See Notes to Condensed Financial Statements (Unaudited).

Electromed, Inc.

Condensed Statements of Cash Flows (Unaudited)

See Notes to Condensed Financial Statements (Unaudited).

Electromed, Inc.

Condensed Statements of Cash Flows (Unaudited)

Electromed, Inc.

Condensed Statements of Shareholders’ Equity (Unaudited)

See Notes to Condensed Financial Statements (Unaudited).  

Electromed, Inc.

Notes to Condensed Financial Statements

(Unaudited)

Note 1.  Interim Financial Reporting

Basis of presentation: Electromed, Inc. (the “Company”) develops, manufactures and markets innovative airway clearance products that apply High Frequency Chest Wall Oscillation (“HFCWO”) therapy in pulmonary care for patients of all ages. The Company markets its products in the U.S. to the home health care and institutional markets for use by patients in personal residences, hospitals and clinics. The Company also sells internationally both directly and through distributors. International sales were approximately $267,000$66,000 and $332,000$135,000 for the sixthree months ended December 31, 2017September 30, 2019 and 2016,2018, respectively. Since its inception, the Company has operated in a single industry segment: developing, manufacturing and marketing medical equipment.

The accompanying unaudited condensed financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial statements and pursuant to the rules and regulations of the U.S. Securities and Exchange Commission. In the opinion of management, the accompanying unaudited condensed financial statements reflect all adjustments consisting of normal recurring adjustments necessary for a fair presentation of the Company’s financial position and results of operations as required by Regulation S-X. Interim results of operations are not necessarily indicative of the results that may be achieved for the full year. The financial statements and related notes do not include all information and footnotes required by U.S. GAAP for annual reports. This interim report should be read in conjunction with the financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 20172019 (“fiscal 2017”2019”).

A summary of the Company’s significant accounting policies follows:

Use of estimates: Management uses estimates and assumptions in preparing the condensed financial statements in accordance with U.S. GAAP. Those estimates and assumptions affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities, and the reported revenues and expenses. Actual results could vary from the estimates that were used. The Company believes the critical accounting policies that require the most significant assumptions and judgments in the preparation of its condensed financial statements include revenue recognition and the related estimation of selling price adjustments,variable consideration, allowance for doubtful accounts, inventory obsolescence, share-based compensation income taxes and the warranty reserve.liability.

Net income per common share:Net income is presented on a per share basis for both basic and diluted common shares. Basic net income per common share is computed using the weighted average number of common shares outstanding during the period, excluding any restricted stock awards which have not vested. The diluted net income per common share calculation includes outstanding restricted stock grants and assumes that all stock options were exercised and converted into common stock at the beginning of the period, unless their effect would be anti-dilutive. Common stock equivalents excluded from the calculation of diluted earnings per share because their impact was anti-dilutive was 177,750446,350 and 196,500375,750 for the three and six months ended December 31, 2017September 30, 2019 and 2016,2018, respectively.

New accounting pronouncements:  In May 2014,February 2016, the Financial Accounting Standards Board (“FASB”) issued guidance creating Accounting Standards CodificationUpdate (“ASC”ASU”) Section 606, “Revenue from Contracts with Customers.” The new section will replace ASC Section 605, “Revenue Recognition,” and creates modifications to various other revenue accounting standards for specialized transactions and industries. The section is intended to conform revenue accounting principles to a concurrently issued International Financial Reporting Standards with previously differing treatment between U.S. practice and that of much of the rest of the world, as well as to enhance disclosures related to disaggregated revenue information. Entities will have the option to apply the standard retrospectively to all prior periods presented (“full retrospective”), or to apply it retrospectively only to contracts existing at the effective date (“modified retrospective”), with the cumulative effect of the standard recorded as an adjustment to beginning retained earnings. The updated guidance will be effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within that year. The Company is currently evaluating which of the alternative approaches it will apply and the potential impact of adoption of the revised revenue standards on its financial statements. The Company intends to complete its evaluation during its fiscal year ending June 30, 2018 (“fiscal 2018”).

In July 2015, FASB issued ASU 2015-11, “Inventory (Topic 330) Related to Simplifying the Measurement of Inventory,” which applies to all inventory except that which is measured using last-in, first-out (“LIFO”) or the retail inventory method. Inventory measured using first-in, first-out (“FIFO”) or average cost is within the scope of the new guidance and should be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable cost of completion, disposal, and transportation. Subsequent measurement is unchanged for inventory measured using LIFO or the retail inventory method. The amendments are effective for public business entities for fiscal years beginning after December 15, 2016, including interim periods within those fiscal years. The new guidance is applied prospectively, and earlier application is permitted as of the beginning of an interim or annual reporting period. The Company adopted ASU 2015-11 effective July 1, 2017, which had no material impact on its financial statements or financial statement disclosures.

In February 2016, FASB issued ASU 2016-02, “Leases (Topic 842)” (“ASU 2016-02”).”   This standard requires the recognition of all lease transactions with terms in excess of 12 months on the balance sheet as a lease liability and a right-of-use asset (as defined in the standard)ASC 2016-02). ASU 2016-02 will beto Topic 842 – Leases (“ASC 842”) became effective for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years, with earlier application permitted.  Upon adoption, the lessee will apply the new standardCompany on July 1, 2019 and was applied retrospectively to all periods presented or retrospectively using a cumulative effect adjustment in the year of adoption.presented.  The Company has evaluated ASU 2016-02applied the practical expedient to calculate the present value of the fixed payments without having to perform an allocation to lease and expects that it will have no material impactnon-lease components.  Additional information and required disclosures are included in Note 9.

