compromised pulmonary function. Our products are sold for both the home health care market and the institutional market for use by patients in hospitals, which we refer to as "institutional sales." For approximately twelve years, we have marketed the SmartVest System and its predecessor products to patients suffering from cystic fibrosis, bronchiectasis and repeated episodes of pneumonia. Additionally, we offer our products to a patient population that includes post-surgical and intensive care patients at risk of developing pneumonia, patients with end-stage neuromuscular disease, and ventilator-dependent patients.

Because sale of the SmartVest System is by a physician's prescription only, we market to physicians and health care providers as well as directly to patients. In addition to distributors overseas, we have established our own domestic sales force, which we believe is able to provide superior support and training to our customers. In addition, we have non-exclusive independent contractor arrangements with more than 300 respiratory therapists and health care professionals who also provide education and training to our customers. Further, although the reimbursement process is subject to many contingencies, the SmartVest System is often eligible for reimbursement from major private insurance providers, HMOs, state Medicaid systems, and the federal Medicare system, which is an important consideration for patients considering an HFCWO course of therapy.

For domestic sales, the SmartVest System may be reimbursed under the Medicare-assigned billing code for High Frequency Chest Wall Oscillation devices if the patient has cystic fibrosis, bronchiectasis (including chronic bronchitis or COPD that has resulted in a diagnosis of bronchiectasis), or any one of certain enumerated neuro-muscular diseases, and can demonstrate that another less expensive physical or mechanical treatment did not adequately mobilize retained secretions. Private payers consider a variety of sources, including Medicare, as guidelines in setting their coverage policies and payment amounts.

We have been generating revenue from the sale of the SmartVest System or its predecessor products since 2000 and have generated net income since the fiscal year ended June 30, 2006. For the fiscal year ended June 30, 2012, we generated revenue of approximately $19,524,000 and net income of approximately $187,000. Our sales growth rate was 2.7% for the 2012 fiscal year compared to the 2011 fiscal year and was 32.9% for the 2011 fiscal year compared to the 2010 fiscal year. Net income as a percentage of sales was 1.0% in 2012 compared to 5.6% in 2011. Management believes the deceleration in revenue growth was primarily due to turnover in our domestic sales force. The decrease in net income was primarily due to retirement costs for two former officers of the Company, recruitment costs associated with replacing sales representatives, and staffing increases for sales growth that did not materialize.

Critical Accounting Policies and Estimates

During the preparation of our consolidated financial statements, we are required to make estimates, assumptions and judgments that affect reported amounts. Those estimates and assumptions affect our reported amounts of assets and liabilities, our disclosure of contingent assets and liabilities, and our reported revenues and expenses. We update these estimates, assumptions and judgments as appropriate, which in most cases is at least quarterly. We use our technical accounting knowledge, cumulative business experience, judgment and other factors in the selection and application of our accounting policies. While we believe the estimates, assumptions and judgments we use in preparing our consolidated financial statements are appropriate, they are subject to factors and uncertainties regarding their outcome and therefore, actual results may materially differ from these estimates. The following is a summary of our primary critical accounting policies and estimates. Please also refer to Note 1 to the Consolidated Financial Statements, included in Part II, Item 8 of this Report.

Revenue Recognition and Allowance for Doubtful Accounts

Revenues from direct patient sales are recorded at the amount to be received from patients under their arrangements with third-party payers, including private insurers, prepaid health plans, Medicare and Medicaid. In addition, we record an estimate for selling price adjustments that often arise from changes in a patient's insurance coverage, changes in a patient's state of domicile, insurance company coverage limitations or patient death. We periodically review originally billed amounts and our collection history and make changes to the estimation process by considering any changes in recent collection or sales allowance experience, but have not made material adjustments to previously recorded revenues and receivables.

Other than the installment sales as discussed below, we expect to receive payment on the vast majority of accounts receivable within one year and therefore classify all receivables as current assets. However, in some instances, payment for direct patient sales can be delayed or interrupted resulting in a small portion of collections occurring later than one year. In the event receivables are expected to be paid over longer intervals than one year, we recognize revenue under the installment method.

