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ITEM 2.
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
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FORWARD LOOKING STATEMENTS
This quarterly report on Form 10-Q contains
various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended,
and Section 21E of the Securities Exchange Act of 1934, as amended (the Exchange Act), which represent our expectations or
beliefs concerning future events. Forward-looking statements generally include words such as “anticipates,” “believes,”
“expects,” “planned,” “scheduled,” or similar expressions and statements. Although we believe
these forward-looking statements are based on reasonable assumptions, statements made regarding future results are subject to a
number of assumptions, uncertainties, and risks that could cause future results to be materially different from the results stated
or implied in this document. Uncertainties, risks, and other factors that may cause actual results or performance to differ materially
from any results of performance expressed or implied by forward-looking statements in this Form 10-Q include: (1) our ability
to manage our operating expenses and realize operating efficiencies, (2) our ability to maintain and grow our sales with existing
and new customers, (3) our ability to retain existing members of our senior management team and to attract additional management
employees, (4) our ability to manage fluctuations in the availability and cost of key materials and tools of production, (5) general
economic conditions that might impact demand for our products, (6) competition from existing or new participants in the pet
products industry, (7) our ability to design and bring to market new products on a timely and profitable basis, (8) challenges
to our patents or trademarks on existing or new products, (9) our ability to secure access to sufficient capital on favorable
terms to manage and grow our business, or (10) our ability to manage and fund claims resultant from our self-insurance program.
We caution that these risk factors are not exclusive. Additionally, we do not undertake to update any forward looking statements
that may be made from time to time by or on behalf of us except as required by law.
OVERVIEW
We develop and market products for improving
the health, safety, comfort and enjoyment of pets. Our mission is “to exceed pet and pet parent/owner expectations with innovative
solutions.” Our dual-brand strategy is focused on OurPets® for the Pet Specialty channel and PetZone® for the food,
drug and mass retail channel. The products sold have increased from the initial Big Dog Feeder® to approximately 900 products
for dogs, cats and birds. Products are marketed under the OurPet’s®, Pet Zone®, Flappy®, SmartScoop®, Ecopure
Naturals®, Play-N-Squeak®, Durapet®, Clipnosis®, Go! Cat!Go!®, Festiva®, Cosmic Pet™, Intelligent
Pet Care®, Switchgrass BioChar® Natural Cat Litter labels to domestic and international customers. The manufacturing of
these products is subcontracted to other entities, both domestic and international, based upon price, delivery and quality.
Packaged Facts, a leading publisher in
the United Sates of market studies on consumer products, recently published its report of the “U.S. Pet Market Outlook, 2016-2017.”
It estimates the overall pet products and services market totaled $77.07 billion in 2015. The report expects the industry to reach
about $96 billion by the end of 2020. The pet supplies segment (OurPet’s segment) was the third-largest segment in 2015 with
$15.18 billion in revenue. This segment showed an increase of 4.7% from the previous year. U.S. retail channel sales of pet products,
which includes pet food and pet supplies, were estimated at $45.3 billion in 2015, up 3.4% over 2014 (U.S. Pet Market Outlook,
2016-2017).
Packaged Facts cites higher income households
as crucial to the success of the pet industry. It also identifies the human/animal bond and humanization of pets as key drivers.
As it explains in its outlook study, “[h]umanization of pets is a natural expression of the ‘pets as family’
trend, whereby pet owners treat their pets like children and are highly receptive to products similar to the ones they use for
themselves.” (U.S. Pet Market Outlook, 2016-2017).
As discussed in “Liquidity and Capital
Resources” beginning on page 17, we funded our operations principally from the net cash provided from operating activities
for both the three-month periods ended March 31, 2017, and March 31, 2016. Net cash provided by operating activities for the three
months ended March 31, 2017 was $1,003,740.
Under the Company’s credit facilities
with our bank, the Company can borrow up to $5,000,000 based on the level of qualifying accounts receivable and inventories. As
of March 31, 2017, we had a balance due of $1,865,492 under the line of credit with our bank at a variable interest rate of 30
Day LIBOR plus 2.25%.
RESULTS OF OPERATIONS
Three Months Ended March 31, 2017, Compared to Three Months Ended
March 31, 2016
In the following discussion, all references
to 2017 are for the three months ended March 31, 2017, and all references to 2016 are for the three months ended March 31, 2016.