Impact on its financial statements or financial statement disclosures upon adoption based on current facts and circumstances.Previously Reported Results:

In March 2016, FASB issued ASU 2016-09, “Compensation—Stock Compensation (Topic 718): ImprovementsThe following table presents a recast of selected unaudited statement of operations line items after giving effect to Employee Share-Based Payment Accounting,” which reduces complexity in accounting standards relatedthe adoption of ASC 842:

The following table presents a recast of selected unaudited balance sheet line items after giving effect to share-based payment transactions, including, among others, (1) accounting for income taxes, (2) classificationthe adoption of excess tax benefits on theASC 842:

The following table presents a recast of selected unaudited statement of cash flow (3) forfeitures,line items after giving effect to the adoption of ASC 842:

Note 2.  Revenues

Revenue is measured based on consideration specified in the contract with a customer, adjusted for any applicable estimates of variable consideration and (4) statutory tax withholding requirements.  ASU 2016-09other factors affecting the transaction price, including noncash consideration, consideration paid or payable to customers and significant financing components.  Revenue from all customers is effectiverecognized when a performance obligation is satisfied by transferring control of a distinct good or service to a customer, as further described below under Performance obligations and transaction price. 

Individual promised goods and services in a contract are considered a performance obligation and accounted for annual reporting periods beginningseparately if the individual good or service is distinct (i.e., the customer can benefit from the good or service on its own or after December 15, 2016,with other resources that are readily available to the customer and interim periods within those annual periods.  the good or service is separately identifiable from other promises in the arrangement).  If an arrangement includes multiple performance obligations, the consideration is allocated between the performance obligations in proportion to their estimated standalone selling price, unless discounts or variable consideration is attributable to one or more but not all the performance obligations. Costs related to products delivered are recognized in the period incurred, unless criteria for capitalization of costs under FASB Accounting Standards Codification (“ASC”) 340-40, “Other Assets and Deferred Costs” (“ASC 340”), or other applicable guidance are met.

The Company adopted ASU 2016-09 effective July 1, 2017, which had no material impactincludes shipping and handling fees in net revenues. Shipping and handling costs associated with the shipment of the Company’s SmartVest^® Airway Clearance System (“SmartVest System”) after control has transferred to a customer are accounted for as a fulfillment cost and are included in cost of revenues.

The timing of revenue recognition, billings and cash collections results in accounts receivable on its previously reported financial statementsthe condensed balance sheets as further described below under Accounts receivable and Contract assets.

Disaggregation of revenues.  In the following table, revenue is disaggregated by market:

In the following table, homecare revenue is disaggregated by payer type:

Revenues in the Company’s Annual Report on Form 10-Khome care, home care distributor and international markets are recognized at a point in time when control passes to the customer upon product shipment or delivery.  Revenues in the Company’s institutional market include sales recognized at a point in time upon shipment or delivery as well as revenues recognized over time under operating leases.

Performance obligations and transaction price.  A performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account under ASC 606, “Revenue From Contracts With Customers” (“ASC 606”). A contract’s transaction price is allocated to each distinct performance obligation in proportion to the standalone selling price for fiscal 2017. each and recognized as revenue when, or as, the performance obligation is satisfied.  The Company’s performance obligations and the timing or method of revenue recognition in each of the Company’s markets are discussed below: 

Home care market.  In the Company’s home care market, its customers are patients who use the SmartVest System.  The various models of the SmartVest System are comprised of three main components - a generator, a vest and a connecting hose that are sold together as an integrated unit.  Accordingly, in contracts within the home care market, the Company regards the SmartVest System to be a single performance obligation.

The Company makes available to its home care patients limited post-sale services that are not material in the context of the contracts, either individually or taken together, and therefore does not consider them to be performance obligations. The costs associated with the services are accrued and expensed when the related revenues are recognized.  As such, transactions in the home care market consist of a single performance obligation, the SmartVest System.

Home care patients generally will rely on third-party payers, including commercial payers and governmental payers such as Medicare, Medicaid, and the Veteran’s Administration to cover and reimburse all or part of the cost of the SmartVest System.  The third-party payers’ reimbursement programs fall into three types, distinguished by the differences in the timing of payments from the payer, consisting of either (i) outright sale, in which payment is received from the payer based on standard terms, (ii) capped installment sale, under which the SmartVest System is sold for a series of payments that are capped not to exceed a prescribed or negotiated amount over a period of time or (iii) installment sale under which the SmartVest Systems are paid for over a period of several months as long as the patient continues to use the SmartVest System.

Regardless of type of transaction, provided criteria for an enforceable contract are met, it is the Company’s long-standing business practice to regard all home care agreements as transferring control to the patient upon shipment or delivery, in spite of possible payment cancelation under government or commercial programs where the payer is controlling the payment over specified time periods. For home care sales that feature installment payments, the ultimate amount of consideration received from Medicare, Medicaid or commercial payers can be significantly less than expected if the contract is terminated due to changes in the patient’s status, including insurance coverage, hospitalization, death, or otherwise becoming unable to use the SmartVest System.  However, once delivered to a patient who needs the SmartVest System, the patient is under no obligation to return the SmartVest System should payments be terminated as a result of the described contingencies.  As a result, the Company’s product sales qualify for point in time revenue recognition.  Control transfers to the patient, and revenue is recognized upon shipment of the SmartVest System.  At this point, physical possession and the significant risks and rewards of ownership are transferred to the patient and either a current or future right to payment is triggered, as further discussed under Accounts receivable and Contract assets below.