Certain third-party reimbursement agencies pay us on a monthly installment basis, which can span from 18 to 60 months in the cases of Wisconsin, Texas, and New York Medicaid, which constitute the majority of our installment method sales. Due to the length of time over which reimbursement is received, we believe that the inherent uncertainty of collection due to external factors noted above precludes us from making a reasonable estimate of revenue at the time the product is shipped. In certain circumstances, the patient must periodically attest that the unit continues to be utilized as a prerequisite to continued reimbursement coverage. Therefore, we believe the installment method is appropriate for these sales. If the third party reimbursement agency discontinues payment and we determine no further payments will be made from the patient, the carrying value of the account receivable is written off as a period adjustment against the previously recognized sales. Under the installment method, we do not record accounts receivable or revenue at the time of product shipment. We defer the revenue associated with the sale and, as each installment is received, that amount is recognized as revenue. Deferred costs associated with the sale are amortized to cost of revenue ratably over the estimated period in which collections are scheduled to occur.

Accounts receivable are also net of an allowance for doubtful accounts, which are accounts from which payment is not expected to be received although product was provided and revenue was earned. Management determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customer's financial condition and credit history. Receivables are written off when deemed uncollectible. Recoveries of receivables previously written off are recorded when received.

We request that customers return previously-sold units that are no longer in use to us in order to limit the possibility that such units would be resold by unauthorized parties or used by individuals without a prescription. The customer is under no obligation to return the product; however, we do reclaim the majority of previously sold units upon the discontinuance of patient usage. We have not obtained certification to recondition and resell returned units. Returned units are primarily used for warranty replacement parts and demonstration equipment. Returned products do not have significant value to us as the costs of becoming certified to resell, reclamation and reconditioning typically exceed the costs of producing a new unit.

Valuation of Long-lived and Intangible Assets

Long-lived assets, primarily property and equipment and finite-life intangible assets are evaluated for impairment whenever events or changes in circumstances indicate the carrying value of an asset may not be recoverable. In evaluating recoverability, the following factors, among others, are considered: a significant change in the circumstances used to determine the amortization period, an adverse change in legal factors or in the business climate, a transition to a new product or service strategy, a significant change in customer base, and a realization of failed marketing efforts. The recoverability of an asset is measured by a comparison of the unamortized balance of the asset to future undiscounted cash flows. If we believe the unamortized balance is unrecoverable, we would recognize an impairment charge necessary to reduce the unamortized balance to the estimated fair value of the asset. The amount of such impairment would be charged to operations at the time of determination.

Property and equipment are stated at cost less accumulated depreciation. We use the straight-line method for depreciating property and equipment over their estimated useful lives, which range from 3 to 39 years. Our finite-life intangibles consist of patents and trademarks and their carrying costs include the original cost of obtaining the patents, periodic renewal fees, and other costs associated with maintaining and defending patent and trademark rights. Patents and trademarks are amortized over their estimated useful lives, generally 15 and 12 years, respectively, using the straight-line method. During the year ended June 30, 2011 we incurred legal defense costs associated with a trademark infringement lawsuit filed against us (see Note 9 to the Consolidated Financial Statements included in Part II, Item 8 of this Report). Such legal defense costs are being capitalized and amortized over the remaining useful life of the trademark. We expect future amortization expense to increase as we incur additional costs associated with our patents and trademarks.

Allowance for Excess and Slow-moving Inventory

An allowance for potentially slow-moving or excess inventories is made based on our analysis of inventory levels on hand and comparing it to expected future production requirements, sales forecasts and current estimated market values.

Income Taxes

We recognize deferred tax assets and liabilities based on the differences between the financial statement carrying amounts and the tax basis of assets and liabilities. We provide a valuation allowance for deferred tax assets if we determine, based on the weight of available evidence, that it is more likely than not that some or all of the deferred tax assets will not be realized.

Warranty Reserve

We provide a lifetime warranty on products sold to patients in the United States and Canada, a three-year warranty for institutional sales within the United States and Canada, a five-year warranty on products sold to patients in Greece, and a three-year warranty on all other sales to individuals and institutions outside of the United States, Canada and Greece. We estimate, based upon a review of historical warranty claim experience, the costs that may be incurred under our warranty policies and record a liability in the amount of such estimate at the time a product is sold. The warranty cost is based upon future product performance and durability, and is estimated largely based upon historical experience. We estimate the average useful life of our products to be approximately five years. Factors that affect our warranty liability include the number of units sold, historical and anticipated rates of warranty claims, the product's useful life, and cost per claim. At our discretion, based upon the cost to either repair or replace a product, we have occasionally replaced such products covered under warranty with a new model. We periodically assess the adequacy of our recorded warranty liability and make adjustments to the accrual as claim data and historical experience warrant.