Our net revenue is primarily derived from sales
of proprietary products for the retail pet business. In 2015, we completed the conversion of our brands to deliver products that
are specifically marketed to our three main channels. The OurPets® brand is sold to the “Pet Specialty” channel.
The Pet Zone brand is sold to the “Grocery, Drug, Mass Retail” channel. Both brands are sold to the “E-Commerce”
channel.
In 2017, net sales grew approximately 5.8% to
$6.54 million or $361,000 above first quarter 2016 sales. This sales growth occurred despite an overall United States economic
climate that was stagnant and borderline recessionary. We also saw a significant shift in our revenue growth this quarter from
the “Big Box/Brick and Mortar” stores to E-Commerce.
Despite this changing of the retail landscape
we continue to focus on our three main channels: “Grocery, Drug, Mass Retail,” “Pet Specialty,” and “E-Commerce.”
In 2017, “Grocery, Drug, Mass Retail” customers accounted for 39% of our sales compared to 43% in 2016; “Pet
Specialty” customers accounted for 35% of our sales compared to 40% in 2016; and “E-Commerce” customers accounted
for 14% of our sales, up from 9% of total sales for the first quarter of 2016. We also sell our products in the “value”
and “closeout” channels, which made up 8.5% of our sales in 2017. Miscellaneous sales accounted for the other 3.5%
of our revenue.
Sales in the E-Commerce channel increased approximately
61%, or $341,000, with most of this growth coming from our toys/accessories and raised feeder products. Within the “Grocery,
Drug, Mass retail” channel, sales decreased by approximately $125,000 or 5% compared to the same period a year ago. Sales
in the “Pet Specialty” channel decreased about 7% or approximately $174,000 from the same quarter in 2016. These decreases
in the Grocery, Drug, Mass Retail and Pet Specialty channels were primarily due to our largest retailers selling down our existing
phased-out inventory (bowls and toys/accessories) in order to bring in our new products in the second and third quarters of 2017.
The value channel which comprises about 5% of
our overall sales grew about 5% for the quarter mainly due to increased sales of toys and accessories. Likewise, we increased sales
to close-out customers by approximately $99,000 over last year to reduce excess and slow moving inventory. Across all channels,
sales to new customers provided approximately $25,000 in additional net revenue during the first quarter of 2017.
Our net sales to international customers generated
about $597,000 in revenue or about 9% of total sales for the quarter. International sales decreased by approximately $5,000, or
1%, compared to a year ago, apparently impacted by the strong US dollar. Most of our international sales came from Canada (64%
for the first quarter) and the United Kingdom (16% for the first quarter). Sales to customers in Canada were down by approximately
$15,000, or 3.79%, from a year ago. Sales to customers in the United Kingdom were down by approximately $20,000, or 17.1%, from
a year ago. Sales to our customer in Japan were up by approximately $57,000 from a year ago.
Our two main product categories remain toys/accessories,
comprising 50% of sales (up from 47% last year), and bowls/feeders, comprising 36% of sales (down from 40% last year). The remaining
14% of our sales consists of edible/consumable catnip products (6%), waste/odor products (6%), and health/wellness products and
dog houses (2%).
Sales of our toys/accessories were up by approximately
$315,000, or 11%, over a year ago fueled by electronic cat toys and interactive cat toys. Top electronic toys sold continue to
be our Fly By Spinner Toy® and our Catty Whack® hide and seek action toy with random feather movement. Gaining significant
traction are our newer Pounce House®/Teaser Teepee and our Bird in a Cage®/Caged Canary®. Sales of our bowls and feeders
decreased approximately $148,000, or 6%, from first quarter sales in 2016 as customers continue to establish their own direct order
sources for Stainless Steel bowls. Decreases in our Stainless Steel bowl sales of $253,000 were offset by increases of sales in
our Raised Feeder category, which grew about 20% over last year’s first quarter as our Designer Diner ®/Barking Bistro®
three height adjustable feeder became a very popular item in the E-Commerce channel. Sales of our Edible/Consumable product category
increased about 8% over last year’s first quarter with tuna flake products leading the growth. Finally, we increased sales
of our litter boxes and grew the waste and odor category by approximately $95,000, or 34%, over last year’s sales. Across
all product categories, our top three products were our large and medium hybrid stainless steel bowls and our Ball of Furry Fury.
