Summary of DYNATRONICS CORP

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Our principal business is the distribution, marketing and sale of physical medicine and aesthetic products, many of which we design and manufacture. We offer a broad line of medical equipment including therapy devices, medical supplies and soft goods, treatment tables and rehabilitation equipment. Our line of aesthetic products includes aesthetic massage and microdermabrasion devices, as well as skin care products. Our products are sold to and used primarily by physical therapists, chiropractors, sports medicine practitioners, podiatrists, plastic surgeons, dermatologists and aestheticians. We have a fiscal year ending June 30. For example, reference to fiscal year 2013 refers to the year ending June 30, 2013.

Recent Developments

In August 2012, we introduced to the market our new Dynatron® Solaris®Plus line of combination therapy devices that are capable of generating seven waveforms of electrotherapy and our patented three-frequency ultrasound, as well as light therapy through a newly designed hand-held light probe or two light pads. These newly-designed light pads and probes are the most powerful and reliable light therapy tools we have ever offered. The light probe includes outputs of up to 1,000 mW of infrared wavelength light, 500 mW of blue wavelength light and 500 mW of red wavelength light. The SolarisPlus product line consists of four new units, the Dynatron SolarisPlus 709, 708, 706, and 705, as well as the new Tri-Wave light probe and light pads. These attractive new units provide our most advanced technology and can be mounted on a customized cart for ease of use. This new line of products represents the most comprehensive redesign project in our history and updates the Solaris line of products introduced in 2003.

Results of Operations

The following discussion and analysis of our financial condition and results of operations for the three months ended September 30, 2012, should be read in conjunction with the condensed consolidated financial statements and notes thereto appearing in Part I, Item 1 of this report, and our Annual Report on Form 10-K for the fiscal year ended June 30, 2012, which includes audited financial statements for the year then ended. Results of operations for the first fiscal quarter ended September 30, 2012, are not necessarily indicative of the results that will be achieved for the full fiscal year ending June 30, 2013.

Net Sales

Net sales decreased $790,777 or approximately 9.9% to $7,206,025 for the quarter ended September 30, 2012, compared to net sales of $7,996,802 for the quarter ended September 30, 2011. The decrease in sales is attributable primarily to three factors. First, we were not able to fill all of the orders we received for our new SolarisPlus units and other capital products during September 2012. Second, we experienced lower sales of capital exercise products, metal tables and certain other products. Third, we believe that the renewed softness of the U.S. economy and uncertainty surrounding healthcare reform in the United States has had the effect of limiting expansion and improvements in our market sector. The Company expects the new SolarisPlus line, along with additional new products being introduced this fiscal year will help strengthen sales going forward.

Gross Profit

Gross profit decreased approximately $290,000 or about 9.7% to $2,710,848, or 37.6% of net sales, for the quarter ended September 30, 2012, compared to $3,002,098, or 37.5% of net sales, for the quarter ended September 30, 2011. The decrease in gross profit during the current quarter reflects the decrease in total sales discussed above. Looking ahead, we expect to generate improved sales of higher margin capital equipment, including our new SolarisPlus products now on the market, as well as from the introduction of other new products currently under development.

Selling, General and Administrative Expenses

Selling, general and administrative ("SG&A") expenses decreased $235,763 to $2,459,104, or 34.1% of net sales, for the quarter ended September 30, 2012, from $2,694,867, or 33.7% of net sales, for the quarter ended September 30, 2011. The decrease in SG&A expenses for the quarter reflects lower sales expenses and lower personnel costs. The following factors impacted SG&A expenses for the three months ended September 30, 2012, as compared to the same period in 2011:

· $182,106 of lower selling expenses mostly associated with lower commission expense due to lower sales;

· $59,232 of lower labor and benefits expense;

· $5,575 of higher general expenses including higher legal and professional fees

During the fourth quarter of fiscal year 2012 and the first quarter of fiscal year 2013, the Company identified over $750,000 of annual cost reductions which are being implemented. These cost reductions contributed to the lower SG&A expense incurred this quarter.