The Company’s contractually stated transaction prices in the home care market are generally set by the terms of the contracts negotiated with insurance companies or by government programs.  The transaction price for the Company’s products may be further impacted by variable consideration. ASC 606 requires the Company to adjust the transaction price at contract inception and throughout the contract duration for the estimated value of payments to be received from insurance payers based on historical experience and other available information, subject to the constraint on estimates of variable consideration. Transactions requiring estimates of variable consideration primarily include (i) capped installment payments which are subject to the third-party payer’s termination due to changes in insurance coverage, death or the patient’s discontinued use of the SmartVest System, (ii) contracts under appeal and (iii) patient responsibility amounts for deductibles, coinsurance, copays and other similar payments.

Although estimates may be made on a contract-by-contract basis, whenever possible, the Company uses all available information including historical collection patterns to estimate variable consideration for portfolios of contracts.  The Company’s estimates of variable consideration consist of amounts it may receive from insurance providers in excess of its initial revenue estimate due to patients meeting deductibles or coinsurance during the payment duration, changes to a patient’s insurance status, changes in an insurance allowable, claims in appeals with Medicare and amounts received directly from patients for their allowable or coinsurance. The Company believes it has electedrepresentative historical information to continueestimate the amount of variable consideration in relevant portfolios considering the significant experience it has with each portfolio and the similarity of patient accounts within a portfolio.  The analysis includes steps to recognizeensure that revenue recognized on a portfolio basis does not result in a material difference when compared with an individual contract approach.  The Company also leverages its historical experience and all available relevant information for each portfolio of contracts to minimize the risk its estimates used to arrive at the transaction price will result in a significant reversal in the amount of cumulative revenue recognized when the uncertainty associated with the variable consideration is subsequently resolved.  Variable consideration is included in the transaction price if, in the Company’s judgment, it is probable that a significant future reversal of cumulative revenue under the contract will not occur.

For example, for contracts in which the Company believes the criteria for reimbursement under government or commercial payer contracts have been met but for which coverage is unconfirmed or payments are under appeal, the Company has significant observable evidence of relatively consistent claims recovery experience over the prior three to five years. The Company believes the low volatility in historical claims approval rates for populations of patients whose demographics are similar to those of current patients provides reliable predictive value in arriving at estimates of variable consideration in such contracts.   Similarly, historical payment trends for recovery of claims subject to payer installments and payments from patients have remained relatively consistent over the past five years.  No significant changes in patient demographics or other relevant factors have occurred that would limit the predictive value of such payment trends in estimating variable consideration for current contracts.  As a result, the Company believes its estimates of variable consideration are generally not subject to the risk of significant revenue reversal.

For each type of variable consideration discussed above, there are a large number of contracts with similar characteristics with a wide range of possible transaction prices.  For that reason, the Company uses the probability-weighted expected value method provided under ASC 606 to estimate variable consideration.

The Company often receives payment from third-party payers for the SmartVest System sales over a period of time that may exceed one year. Despite these extended payment terms, no significant financing component is deemed to exist because the purpose of such terms is not to provide financing to the patient, the payer or the Company.  Rather, the extended payment terms are mandated by the government or commercial insurance programs; the fundamental purpose of which is to avoid paying the full purchase price of equipment that may potentially be used by the patient for only a short period of time.

Home Care Distributors.  Sales to distributors, who sell direct to patients, are made at fixed contract prices and may include tiered pricing structures or volume-based rebates which offer more favorable pricing once certain volumes are achieved per the negotiated contract.  The distributor’s purchases accumulate to give the distributor a right to a higher discount on purchases in excess of the specified level within the contract period. As a result, to the extent the Company expects the distributor to exceed the specified volume of purchases in the annual period, it recognizes revenue at a blended rate based on estimated forfeiturestotal annual volume and sales revenue. This effectively defers a portion of the transaction price on initial purchases below the specified volumes for recognition when the higher discount is earned on purchases in excess of specified volumes. Transfer of control of the products occurs upon shipment or delivery to the distributor as stock-based compensation expense.applicable.

Institutional market.  The Company’s institutional sales are made to hospitals and home health care centers, pulmonary rehabilitation centers and other clinics. Sales to these institutions are negotiated with the individual institution or with group purchasing organizations, with payments received directly from the institution.  No insurance reimbursement is involved.  Generators are either sold or leased to the institutions and associated hoses and wraps (used in institutional settings rather than vests) are sold separately. Accordingly, each product is distinct and considered a separate performance obligation in sales to institutional customers. The agreements with institutions fall into two main types, distinguished by differences in the timing of transfer of control and timing of payments:

International market.  Sales to international markets are made directly to a number of independent distributors at fixed contract prices that are not subject to further adjustments for variable consideration.  Transfer of control of the products occurs upon shipment or delivery to the distributor as applicable.

Product Warranty.  The Company offers warranties on its products. These warranties are assurance type warranties not sold on a standalone basis or are otherwise considered immaterial in the context of the contract, and therefore are not considered distinct performance obligations under ASC 606.  The Company estimates the costs that may be incurred under its warranties and records a liability in the amount of such costs at the time the product is sold.

Accounts receivable.  Accounts receivable include amounts billed to customers and third-party payers, for which only the passage of time is required before payment of consideration is due. Amounts due are stated at their net estimated realizable value.

Contract assets.  Contract assets include amounts recognized as revenue that are estimates of variable consideration for Medicare appeals where the final determination of the insurance coverage amount is dependent on future approval of an appeal, or when the consideration due to the Company is dependent on a future event such as the patient meeting a deductible prior to the Company’s claim being processed by the payer. Contract assets are classified as current as amounts will turn in to accounts receivable and be collected during the Company’s normal business operating cycle.  Contract assets are reclassified to accounts receivable when the right to receive payment is unconditional.