Our Private Label sales accounted for about 11% of total sales compared to about 14 % of last year’s sales with the decrease
mainly due to a decrease in sales of Stainless Steel bowls.
Sales of new products in the first quarter of
2017 not sold previously were approximately $253,000 or 4% of total sales for the quarter. Most of these sales were from products
in the toys and accessories category, including our Pet Zone Snagables line, our new Cat Scratcher Post, our new Sisal Dumbbell
Toy, and a variety of other action and interactive toys. We also sold a new tuna flake .5 oz. gusseted bag.
Our cost of goods sold increased in net by approximately
$68,000 (1.6%) from $4,344,128 in 2016 to $4,412,042 in 2017. The rise in sales led to an increase in our material and our freight
out costs. We kept the increase to a minimum by negotiating payment discounts based on exchange rate gains of the U.S. Dollar against
the Chinese Yuan Renminbi. We also reduced costs in several other areas to further offset some of the increased material costs.
Depreciation related to operating fixed assets decreased by approximately $25,000. Salaries and payroll related items decreased
by approximately $27,000. Expenditures made for warehouse supplies decreased by approximately $14,000. Expense related to the write
off of excess and obsolete inventory decreased by approximately $41,000.
Our gross margin percentage increased from a
year ago to 32.5% from 29.7%. This is mainly from our increased sales providing better absorption of operations overhead. Our warehouse
overhead costs decreased by approximately $68,000, or 9.2%, from the comparable three months in 2016. The largest items were the
decreases in depreciation and payroll related items mentioned above.
By improving our sales and increasing our gross
margin percentage, we increased our gross profit margin dollars from $1,831,857 in 2016 to $2,124,768 in 2017 (an increase of $292,911
or 16.0%).
Selling, general and administrative expenses
in 2017 were $1,643,880 (an increase of 16.0% or $227,292) from $1,416,588 in 2016. Over two-thirds of this increase was the net
result of an increase in selling expenses of approximately $156,000 from increased expenditures for customer incentives and discounts
allowed. The remaining one-third of the increase was the result of: (1) an increase in promotional costs of approximately $44,000;
(2) an increase in expenses for investor relations of approximately $23,000; (3) an increase in fees of approximately $21,000 related
to the establishment of the subsidiary to self-insure against business losses; (4) an increase in IT (Information Technology) expenses
of approximately $19,000; (5) an increase of approximately $12,000 for travel expenses; (6) an increase of approximately $11,000
for cash discounts allowed to our customers for early payment; (7) a decrease in salaries, payroll taxes, and benefits of approximately
$32,000; (8) a decrease in marketing expenses of approximately $23,000; (9) a decrease in depreciation expenses of approximately
$10,000; and (10) a net increase of $6,000 in all other selling, general and administrative expenses.
As a result of the increase in gross profit
on sales of $292,911 and the offsetting increase in selling, general and administrative expenses of $227,292, our income from operations
increased by $65,619 (or 15.8%) from $415,269 in 2016 to $480,888 in 2017.
We incurred “other expense” of approximately
$10,000 in 2017 and earned “other income” of approximately $27,000 in 2016. The $10,000 incurred in 2017 was the net
result of a $4,000 loss on the exchange rate related to payments received from one UK customer, $15,000 of royalty expense paid
out, and $9,000 of royalty income. Of the $27,000 earned in 2016, $20,000 was derived from customer payments for tooling/molds
needed in the joint development of new toy products. The remaining approximately $7,000 of other income in 2016 was from royalty
income resulting from favorable patent litigation settlements.
Interest expense for 2017 was $21,846, a decrease
of $10,989, from $32,835 in 2016. Most of this decrease resulted from a decrease in our average line of credit balance to approximately
$1,800,000, which is an approximately $1,700,000 reduction from about $3,500,000 a year ago. As a result, interest on the line
decreased by approximately $9,600. The payoff of other loans and leases resulted in the rest of the decrease.
We lowered our estimated effective tax rate
based on presumed transactions which will take place at the end of 2017 with our wholly owned subsidiaries, an insurance company
and a domestic international sales corporation (DISC). As a result, income tax expense decreased by approximately $77,000 from
$142,859 in 2016 to $65,713 in 2017.