Research and Development Expenses

Research and development ("R&D") expenses decreased $90,079 to $266,268, or 3.7% of sales, in the quarter ended September 30, 2012, compared to $356,347, or 4.5% of sales in the quarter ended September 30, 2011. In August 2012, we introduced the SolarisPlus product line, the first of several new product introductions anticipated to be made in fiscal year 2013. The new products that are currently under development will allow us to expand distribution into a broader segment of our industry and help us capture greater market share in the physical medicine market. We believe that developing new products is a key element in our growth strategy. In future periods we expect our R&D costs will decrease to more historical levels. We expense R&D costs as they are incurred.

Income (Loss) Before Income Tax Provision

Pre-tax loss for the quarter ended September 30, 2012, totaled $73,609 compared to a pre-tax loss of $105,928 for the quarter ended September 30, 2011. Despite the reduction in sales and gross profits, the Company was able to reduce its loss before income tax provision for the current quarter compared to the same quarter last year as a result of lower selling, labor, and R&D expenses. Lower sales and gross profits in the quarter ended September 30, 2012 resulted from a backlog of orders, lower sales of capital exercise products, metal tables and certain other products, and the weakness in the U.S. economy generally and the healthcare industry specifically. As noted above, steps have been taken to reduce expenses at an annualized amount of approximately $750,000 by reducing labor and overhead costs and improving operating efficiencies.

Income Tax Provision (Benefit)

Income tax benefit was $22,464 for the quarter ended September 30, 2012, compared to income tax benefit of $37,669 for the quarter ended September 30, 2011. The effective tax benefit rate for the first quarter of fiscal year 2013 was 30.5% compared to 35.6% for the same period in fiscal year 2012. The difference in the effective tax rates is attributable to a difference in R&D tax credits as well as certain permanent book to tax differences.

Net Income (Loss)

Net loss was $51,145 or $.00 per share for the quarter ended September 30, 2012, compared to a net loss of $68,259 or $.01 per share for the quarter ended September 30, 2011. The decrease in loss per share for the quarter ended September 30, 2012, compared to the prior year period, reflects the cumulative effect of the various components discussed above.

Liquidity and Capital Resources

We have financed operations through available cash reserves and borrowings under a line of credit with a bank. Working capital was $3,531,085 as of September 30, 2012, inclusive of the current portion of long-term obligations and credit facilities, compared to working capital of $3,565,858 as of June 30, 2012. The current ratio was 1.5 to 1 as of September 30, 2012 and June 30, 2012. Current assets remained consistent at 70% of total assets as of September 30, 2012 and June 30, 2012.

Cash and Cash Equivalents

Our cash and cash equivalents position as of September 30, 2012, was $285,639, an increase of 2.7%, from cash and cash equivalents of $278,263 as of June 30, 2012. Our cash position varies from quarter to quarter, but typically stays within a range of $200,000 to $400,000. We expect that cash flows from operating activities, together with amounts available through an existing line-of-credit facility, will be sufficient to cover operating needs in the ordinary course of business for at least the next twelve months. If we experience an adverse operating environment, including a further worsening of the general economy in the United States, or unusual capital expenditure requirements, additional financing may be required. No assurance can be given that additional financing, if required, would be available on terms favorable to us, or at all.

Accounts Receivable

Trade accounts receivable, net of allowance for doubtful accounts, increased $37,827, or 1.0%, to $3,704,913 as of September 30, 2012, compared to $3,667,086 as of June 30, 2012. Trade accounts receivable represent amounts due from our customers including medical practitioners, clinics, hospitals, colleges and universities and sports teams as well as dealers and distributors that purchase our products for redistribution. We believe that our estimate of the allowance for doubtful accounts is adequate based on our historical knowledge and relationship with these customers. Accounts receivable are generally collected within 30 days of the agreed terms.

Inventories

Inventories, net of reserves, decreased $8,006, or 0.1%, to $6,090,591 as of September 30, 2012, compared to $6,098,597 as of June 30, 2012. The current level of inventory as of September 30, 2012 and June 30, 2012 reflects the Company's acquisition of component parts for the new SolarisPlus and Quad7 products.

Accounts Payable

Accounts payable decreased $61,659, or 2.6%, to $2,351,542 as of September 30, 2012, from $2,413,201 as of June 30, 2012. The decrease in accounts payable is a result of the timing of our weekly payments to suppliers and the timing of purchases of product components. Accounts payable are generally not aged beyond the terms of our suppliers. We generally take advantage of available early payment discounts when offered by our vendors.