Share-Based Compensation

Share-based payment awards consist of options issued to employees for services, and to non-employees in lieu of cash payment for products or services. Expense is estimated using the Black-Scholes pricing model at the date of grant and the portion of the award that is ultimately expected to vest is recognized on a straight-line basis over the requisite service or vesting period of the award. In determining the fair value of our share-based payment awards, we make various assumptions when using the Black-Scholes pricing model, including expected risk free interest rate, stock price volatility, life and forfeitures. Please see Note 7 to the Consolidated Financial Statements included in Part II, Item 8 of this Report for these assumptions.

Results of Operations

Fiscal Year Ended June 30, 2012 Compared to Fiscal Year Ended June 30, 2011



Revenues



Revenue results for the 12 month periods are summarized in the table below
(dollar amounts in thousands).



                                  Twelve Months Ended June 30,     Increase (Decrease)
                                       2012           2011
 Total Revenue                       $ 19,524      $  19,004       $ 520         2.7%

 Home Care Revenue                   $ 17,959      $  17,348       $ 611         3.5%

 International Revenue               $    547       $    608       $ (61)      (10.0%)

 Government/Institutional Revenue   $   1,018      $   1,048       $ (30)       (2.9%)

Home Care Revenue. Our home care revenue increased by 3.5% or approximately $611,000 in fiscal 2012 compared to fiscal 2011. While this was an increase year over year, sales grew at a slower rate than in prior years. This resulted primarily from turnover in our domestic sales force. We did see a slight increase in the number of referrals and the number of approvals for reimbursement in fiscal 2012 compared to fiscal 2011.

International Revenue. International revenue decreased by 10.0% in fiscal 2012, or $61,000. Revenue from sales in Asia and Europe in fiscal 2012 decreased by approximately $133,000 and $78,000, respectively, over fiscal 2011, while sales in the Middle East and Central/South America increased by approximately $94,000 and $45,000, respectively, over fiscal 2011. Sales to Europe continue to be negatively affected by the debt crises and austerity programs in many European countries.

Government/Institutional Revenue. Revenue from sales to government and private institutions decreased by approximately $30,000 in fiscal 2012 compared to fiscal 2011. Revenue from sales to the U.S. Department of Veterans Affairs ("VA") and other government institutions decreased by approximately $19,000 or 8.0%, from approximately $238,000 in fiscal 2011 to approximately $219,000 in fiscal 2012. Revenue from sales to private institutions decreased by approximately $11,000 or 1.4%, from approximately $810,000 in fiscal 2011 to approximately $799,000 in fiscal 2012. The decreases were driven primarily by sales force turnover and by uncertainty concerning the implementation of the Patient Protection and Affordable Care Act negatively impacting institutional purchases of equipment.

Gross Profit

Gross profit increased to $14,145,000, or 72.4% of net revenues, for the fiscal year ended June 30, 2012, from approximately $13,778,000, or 72.5% of net revenues, for the fiscal year ended June 30, 2011. The increase in gross profit dollars resulted from the increase in sales volume.

Operating expenses

Selling, general and administrative expenses.Selling, general and administrative ("SG&A") expenses for the fiscal year ended June 30, 2012 were approximately $12,618,000, compared to approximately $10,874,000 for the prior year, an increase of approximately $1,744,000 or 16%. SG&A payroll and compensation related expenses increased by approximately $987,000 or 19.1% to approximately $6,168,000. The increase was primarily driven by the hiring of several key managers to support the current and future growth of the Company, specifically the Chief Operating Officer, Director of Human Resources, three Regional Sales Managers, Reimbursement Manager, and an Accounting Manager. There were also severance and certain other expense related to the retirement of two former officers of approximately $482,000 during the year ended June 30, 2012. Travel, meals and entertainment and trade show expenses increased by approximately $93,000 to approximately $1,712,000, compared to approximately $1,619,000 in fiscal 2011. This increase was primarily due to the increased size of the sales force.