Net income for 2017 was $383,377 as compared
to net income of $266,581 for 2016, an increase of $116,796, or 43.8%. This increase was a result of the following changes from
2016 to 2017:
Net revenue increase of 5.8%
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$
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360,825
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Cost of goods sold increase of 1.6%
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(67,914
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)
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Gross profit increase of 16.0%
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292,911
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Selling, general, and administrative expenses increase of 16.0%
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(227,292
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)
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Interest expense decrease of 33.5%
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10,989
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Decrease in other income/ expense
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(36,958
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)
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Income tax expense decrease
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77,146
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Increase in profitability
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$
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116,796
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LIQUIDITY AND CAPITAL RESOURCES
Our operating activities provide cash from the
sale of our products to customers. The principal uses of cash are payments to suppliers that manufacture our products and freight
charges for shipments to our warehouses and to our customers. Our investing activities use cash mostly for the acquisition of equipment
such as tooling, computers, and software. Our financing activities provide cash, if needed, under our lines of credit with our
bank, which had $3,134,508 in available funds as of March 31, 2017, based upon the balance of accounts receivable and inventories
at that date.
Our short-term and long-term liquidity will
continue to depend on our ability to achieve cash-flow break even on our operations and to increase sales of our products. In both
the first three months of 2017 and 2016, we funded our operating cash requirements primarily with net income. During the remainder
of 2017, we should be able to continue to fund our operating cash requirements with net income. Based on our bank’s loan
covenants we expect to comply with the debt service coverage ratio and tangible net worth required by our bank to maintain our
line of credit through the end of 2017. We have no material commitments for capital expenditures.
Outstanding Debt
As of March 31, 2017, we had $2,784,179 in principal amount
of indebtedness consisting of:
Bank line of credit - $5,000,000
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30 day Libor plus 2.25%
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$
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1,865,492
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Bank term note ($1,000,000 original balance)
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30 day Libor plus 3%
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700,000
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Capitalized Lease
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5.44%
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103,769
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Lake County Economic Development Loan Program
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5.00%
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34,232
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Note Payable to Molor Products
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Non-interest bearing
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80,686
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The bank line of credit indebtedness of $1,865,492
is comprised of a single line of credit under which we can borrow up to a total of $5,000,000 based on the level of qualifying
accounts receivable and inventories. Total eligible collateral at March 31, 2017 was $5,267,261. The line of credit is a two-year
revolver and therefore is classified as a long-term liability on our balance sheet. Currently the line of credit has been renewed
by the bank through June 30, 2018. Under our agreement with the bank we are required to: (1) maintain a debt service
coverage ratio of at least 1.00 to 1.15 measured quarterly on a trailing 12 month basis; (2) maintain a tangible net worth
of no less than $6,000,000 tested at the end of each quarter; and (3) obtain the bank’s permission to incur additional
indebtedness, make any expenditures for property and equipment in excess of $750,000 in any fiscal year, redeem any of our capital
stock, or pay cash dividends other than dividends on our preferred stock (subject to meeting the debt service coverage ratio).
As of March 31, 2017, we were in compliance with the covenant and default provisions under the agreement with the bank. We had
a debt service coverage ratio of 2.93 and a tangible net worth of $10,330,306.
During the third quarter of 2016, we entered
into a commitment to purchase an automatic packaging machine, with a cost of approximately $105,000, to be used at our Mentor facility.
The equipment was installed and the purchase was finalized in March of 2017. To finance the purchase, we entered into a capital
lease that has a 60-month term with a $1.00 buyout at the end of the lease resulting in an approximate 5.44% interest rate. The
lease began in March of 2017 with the installation of the equipment. Monthly payments are $2,008.
Changes in Cash- Quarter One of 2017
Net cash provided by operating activities for
the three months ended March 31, 2017 was $1,003,740. Cash was provided by the net income for the three months of $383,377, as
well as the non-cash charges for depreciation of $124,068; amortization of $14,653; stock option expense of $6,000; and loss on
fixed assets of $995.