Line of Credit

The outstanding balance on our line of credit increased $175,737 to $3,673,334 as of September 30, 2012, compared to $3,497,597 as of June 30, 2012. Interest on the line of credit is based on the 90-day LIBOR rate (0.36% as of September 30, 2012) plus 3%. The line of credit is collateralized by accounts receivable and inventories. Borrowing limitations are based on approximately 45% of eligible inventory and up to 80% of eligible accounts receivable, up to a maximum credit facility of $7,000,000. Interest payments on the line are due monthly. As of September 30, 2012, the borrowing base was approximately $5,117,000, resulting in approximately $1,444,000 of available credit on the line. The line of credit is renewable on December 15, 2012 and includes covenants requiring us to maintain certain financial ratios. As of September 30, 2012, we were not in compliance with one of the loan covenants regarding our debt coverage ratio. We are in discussions with the lender to renew the line of credit and believe that it will be renewed, notwithstanding this breach. However, if the line of credit is not renewed, we will need to find additional sources of financing. Failure to obtain additional financing would have a material adverse effect on our business operations.

We believe that amounts available under the line of credit as well as cash generated from operating activities will continue to be sufficient to meet our operating requirements.

Debt

Long-term debt, excluding current installments decreased $101,970 to $1,814,345 as of September 30, 2012, compared to $1,916,315 as of June 30, 2012. Long-term debt is comprised primarily of the mortgage loans on our office and manufacturing facilities in Utah and Tennessee. The principal balance on the mortgage loans is approximately $2,037,900 with monthly principal and interest payments of $37,503.

Inflation

Our revenues and net income have not been unusually affected by inflation or price increases for raw materials and parts from vendors.

Stock Repurchase Plans

We have a stock repurchase plan that has been ongoing since 2003. Purchases of shares may be made from time-to-time, in the open market, through block trades or otherwise, and are based on market conditions, the level of our cash balances, general business opportunities, and other factors. Our Board of Directors periodically approves the dollar amounts for share repurchases under the plan. As of September 30, 2012, $748,450 remained available under the plan for purchases. There is no expiration date for the plan.

We have also entered into stock repurchase agreements with two shareholders pursuant to which each of these shareholders may require the Company to purchase up to $100,000 of common stock annually for three years. We repurchased $100,000 of stock from each of these shareholders during the year ended June 30, 2012, the first year the agreements were in effect. In addition, we purchased $100,000 of stock from one of the two shareholders in April 2012 during the second year of the agreements.

No purchases were made during the quarter ended September 30, 2012 under any of the plans described above.

Critical Accounting Policies

The discussion in this Management's Discussion and Analysis of Financial Condition and Results of Operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles. The preparation of these financial statements requires estimates and judgments that affect the reported amounts of our assets, liabilities, net sales and expenses. Management bases estimates on historical experience and other assumptions it believes to be reasonable given the circumstances and evaluates these estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.

We believe that the following critical accounting policies involve a high degree of judgment and complexity. The following summary sets forth information regarding significant estimates and judgments used in the preparation of our consolidated financial statements.

Inventory Reserves

The nature of our business requires that we maintain sufficient inventory on hand at all times to meet the requirements of our customers. We record finished goods inventory at the lower of standard cost, which approximates actual costs (first-in, first-out) or market. Raw materials are recorded at the lower of cost (first-in, first-out) or market. Inventory valuation reserves are maintained for the estimated impairment of the inventory. Impairment may be a result of slow-moving or excess inventory, product obsolescence or changes in the valuation of the inventory. In determining the adequacy of reserves, we analyze the following, among other things:

· Current inventory quantities on hand;

· Product acceptance in the marketplace;

· Customer demand;

· Historical sales;

· Forecast sales;

· Product obsolescence;

· Technological innovations; and

· Character of the inventory as a distributed item, finished manufactured item or raw material.

Any modifications to estimates of inventory valuation reserves are reflected in cost of goods sold within the statements of operations during the period in which such modifications are determined necessary by management. As of September 30, 2012 and June 30, 2012, our inventory valuation reserve balance, which established a new cost basis, was $304,963 and $292,999, respectively, and our inventory balance was $6,090,591 and $6,098,597, net of reserves, respectively.