Incremental costs to obtain a contract. Sales incentives paid to sales representatives are eligible for capitalization as they are incremental costs that would not have been incurred without entering into a specific sales arrangement and are recoverable through the expected margin on the transaction. However, the recovery period is less than one year as the performance obligation is satisfied upon shipment or delivery. Consequently, the Company applies the practical expedient provided by ASC 340 and expense sales incentives as incurred. These costs are included in selling, general and administrative expenses in the Company’s condensed statements of operations.

Contract balances. The following table provides information about accounts receivable and contracts assets from contracts with customers:

Significant changes in contract assets during the period are as follows:

Note 2.3. Inventories

The components of inventory were approximately as follows:

Note 3.4. Finite-life Intangible Assets

The carrying value of patents and trademarks includes 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. There were no abandonments of domestic or foreign patents that occurred during the six months ended December 31, 2017. During fiscal 2017, the Company abandoned certain domestic and foreign patents with net values of approximately $133,000, which were included as an expense in selling, general and administrative expense on the statements of operations. The majority of the pending patents that were abandoned related to the initial development of the Company’s SQL SmartVest technology. During a review of the Company’s patent portfolio it was determined that certain patents proved redundant to a subsequent SQL patent filing and were therefore abandoned. A smaller portion of expense was related to patents that covered technology that management considered outdated, and was no longer in use. Accumulated amortization was $847,000$1,040,000 and $790,000$1,010,000 at December 31, 2017September 30, 2019 and June 30, 2017,2019, respectively.

The activity and balances of finite-life intangible assets were approximately as follows:

Note 4.5. Warranty Liability

The Company provides a lifetime warranty on its products to the prescribed patient for sales within the U.S. and a three-year warranty for all institutional sales and sales to individuals outside the U.S. The Company estimates the costs that may be incurred under its warranty and records a liability in the amount of such costs at the time the product is shipped. Factors that affect the Company’s warranty liability include the number of units shipped, historical and anticipated rates of warranty claims, the product’s useful life and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the amounts as necessary.

Changes in the Company’s warranty liability were approximately as follows:

Note 5.6. Income Taxes

On December 22, 2017, the U.S. government enacted comprehensive tax legislation commonly referred to as the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act significantly revises future and ongoing U.S. corporate tax obligations by, among other things, lowering U.S. corporate income tax rates. Since the Company has a June 30 fiscal year-end, the lower corporate income tax rate will be phased in, resulting in a blended U.S. statutory federal rate of approximately 28% for fiscal 2018, and 21% for subsequent fiscal years. The Tax Act also eliminates the domestic production manufacturing deduction effective for the Company’s tax year beginning July 1, 2018. For the six months ended December 31, 2017, these changes under the Tax Act resulted in a net income tax expense of approximately $160,000.

On a quarterly basis, the Company estimates its effective tax rate for the full fiscal year and records a quarterly income tax provision based on the anticipated rate. As the year progresses, the Company refines its estimate based on the facts and circumstances by each tax jurisdiction. Income tax expense was estimated at approximately $416,000 and $453,000, respectively,$374,000, and the effective tax rates were 54.4% and 49.1%, respectively,rate was 26.9% for the three and six months ended December 31, 2017. Estimated income tax expense for the three and six months ended December 31, 2017 includes a discrete deferred tax expense of approximately $160,000 as a result of re-measuring certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in future periods under the Tax Act. Additionally, a discrete tax benefit of approximately $2,000 and $27,000 was recognized during the three and six months ended December 31, 2017, respectively, as a result of greater federal and state research and development tax credits than what was originally estimated in the Company’s tax provision for fiscal 2017. The net impact of these discrete events increased the effective tax rate by 20.6% and 14.4% during the three and six months ended December 31, 2017, respectively.

September 30, 2019. Income tax expense was estimated at $351,000$58,000 and the effective tax rate was 35.6%27.0% for the sixthree months ended December 31, 2016. Income tax expense for the six months ended December 31, 2016 included a recognized tax benefit of approximately $22,000 as a result of the lapse of the statute of limitations on uncertain tax positions, which reduced the effective tax rate for the period by 2.2%.September 30, 2018.

Note 6.7. Financing Arrangements

The Company has a credit facility that provides for a revolving line of credit and a term loan. Effective December 18, 2017,2018, the Company renewed its $2,500,000 revolving line of credit. There was no outstanding principal balance on the line of credit as of December 31, 2017September 30, 2019 or June 30, 2017.2019. Interest on borrowings under the line of credit, if any, would accrueaccrues at the prime rate (5.00% at September 30, 2019) less 0.25% (4.25% at December 31, 2017)1.00% and is payable monthly. The amount eligible for borrowing on the line of credit is limited to the lesser of $2,500,000 or 57.00% of eligible accounts receivable and the line of credit expires on December 18, 2018,2019, if not renewed. At December 31, 2017,September 30, 2019, the maximum $2,500,000 was eligible for borrowing. The line of credit is secured by a security interest in substantially all of the tangible and intangible assets of the Company.

In connection with the credit facility, the Company also has a term loan, which had an outstanding principal balance of approximately $1,129,000 at December 31, 2017 and $1,154,000 as of June 30, 2017. The term loan was refinanced effective December 18, 2016, reducing the interest rate from 5.00% to 3.88%. The unamortized debt issuance cost associated with this debt was approximately $4,000 and $6,000 as of December 31, 2017 and June 30, 2017, respectively. The term loan bears interest at 3.88%, with monthly payments of principal and interest of approximately $7,900 and a final payment of principal and interest of approximately $1,085,000 due on the maturity date of December 18, 2018. Payment obligations under the term loan are secured by a mortgage on the Company’s real property. 