Cash was provided by the net change of $474,647
in our operating assets and liabilities as follows:
Accounts Receivable decrease
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$
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823,956
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Inventories increase
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(1,013,345
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)
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Prepaid Expenses increase
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(49,643
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)
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Deposits decrease
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20,874
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Amortizable Intangible Assets increase
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(19,565
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)
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Accounts Payable increase
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759,404
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Accrued Expenses decrease
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(65,304
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)
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Deferred Tax Liability increase
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18,270
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Net Change
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$
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474,647
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Accounts receivable decreased due to lower
sales in the first quarter of 2017 compared to the fourth quarter of 2016. Inventories increased due to bringing in product to
prepare for initial stocking orders which will take place in the second quarter of 2017 with a few of our major customers and
also due to bringing in new product inventory in preparation for launch in the early part of this year. Also inventory increases
over year end are typical in the first quarter of each new year as we need to bring in sufficient product to minimize stock outs
through the Chinese New Year, which effectively shuts down production during the entire month of February. Accounts payable increased
due to the increase in inventory. Accrued expenses decreased from paying bonus and profit sharing amounts related to last year,
offset by increased accruals for salaries and customer incentive discounts and rebates. Prepaid expenses increased due to prepayments
for consulting work and royalty advances, offset by expense recognized for income taxes prepaid last year.
Net cash used for investing activities for the
three months ended March 31, 2017 was $116,750. Approximately $60,000 was used for warehouse equipment. Another approximately $50,000
was used for tooling/molds and approximately $11,000 was used towards the development of software compatible with our new Bluetooth
products. We sold a truck that was being used for the transport of goods between warehouses and that provided $4,000 in cash.
Cash used by financing activities for the three
months ended March 31, 2017, was $279,231 and consisted of: (1) net increased payments on the bank line of credit of $218,474 and
(2) principal payments on long-term debt of $60,757. Besides the capital lease, no changes were made to the structure of our debt
during the first quarter of 2017. All scheduled payments were made on time.
Changes in Cash- Quarter One of 2016
Net cash provided by operating activities for
the three months ended March 31, 2016, was $355,004. Cash was provided by the net income for the three months of $266,581, as well
as the non-cash charges for depreciation of $158,685; amortization of $12,508; stock option expense of $6,000; and loss on fixed
assets of $9,474. Cash was used by the net change of $98,244 in our operating assets and liabilities.
Accounts receivable decreased due to
lower sales in the first quarter of 2016 compared to the fourth quarter of 2015. Inventories decreased due to close out sales
and improved management of our supply chain. Accounts payable decreased due to the reduction in inventory. Accrued expenses
decreased from paying bonus and profit sharing amounts related to last year as well as paying customer incentive payments
related to last year’s programs. Prepaid expenses increased due to prepayments for market research, royalty advances,
and inventory advances, offset by expense recognized for income taxes prepaid last year.
Net cash used for investing activities for the
three months ended March 31, 2016, was $224,485. Approximately $189,000 was used for new product development (mainly tooling/molds)
with the balance used to purchase various computer/software and various other asset purchases.
Cash used by financing activities for the three
months ended March 31, 2016, was $152,628 and consisted of: (1) net increased payments on the bank line of credit of $87,138; (2)
principal payments on long-term debt of $72,490; and (3) issuances of common stock of $7,000. No changes were made to the structure
of our debt during the first quarter of 2016. All scheduled payments were made on time.
CRITICAL ACCOUNTING POLICIES/ESTIMATES
We prepare our consolidated financial statements
in accordance with United States generally accepted accounting principles. We have identified the accounting policies below as
critical to our business operations and understanding of our results of operations. For a detailed discussion on the application
of these and other accounting policies, see the summarized significant accounting policies accompanying our audited consolidated
financial statements included in our Form 10-K filed on March 31, 2017. The application of these policies may require management
to make judgments and estimates that affect the reported amount of assets and liabilities, disclosure of contingent assets and
liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period.
Management uses historical experience and all available information to make these estimates and judgments, and different amounts
could be reported using different assumptions and estimates.
In our Form 10-K for the fiscal year ended December
31, 2016, our most critical accounting policies and estimates upon which our financial status depends were identified as those
relating to: revenue recognition, research and development costs, income taxes, impairment of long lived assets, intangible assets,
product warranties, prepaid expenses, and inventories and inventory reserves. We reviewed our policies and determined that those
policies remain our most critical accounting policies for the three months ended March 31, 2017.
OFF-BALANCE SHEET ARRANGEMENTS
We have no off-balance sheet arrangements that
have or are likely to have a current or future effect on our financial condition, revenues or expenses, results of operations,
liquidity, capital expenditures, or capital resources.