Revenue Recognition

Our sales force and distributors sell our products to end users, including physical therapists, professional trainers, athletic trainers, chiropractors, medical doctors and aestheticians. Sales revenues are recorded when products are shipped FOB shipping point under an agreement with a customer, risk of loss and title have passed to the customer, and collection of any resulting receivable is reasonably assured. Amounts billed for shipping and handling of products are recorded as sales revenue. Costs for shipping and handling of products to customers are recorded as cost of sales.

Allowance for Doubtful Accounts

We must make estimates of the collectability of accounts receivable. In doing so, we analyze historical bad debt trends, customer credit worthiness, current economic trends and changes in customer payment patterns when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivable balance was $3,704,913 and $3,667,086, net of allowance for doubtful accounts of $242,833 and $201,349, as of September 30, 2012 and June 30, 2012, respectively.

Deferred Income Tax Assets

In August 2012 and August 2011, our management performed an analysis of the deferred income tax assets and their recoverability. Based on several factors, including our strong earnings history of pre-tax profit averaging over $500,000 per year in 19 of the last 23 fiscal years and the fact that the principal causes of the loss in fiscal 2008 (goodwill impairment and expenses resulting from six acquisitions) are considered to be unusual and are not expected to recur in the near future, we believe that it is more likely than not that all of the net deferred income tax assets will be realized.

Business Plan and Outlook

During the past two years, we have focused much of our resources and energy on developing new and innovative products. The scope of that R&D effort has been more significant than at any time in our history. As a result, more new products will be introduced during fiscal year 2013 than we have introduced in any other year.

In March 2012, we introduced the new Dynatron Quad7 therapy device to the market. The innovative Quad7 utilizes thermoelectric technology to deliver thermal therapy (either cold or hot therapy) combined with compression treatments through a variety of wraps and innovative ThermoStim Probes. The ThermoStim Probes are unique in their design as they allow for delivery of electrotherapy treatments concurrent with thermal therapy. The Quad7 has the flexibility to offer seven different treatments including intermittent compression, cold with compression, heat with compression, cold with stim, heat with stim, cold therapy alone, and heat therapy alone. This capability dramatically expands both the variety and location of conditions that can be treated. The Quad7 employs state-of-the-art technology providing precise temperature control moving beyond the current technology by eliminating the need for ice. Thermal therapy in our Quad7 is achieved by using a thermoelectric computer chip technology.

In August 2012, we introduced to the market our new Dynatron SolarisPlus line of electrotherapy/ultrasound/ light therapy units. This new product line consists of four new units: the Dynatron SolarisPlus 709, 708, 706, and 705. These attractive new units provide our most advanced technology in combination therapy devices by adding tri-wave light therapy capabilities to enhanced electrotherapy and ultrasound combination devices. Tri-wave light therapy features infrared, red and blue wavelength light. The new Dynatron Solaris light pad is capable of treating large areas of the body via unattended light therapy. As part of the SolarisPlus product line introduction, we also introduced a new display cart specifically designed for these units. The SolarisPlus line is quickly becoming popular for its power and versatility. The new units are capable of simultaneously powering five electrotherapy channels, ultrasound therapy, a light probe and light pad.

The commitment to innovation of high-quality products has been a hallmark of Dynatronics and will continue to be part of our future strategic objectives. In addition to the four new products introduced in August 2012, we have plans to introduce another 5-10 new proprietary products in this current fiscal year ending June 30, 2013 making fiscal year 2013 the most prolific year for new product introductions in our history. The introduction of these new products represents the culmination of years of R&D investment to transform our product lines to be more attractive than ever and further drive sales of our profitable proprietary products.

R&D costs for us have been cyclical in nature. The higher costs in fiscal year 2011 and 2012 reflect the fact that we have been in a more intense part of the product development cycle. With the new products being introduced to the market in this fiscal year, we expect that R&D costs will cycle back to a lower level more in line with historical amounts. Management is confident the higher costs associated with the more intense part of the development cycle in the short term will yield long-term benefits and are important to assuring that we maintain our reputation in the industry for being an innovator and leader in product development.