The documents governing the line of credit and term loan contain certain financial and nonfinancial covenants that include a minimum tangible net worth covenant of not less than $10,125,000 and restrictions on the Company’s ability to incur certain additional indebtedness or pay dividends.

Note 7.8. Stock-Based Compensation

In November 2017, the Company’s shareholders approved the 2017 Omnibus Incentive Plan (the “2017 Plan”) which supersedes the 2014 Equity Incentive Plan (the “2014 Plan”). The 2017 Plan allows the Company’s Board of Directors (“the Board of Directors”) to grant stock options, stock appreciation rights, restricted stock, restricted stock units and other stock-based awards, as well as cash incentive awards to all employees, non-employee directors, and advisors or consultants of the Company. The vesting schedule and term for each award are determined by the Board of Directors upon each grant. The maximum number of shares of common stock available for issuance under the 2017 Plan is 900,000. There were 918,300490,750 stock options granted under the 2014 Plan and prior plans outstanding as of December 31, 2017.September 30, 2019. There were no315,600 stock options and 10,00082,500 shares of restricted sharesstock issued under the 2017 Plan outstanding and 890,000500,400 shares available for grant under the 2017 Plan as of December 31, 2017.September 30, 2019.

The Company recorded approximately $386,000$210,000 and $235,000$257,000 of compensation expense related to current and past grants of stock options and restricted stock for the sixthree months ended December 31, 2017September 30, 2019 and 2016,2018, respectively. This expense is included in selling, general and administrative expense. As of December 31, 2017,September 30, 2019, approximately $1,026,000$1,254,000 of total unrecognized compensation expense related to non-vested equity awards iswas expected to be recognized over a weighted average period of approximately 0.9 years.

The Company recognizes compensation expense related to share-based payment transactions in the financial statements based on the estimated fair value of the award issued. The fair value of each option is estimated using the Black-Scholes pricing model at the time of award grant. The Company estimates the expected life of options based on the expected holding period by the option holder. The risk-free interest rate is based upon observed U.S. Treasury interest rates for the expected term of the options. The Company makes assumptions with respect to expected stock price volatility based upon the historical volatility of its stock price. Forfeitures are estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from initial estimates. Forfeitures are estimated based on the percentage of awards expected to vest, taking into consideration the seniority level of the award recipient.

The following assumptions were used to estimate the fair value of stock options granted:

Stock Options

The Company issued 182,250149,300 stock options pursuant to the 20142017 Plan during the sixthree months ended December 31, 2017.September 30, 2019. Stock option transactions during the sixthree months ended December 31, 2017September 30, 2019 are summarized as follows:

The intrinsic value of an option is the amount by which the fair value of the underlying stock exceeds its exercise price. At December 31, 2017,September 30, 2019, the weighted average remaining contractual term for all outstanding stock options was 5.707.21 years and their aggregate intrinsic value was approximately $2,817,000.$2,046,000. Outstanding at December 31, 2017September 30, 2019 were 918,300806,350 stock options issued to employees, of which 586,303504,174 were exercisable and had an aggregate intrinsic value of approximately $2,178,000.$1,679,000.

Restricted Stock

The 2017 Plan also permits and the 2014 Plan permitted, the grant of other stock-based awards.awards, including shares of restricted stock. Historically, the Company makes restricted stock grants to key employees and non-employee directors that vest over six months to three years.

During the sixthree months ended December 31, 2017,September 30, 2019, the Company issued restricted stock awards to employees totaling 40,00032,500 shares of the Company’s common stock, with a vesting term of one to three years and a fair value of $5.59$5.29 per share. The restricted stock’s fair value per share or restricted stock represents the closing price of the Company’s common stock the on the NYSE American on the date of the grants were made.grant. Restricted stock transactions during the sixthree months ended December 31, 2017September 30, 2019 are summarized as follows:

Note 9. Leases

The Company has four leases for office and warehouse space that require monthly payments. These leases have escalating payments ranging from approximately $450 to $4,400 per month which expire through July 2022 and are recognized on a straight-line basis over the life of the lease. The Company has a lease for office equipment that requires payments of approximately $1,500 per month through December 2022. All leases are classified as operating leases which do not include renewal options. The Company currently does not have any short-term or variable lease costs. The Company applied the practical expedient to calculate the present value of the fixed payments without having to perform an allocation to lease and non-lease components.

The Company has recognized a right of use assets associated with its operating leases of approximately $138,000 and $45,000 as of September 30, 2019 and June 30, 2019, respectively, which is included in other assets on the Company’s Condensed Balance Sheet. Operating lease liabilities were $138,000 and $45,000 as of September 30, 2019 and June 30, 2019, respectively, which are included in current maturities of long-term liabilities and other long-term liabilities on the Company’s Condensed Balance Sheet.

For the three months ended September 30, 2019, the Company has a weighted-average lease term of 0.9 years for its operating leases, which have a weighted-average discount rate of 4.0%. Operating lease payments of $22,000 are included in operating cash flows for the three months ended September 30, 2019.

Maturities of lease liabilities, which are included in current maturities of long-term liabilities and other long-term liabilities on the Company’s Condensed Balance Sheet, are as follows:

Note 8.10. Commitments and Contingencies

The Company is occasionally involved in claims and disputes arising in the ordinary course of business. The Company insures its business risks where possible to mitigate the financial impact of individual claims and establishes reserves for an estimate of any probable cost of settlement or other disposition.