Legal and professional fees increased by approximately $300,000 to approximately $990,000, compared to approximately $690,000 in fiscal 2011, due to additional accounting and legal expenses associated with public company reporting and compliance requirements. Advertising and marketing expenses increased by approximately $52,000 to approximately $875,000 in fiscal 2012, compared to approximately $823,000 in fiscal 2011. Patient training expenses increased by approximately $56,000 to approximately $532,000 in fiscal 2012, compared to approximately $476,000 in fiscal 2011. The increase in patient training expenses was primarily driven by the increase in the number of referrals. Insurance expenses increased by approximately $29,000 to approximately $730,000 in fiscal 2012, compared to approximately $701,000, or 3.7% of sales, in fiscal 2011. The insurance costs increase is related to an increase in the Company-paid portion of health insurance premiums, as the number of employees covered increased during the fiscal year.

Research and development expenses. Research and development ("R&D") expenses were approximately $921,000 and $1,034,000 for the fiscal years ended June 30, 2012 and 2011, respectively, a decrease of approximately $113,000. The decrease in R&D expenses was caused by a reduction in hours of certain vendors and payroll expense. As a percentage of sales, management expects to spend approximately 5.0% of sales on R&D expenses for the foreseeable future.

Interest expense

Interest expense decreased to approximately $169,000 in fiscal 2012, compared to $191,000 in fiscal 2011, a decrease of approximately $22,000. The decrease was primarily due to a decrease in average outstanding debt.

Income tax expense

Income tax expense was $251,000 in fiscal 2012, compared to $623,000 in fiscal 2011. The effective income tax rate in fiscal 2012 was approximately 57.0% compared to approximately 37.1% in fiscal 2011. The increase in the effective tax rate is related to changes in permanent differences including the estimate for the Federal Research and Development Tax Credit, which has not been extended past December 31, 2011 by the U.S. Congress.

Net income

Net income for the twelve months ended June 30, 2012 was approximately $187,000, or 1.0% of revenues, compared to approximately $1,056,000, or 5.6% of revenues, in fiscal 2011. The decrease in net income as a percentage of sales was the result of higher expenses from recruitment following turnover in our sales force, retirement costs for two former officers of the Company, staffing increases for sales growth that did not materialize, and additions to our management team to support our operations as we increase revenues and manage compliance with public company reporting requirements.

Liquidity and Capital Resources

Cash Flows and Sources of Liquidity

Cash Flows from Operating Activities

For the fiscal year ended June 30, 2012, our net cash used in operating activities was approximately $1,172,000. Our net income of approximately $187,000 was adjusted for non-cash expenses of approximately $908,000. Net income was offset by approximately $1,258,000, $536,000 and $414,000 increases in accounts receivable, inventories, prepaid expenses and other assets, respectively. Net income was also offset by a decrease in current liabilities of approximately $59,000.

For the fiscal year ended June 30, 2011, our net cash used in operating activities was approximately $1,415,000. Our net income of approximately $1,056,000 was adjusted for non-cash expenses of approximately $477,000 and an increase in current liabilities of approximately $647,000. Net income was also offset by approximately $3,016,000, $385,000 and $193,000 increases in accounts receivable, inventories, prepaid expenses and other assets, respectively.

Cash Flows from Investing Activities

For the fiscal year ended June 30, 2012, cash used in investing activities was approximately $849,000. Cash used in investing activities primarily consisted of approximately $787,000 in net expenditures for property and equipment and $62,000 in payments for patent and trademark costs.

For the fiscal year ended June 30, 2011, cash used in investing activities was approximately $1,111,000. Cash used in investing activities primarily consisted of approximately $452,000 in net expenditures for property and equipment and $659,000 in payments for patent and trademark costs, the majority of which related to the defense of our SmartVest trademark.

Cash Flows From Financing Activities

For the fiscal year ended June 30, 2012, cash used in financing activities was approximately $369,000, consisting of approximately $29,000 net proceeds from the exercise of options, and $23,000 in proceeds from subscription notes receivable. This was offset by principal payments on long-term debt of approximately $409,000.