In calendar 2011, we announced the signing of contracts with four Group Purchasing Organizations (GPOs): Premier, Inc., Amerinet, Inc., FirstChoice Cooperative and Champs Group Purchasing. These GPOs represent tens of thousands of clinics and hospitals around the nation. In addition, during 2012 we obtained approval to sell to the U.S. government, including the Veterans Affairs medical facilities and U.S. armed forces through GSA contracts. We have also been successful in becoming a preferred vendor to many national and regional accounts. With the broader offering of products now available through our catalog and e-commerce website, we are better able to compete for this high volume business. However, securing business with GPO members has proved a challenging and much slower process than originally anticipated. While not abandoning such efforts, our resource commitment to soliciting such business has been scaled back to better reflect the opportunities identified with these potential customers.

In early 2013 we plan to introduce a new, updated version of our product catalog. This new catalog will not only include our new proprietary products previously discussed, but will also expand our offering of non-proprietary products by hundreds of items in order to better service the broader needs of our customers. It will also provide an excellent new sales tool for all of our sales representatives in the field as well as provide a foundation for expanding our e-commerce platform.

Over the past few years, consolidations in our market have changed the landscape of our industry's distribution channels. At the present time, we believe that there remain only two companies with a national direct sales force selling proprietary and distributed products: Dynatronics and Patterson Medical. All other distribution in our market is directed through catalog companies with no direct sales force, or through independent local dealers that have limited

geographical reach. In the past year, we have reinforced our direct sales team that includes over 50 direct sales employees and independent sales representatives. In addition to these direct sales representatives, we continue to enjoy a strong relationship with scores of independent dealers. We believe we have the best trained and most knowledgeable sales force in the industry. The changes taking place within our market provide a unique opportunity for us to grow market share in the coming years through recruitment of high-quality sales representatives and dealers.

To further our efforts to recruit high-quality direct sales representatives and dealers, we intend to continue to improve efficiencies of our operations and the sales support for the industry. Chief among the steps we are taking to make these improvements was the introduction of our first true e-commerce solution on July 6, 2010 and the enhancements to that portal in the years since its introduction. With the availability of this e-commerce solution, customers are able to more easily place orders and obtain information about their accounts. Sales representatives are increasing their effectiveness with the abundance of information available to them electronically through our e-quote system, which is a companion to the e-commerce solution introduced. Not only is our e-commerce solution easy and efficient to use, it should also facilitate reducing transactional costs thus enabling us to accommodate higher sales without significantly increasing overhead.

The passage in 2010 of the Patient Protection and Affordable Care Act and the Health Care and Educational Reconciliation Act will affect our future operations. The addition of millions to the rolls of the insured is expected to increase demand for services. That increased demand could lead to increased sales of our products. The magnitude of those increases is difficult to assess at this time. A negative impact of this legislation as enacted is its imposition of an excise tax on all manufacturers and importers of medical devices. An excise tax is assessed against sales, not profits. Therefore, even in a year when we may have no profits, we will still owe the excise tax to the federal government. Barring a change in the statute, we estimate that this tax would be approximately $300,000 to $400,000 annually based on current sales levels. Because of the phase-in of various provisions in the legislation and other possible legislative actions, we cannot predict what the full effects of this legislation will be on our business and industry. The first impact is expected in the early part of calendar year 2013. In addition, rule-making under the law is not yet complete which could mean a temporary postponement in implementing the tax. In the meantime, we are taking full advantage of every opportunity presented by this legislation to increase sales and to offset any negative effects that may accompany those opportunities. Should the tax become effective January 1, 2013 as anticipated, we will likely be compelled to raise prices as a reflection of that new tax.

Economic pressures from the recent recession in the United States have affected available credit that would facilitate large capital purchases, and have also reduced demand for discretionary services such as those provided by the purchasers of our aesthetic products. As a result, we reduced our expenses in the Synergie department. We believe that our aesthetic devices remain the best value on the market and we are seeking innovative ways to market these products, including strategic partnerships, both domestic and international, to help enhance sales momentum.

We have long believed that international markets present an untapped potential for growth and expansion. Adding new distributors in several countries will be the key to this expansion effort. We remain committed to finding the most effective ways to expand our markets internationally. Over the coming year, our efforts will be focused on partnering with key manufacturers and distributors interested in our product line or technology. Our Utah facility, where all electrotherapy, ultrasound, traction, light therapy and Synergie products are manufactured, is certified to ISO 13485:2003, an internationally recognized standard of excellence in medical device manufacturing. This designation is an important requirement in obtaining the CE Mark certification, which allows us to market our products in the European Union and in other international locations.

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