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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed financial statements and related notes thereto included in Item 1 of Part I of this Quarterly Report on Form 10-Q and the audited financial statements, related notes thereto and Management’sPart II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contained in our Annual Report on Form 10-K for the fiscal year ended June 30, 2017,2019, or “fiscal 2017.2019.”

Overview

Electromed, Inc. (“we,” “our,” “us,” “Electromed” or the “Company”) develops and provides 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®SmartVest^® Airway Clearance System (“SmartVest System”) that includes our newest generation SmartVest SQL®SQL^® and previous generation SV2100, and related products, to patients with compromised pulmonary function. The SmartVest SQL is smaller, quieter and lighter than our previous product, with enhanced programmability and ease of use. Our products are sold in both the home health care market and the institutional market for use by patients in hospitals, which we refer to as “institutional sales.” The SmartVest SQL has been sold in the domestic home care market since theour fiscal quarter ended March 31, 2014. In the fourth quarter of our fiscal year ended June 30, 2015, we launched the SmartVest SQL into the institutional and certain international markets. During February 2017, we entered into an agreement with Monaghan Medical Corporation to distribute and sell the Aerobika® Oscillating Positive Expiratory Pressure (OPEP) Device in the U.S. home care market. In June 2017, we announced the launch of the SmartVest SQL with SmartVest Connect™ wireless technology, which allows data connection between physicians and patients to track therapy performance and collaborate in treatment decisions. SmartVest Connect is currently available to pediatric and cystic fibrosis patients and was made available to certain targeted adult pulmonary clinics starting in November 2017. Since 2000, 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 neuromuscular disorders such as cerebral palsy, muscular dystrophies, amyotrophic lateral sclerosis (“ALS”), the combination of emphysema and chronic bronchitis commonly known as chronic obstructive pulmonary disease (“COPD”), and patients with post-surgical complications or who are ventilator dependent or have other conditions involving excess secretion and impaired mucus transport. During February 2017, we entered into an agreement with Monaghan Medical Corporation to distribute and sell the Aerobika^® Oscillating Positive Expiratory Pressure (“OPEP”) Device in the U.S. home care market. After over a year of offering Aerobika OPEP, we determined that continuing to offer the product direct to patients was unlikely to serve a broader patient population as originally planned. As a result, we discontinued our distribution of the Aerobika OPEP in November 2018.

The SmartVest System is often eligible for reimbursement from major private insurance providers, health maintenance organizations (“HMOs”), state Medicaid systems, and the federal Medicare system, which we believe 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, (E0483), for HFCWO 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 neuromuscular 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.

Critical Accounting Policies and Estimates

For a description of our critical accounting policies, estimates and assumptions used in the preparation of our financial statements, including the unaudited condensed financial statements in this report,Quarterly Report on Form 10-Q, see Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and Note 1 to our audited financial statements, included in Part II, Item 8, of our Annual Report on Form 10-K for fiscal 2017.2019.

Some of our accounting policies require us to exercise significant judgment in selecting the appropriate assumptions for calculating financial statements. Such judgments are subject to an inherent degree of uncertainty. TheseAmong other factors, these judgments are based upon our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. We believe the critical accounting policies that require the most significant assumptions and judgments in the preparation of our financial statements, including the unaudited condensed financial statements in this report,Quarterly Report on Form 10-Q, include: revenue recognition and the estimation of selling price adjustments,variable consideration, allowance for doubtful accounts, inventory obsolescence, share-based compensation income taxes and warranty liability.

Results of Operations

Revenues

Revenue for the three and six monththree-month periods ended December 31, 2017September 30, 2019 and 2016 are2018 is summarized in the table below (dollar amounts in thousands).

Home Care Revenue. Home care revenue for the three months ended December 31, 2017September 30, 2019 was approximately $6,506,000,$7,491,000, an increase of approximately $1,004,000$769,000 compared to the same period in fiscal 2017,2019, or 18.2%11.4%. For the six months ended December 31, 2017, homeHome care revenue was approximately $12,486,000, an increase of approximately $1,851,000, or 17.4%, compared to the same period in fiscal 2017. During the three months ended December 31, 2016, home care revenue was negatively impacted by the retroactive repayment of previously collected and recognized revenue to a state Medicaid program totaling approximately $212,000. The repayment resulted from the state Medicaid program’s reinterpretation of its reimbursement process and a reduction in its allowable payments. We believe that the repayment was a one-time event and is not reflective of other state Medicaid reimbursement processes.

After taking into consideration the negative impact of the retroactive repayment during the three months ended December 31, 2016, home care revenue for the three months ended December 31, 2017 increased year-over-year predominantly due to growth in approvals as a result of continued improvements in our reimbursement operations that ledhigher average allowable due to a greater referral to approval percentage as compared to the prior year. The increase in home care revenue for the six months ended December 31, 2017 was primarily driven bypayer mix, a greater referral to approval percentage and a higher levelnumber of referrals as compared to the prior year. The increase in referrals was primarily due to growth in the number ofper field sales employee. At September 30, 2019 field sales employees astotaled 38, of which 32 were direct sales, compared to 40 at the comparable priorend of our fiscal year period.ended June 30, 2019, of which 34 were direct sales, and 49 at the end of the fiscal quarter ended September 30, 2018 of which 41 were direct sales.

Institutional Revenue. Institutional revenue for the three and six months ended December 31, 2017 was approximately $313,000 and $614,000, respectively, representing a decrease of approximately $292,000 and $337,000, or 48.3% and 35.4%, compared to the same periods in fiscal 2017. The decrease in revenue for the three and six months ended December 31, 2017 was due to a decrease in the number of units and single patient use garments sold compared to the same periods in the prior year. Institutional revenue includes sales to distributors, group purchasing organization (“GPO”) members and other institutions.