For the fiscal year ended June 30, 2011, cash provided by financing activities was approximately $6,007,000, consisting of approximately $6,364,000 in net proceeds from the issuance of common stock in our initial public offering, $26,000 from exercise of options, and $60,000 in proceeds from subscription notes receivable. This was offset by principal payments on long-term debt of approximately $436,000.

Adequacy of Capital Resources

Based on our current operational performance, we believe our cash and cash equivalents and available borrowings under the existing credit facility will provide adequate liquidity for the next year. However, we cannot guarantee that we will be able to procure additional financing upon favorable terms, if at all.

Our primary capital requirements relate to adding employees in our sales force; continuing research and development efforts; and for general corporate purposes, including to finance equipment purchases and other capital expenditures in the ordinary course of business and to satisfy working capital needs.

We spent approximately $792,000 and $466,000 on property and equipment during the 2012 and 2011 fiscal years, respectively. We currently expect to finance equipment purchases with borrowings under our credit facility and cash flows from operations. We may need to incur additional debt or equity financing if we have an unforeseen need for additional capital equipment or if our operating performance does not generate adequate cash flows.

On August 13, 2010, we completed the sale of 1,700,000 shares of common stock, par value $0.01 per share, in an IPO, at an offering price of $4.00 per share. On September 28, 2010, Feltl and Company, Inc., the underwriter of the IPO, acquired 200,000 shares of our common stock at a price of $4.00 per share, pursuant to exercise of its over-allotment option. Gross proceeds from the issuance of common stock in connection with the IPO, including the overallotment option, were approximately $7,600,000. After deducting the payment of underwriters' discounts and commissions and offering expenses, our net proceeds from the sale of shares in the IPO, including the overallotment option, were approximately $5,946,000.

On November 8, 2011 we entered into an amended and restated credit facility with U.S. Bank, National Association ("U.S. Bank"), which was amended on December 30, 2011, May 14, 2012, and September 21, 2012, that provides for an increase in the revolving line of credit to $6,000,000, an increase of $2,500,000 over the prior credit agreement, and $2,520,000 in term debt. A $1,520,000 Term Loan bears interest at 5.79% ("Term Loan A"). The remaining $1,000,000 term loan bears interest at 4.28% ("Term Loan B"). Interest on the operating line of credit accrues at LIBOR plus 3.08% (3.33% at June 30, 2012) and is payable monthly. The amount eligible for borrowing on the line of credit is limited to 60% of eligible accounts receivable less the outstanding balance on our Term Loan B. The line of credit will expire on December 31, 2013, if not earlier renewed. Term Loan A requires monthly payments of principal and interest of approximately $10,700 and has a maturity date of December 9, 2014. Term Loan B requires monthly payments of principal and interest of approximately $29,600 and has a maturity date of December 9, 2012. As of June 30, 2012, we had approximately $1,768,000 outstanding on the operating line of credit and approximately $1,588,000 outstanding on the term loan debt for a total amount outstanding under the U.S. Bank credit facility of $3,356,000. As of June 30, 2012, we had net unused availability of $3,116,000 under the line of credit. We are required to pay a fee of 0.125% per annum on unused portions of the revolving line of credit.

The agreement governing the credit facility contains certain covenants that restrict our ability to, among other things, pay cash dividends, make certain investments, incur indebtedness or liens, change our Chief Executive Officer, merge or consolidate with any person, or sell, lease, assign, transfer or otherwise dispose of any assets other than in the ordinary course of business. The agreement also contains financial covenants that require maintenance of certain fixed charge and total cash flow leverage ratios. As of June 30, 2012 the Company was in violation of its fixed charge coverage ratio financial performance covenant. The Company notified the bank and the bank waived the event of default as of June 30, 2012, in the third amendment to the credit agreement, dated September 21, 2012. The third amendment modifies the fixed charge coverage ratio to exclude one-time expenses related to the retirement of the Company's former CEO and CFO as well as exclude overpayment of certain income tax payments that are to be refunded to the Company. As provided in Note 10 to the Notes to the Consolidated Financial Statements, on May 11, 2012, the Company's former Chairman and Chief Executive Officer retired from his positions as Chairman, Chief Executive Officer and director effective immediately. Under the amended and restated credit facility, as amended, a change in the Company's Chief Executive Officer position is a covenant violation and, by extension, an . . .