International Revenue. International revenue for the three months ended December 31, 2017September 30, 2019 was approximately $166,000,$625,000, representing a decreasean increase of approximately $99,000,$206,000, or 37.4%49.2%, compared to the same period in fiscal 2017. For2019. The increase in institutional revenue was primarily due to a higher selling price per device compared to the sixsame period in the prior fiscal year and an increase in the number of devices sold. Institutional revenue includes sales to group purchasing organization (“GPO”) members, medical equipment rental companies that rent to long-term care facilities and other institutions.

Home Care Distributor Revenue. Home care distributor revenue for the three months ended December 31, 2017, international revenueSeptember 30, 2019 was approximately $267,000,$120,000. We began selling to home medical equipment distributors during the three months ended September 30, 2019, who in turn sell our SmartVest System in the U.S. home care market.

International Revenue. International revenue for the three months ended September 30, 2019 was approximately $66,000, representing a decrease of approximately $65,000,$69,000, or 19.6%51.2%, fromcompared to the same period in fiscal 2017.2019. International sales are affected by the timing of distributor purchases that can cause significant fluctuations in reported revenue on a quarterly basis.

Gross profit

Gross profit increased to approximately $5,587,000,$6,342,000, or 80.0%76.4% of net revenues, for the three months ended December 31, 2017,September 30, 2019, from approximately $4,926,000,$5,543,000, or 77.3%76.2% of net revenues, in the same period in fiscal 2017. Gross profit increased to approximately $10,523,000, or 78.7% of net revenues, for the six months ended December 31, 2017, from approximately $9,254,000, or 77.7% of net revenues, in the same period in fiscal 2017.2019. The increase in gross profit for the three and six months ended December 31, 2017September 30, 2019 was primarily related to increases in domestic home care revenue. The increase in gross profit as a percentage of net revenue was driven by a higher level of net revenue recognized per new device placement asaverage allowable due to payer mix compared to the prior year, which was partially offset by the additional costs to manufacture the SmartVest SQL with SmartVest Connect ™ wireless technology. Additionally, gross profit for the three and six months ended December 31, 2016 was negatively impacted by the retroactive repayment of previously collected and recognized revenue to a state Medicaid program totaling approximately $212,000.year.

Operating expenses

Selling, general and administrative expenses. Selling, general and administrative (“SG&A”) expenses were approximately $4,760,000 and $9,463,000$4,895,000 for the three and six months ended December 31, 2017, respectively,September 30, 2019, representing an increasea decrease of approximately $664,000 and $1,679,000,$378,000, or 16.2% and 21.6%7.2%, respectively, compared to the same periodsperiod in the prior year.

Payroll and compensation-related expenses were approximately $2,712,000 and $5,398,000$3,138,000 for the three and six months ended December 31, 2017, respectively,September 30, 2019, representing an increasea decrease of approximately $362,000 and $1,011,000,$270,000, or 15.4% and 23.0%7.9%, respectively, compared to the same periodsperiod in the prior year. The increasesdecrease in the current year periods wereperiod was due to additionala lower number of employees in sales and administrative roles, lower share-based compensation expense and a decrease in sales incentives. These decreases in payroll and compensation-related expenses were partially offset by annual salary increases and a higher share-based equitymanagement bonus accrual as compared to the prior year period. We anticipate payroll and compensation expense, and additionalrelated expenses to increase as we plan to expand our direct sales incentives on higher revenue accruals.staff to 38 from 32 at the end of the quarter.

Professional fees for the three and six months ended December 31, 2017September 30, 2019 were approximately $516,000 and $1,016,000, respectively, an increase$412,000, a decrease of approximately $191,000 and $344,000,$61,000, or 58.8% and 51.2%12.9%, respectively, compared to the same periodsperiod in the prior year. These fees are primarily for services related to legal costs, shareowner services and reporting requirements, general and administrative temporary labor, information technology (“IT”) security and backup, and consulting fees for sales training. The increasedecrease in professional fees was primarily due to increasesa decrease in general and administrative temporary labor, IT legal costs and consulting fees.compared to the prior year.

Recruiting fees for the three and six months ended December 31, 2017September 30, 2019 were approximately $133,000 and $298,000, respectively,$63,000, an increase of approximately $46,000 and $140,000,$33,000, or 52.9% and 88.6%110.0%, respectively, compared to the same period in the prior year.  The increase in recruiting fees was due primarily to adding more employeesrecruiting for vacant positions in sales and administrative roles as compared to the prior year.year period.

Travel, meals and entertainment expenses were approximately $537,000 and $1,014,000$585,000 for the three and six months ended December 31, 2017, respectively,September 30, 2019, representing an increasea decrease of approximately $123,000 and $159,000,$24,000, or 29.7% and 18.6%3.9%, respectively, compared to the same periodsperiod in the prior year. The increasedecrease was due primarily to additionalhaving fewer sales personnel.

SG&A expenses included a loss on the abandonment of certain domestic and foreign patents with net values of approximately $111,000 during both the three and six months ended December 31, 2016. No losses on the abandonment of patents were recognized during the three and six months ended December 31, 2017.

Research and development expenses.Research and development (“R&D”) expenses were approximately $57,000 and $127,000$99,000 for the three and six months ended December 31, 2017, respectively,September 30, 2019, representing an decreaseincrease of approximately $44,000 and $325,000$31,000 compared to the same periodsperiod in the prior year. R&D expenses for the three and six months ended December 31, 2017September 30, 2019 were 0.8% and 1.0%1.2% of net revenue respectively, compared to 1.6% and 3.8%0.9% of net revenue for the same periodsperiod in the prior year. During the fiscal year ended June 30, 2016, we began developing SmartVest Connect, a new wireless connectivity feature for our HFCWO device which allows data connection between physicians and patients. We believe SmartVest Connect will strengthen our patient and clinician partnerships, leading to greater therapy adherence and improved quality of life for individuals with compromised pulmonary function. We launched this feature in June 2017. As a percentage of net revenues, we expect spending on R&D expenses to remain consistent throughincrease to 2-4% for the remainder of ourthe fiscal year ending June 30, 2018. Certain expenses related to our innovation investments are not always captured in R&D expenses. These expenses may be included in cost of sales as in the case of depreciation of tooling, or for SG&A, in the case of professional fees or higher labor expenses, as we improve our internal processes or enhance our customer service.increase focus on development of a next generation device.

Interest expenseincome, net

Interest expense, net,Net interest income was approximately $5,000 and $9,000$40,000 for the three and six months ended December 31, 2017, respectively,September 30, 2019 compared to $16,000 and $32,000$13,000 in the same periods in thecomparable prior year. The decreaseyear period.  Increases in net interest expense during both the three and six months ended December 31, 2017 as compared to the prior yearincome was primarily driven by an increase in interest income, a lower effective interest ratehigher rates earned on outstanding borrowings, lower deferred financing costs and a lower level of debt as compared to the prior year.our cash deposits.

Income tax expense

Income tax expense was estimated at approximately $416,000$374,000 and $453,000$58,000, and the effective tax rates were 54.4%rate was 26.9% and 49.1%27.0%, respectively, for the three and six months ended December 31, 2017. Estimated income tax expense for the threeSeptember 30, 2019 and six months ended December 31, 2017 includes a discrete deferred tax expense of approximately $160,000 as a result of re-measuring certain deferred tax assets and liabilities based on the rates at which they are expected to reverse in future periods under the Tax Cuts and Jobs Act (the “Tax Act”) that was enacted by the U.S. federal government on December 22, 2017. Additionally, a discrete tax benefit of approximately $2,000 and $27,000 was recognized during the three and six months ended December 31, 2017, respectively, as a result of greater federal and state R&D tax credits than what was originally estimated in our tax provision for fiscal 2017. The net impact of these discrete events increased the effective tax rate by 20.6% and 14.4% during the three and six months ended December 31, 2017,2018, respectively.

Income tax expense was estimated at approximately $270,000 and $351,000 and the effective tax rates were 37.8% and 35.6%, respectively, for the three and six months ended December 31, 2016. Income tax expense during the six months ended December 31, 2016 includes a recognized tax benefit of approximately $22,000 as a result of the lapse of the statute of limitations on uncertain tax positions, which reduced the effective tax rate by 2.2% for that period.

Net income

Net income for the three and six months ended December 31, 2017September 30, 2019 was approximately $349,000 and $470,000, respectively,$1,015,000 compared to net income of approximately $444,000 and $635,000$157,000 for the same periodsperiod in the prior year. The year-over-year decreaseincrease in net income was driven primarily by higher SG&A expenses related to hiring additional new employees, which was partially offset by an increase in gross profit driven by higher revenue and lower R&D expenses as compared to the prior year. Additionally, net income for the threepayroll and six months ended December 31, 2017 was affected by discrete tax events including the $160,000 re-measurement of certain deferred tax assets and liabilities.compensation-related expenses.  

Liquidity and Capital Resources

Cash Flows and Sources of Liquidity

Cash Flows from Operating Activities

For the sixthree months ended December 31, 2017,September 30, 2019, net cash provided by operating activities was approximately $1,530,000.$629,000. Cash flows provided by operating activities consisted of net income of approximately $470,000,$1,015,000, non-cash expenses of $820,000$395,000 and decreasesa decrease in accounts receivable inventory and prepaid expenses and other assets of $269,000, $184,000 and $9,000, respectively.$41,000. These cash flows from operating activities were partially offset by a decrease in income taxes payable of $289,000, a decrease in accounts payable and accrued liabilities of approximately $150,000 and a decrease$250,000, an increase in income tax payableinventory of $72,000.

For the six months ended December 31, 2016, net cash provided by operating activities was approximately $39,000. Cash flows provided by operating activities consisted of net income of approximately $635,000, non-cash expenses of $741,000, a decrease$119,000, an increase in prepaid expenses and other assets of $7,000 and a decrease in income tax receivable of $190,000. These cash flows from operating activities were offset by a decrease of approximately $807,000 in accounts payable and accrued liabilities,$102,000, an increase in accountsincome taxes receivable of $673,000$50,000 and an increase in inventorycontract assets of $54,000.$12,000.

Cash Flows from Investing Activities

For the sixthree months ended December 31, 2017,September 30, 2019, cash used in investing activities was approximately $238,000.$415,000. Cash used in investing activities consisted of approximately $228,000$405,000 in expenditures for property and equipment and $10,000 in payments for patent costs.

For the six months ended December 31, 2016, cash used in investing activities was approximately $312,000. Cash used in investing activities consisted of approximately $267,000 in expenditures for property and equipment and $45,000 in payments for patent costs. The expenditures for property and equipment consisted primarily of costs associated with the development of software associated with SmartVest Connect.

Cash Flows from Financing Activities

For the sixthree months ended December 31, 2017,September 30, 2019, cash used inprovided by financing activities was approximately $25,000,$13,000, which consisted of principal payments on long-term debt.

Forcash we received from the six months ended December 31, 2016, cash used in financing activities was approximately $29,000, which consistedexercise of principal payments on long-term debt of $24,000 and payments of deferred financing fees of $5,000.stock options.