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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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Registrant's telephone number, including area code (913) 747-6111

Securities registered pursuant to Section 12(b) of the Act:

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Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $0.01 par value

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ◻   No ⌧

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes ◻   No ⌧

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ⌧ No ◻

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§229.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes  ⌧   No ◻

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of "large accelerated filer," "accelerated filer", "smaller reporting company", and “emerging growth company” in Rule 12b-2 of the Exchange Act.

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If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ◻ 

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Indicate by check mark whether the registrant has filed a report on and attestation to its management’s assessment of the effectiveness of its internal control over financial reporting under Section 404(b) of the Sarbanes-Oxley Act (15 U.S.C. 7262(b)) by the registered public accounting firm that prepared or issued its audit report.  ◻

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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ◻    No ⌧

The aggregate market value of the voting stock held by non-affiliates of the registrant, computed based on the closing sale price reported on the OTC Market-Pink on October 30, 2019, was $3,597,450. As of July 28, 2020, there were 5,995,750 shares of Common Stock outstanding.

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DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive Proxy Statement for its 2020 Annual Meeting of Shareholders to be filed within 120 days after the end of the registrant’s fiscal year, are incorporated by reference into Part III of this Annual Report.

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TOROTEL, INC. FORM 10-K

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Fiscal Year Ended April 30, 2020

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Forward-Looking Information

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This report, as well as our other reports filed with or furnished to the Securities and Exchange Commission (the “SEC”), contains 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”). The words “believe,” “estimate,” “anticipate,” “project,” “intend,” “expect,” “plan,” “outlook,” “forecast,” “may,” “should,” “predict” and similar expressions are intended to identify forward-looking statements. Statements regarding expectations, including performance assumptions and estimates relating to capital requirements, as well as other statements that are not historical facts, are forward-looking statements. This report contains forward-looking statements regarding, among other topics, our expected financial position, results of operations, cash flows, strategy, budgets and management's plans and objectives. Accordingly, these forward-looking statements are based on management’s judgments based on currently available information and assumptions about a number of important factors. While we believe that our assumptions about such factors are reasonable, such factors involve risks and uncertainties that could cause actual results to differ materially from those in the forward-looking statements. These risk factors include, without limitation:

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● disruption in our business, customers and suppliers in connection with COVID-19;

● economic, political and legislative factors that could impact defense spending;

● risks in fulfilling military subcontracts;

● our ability to finance operations;

● our on-going analysis of the effect on our financial position and results of operations from changes in tax law;

● ability to adequately pass through to customers unanticipated future increases in raw material and labor costs;

● delays in developing new products;

● markets for new products and the cost of developing new markets;

● expected orders that do not occur;

● our ability to adequately protect and safeguard our network infrastructure from cyber security vulnerabilities;

● our on-going ability to satisfy our debt covenant requirements and debt repayment obligations;

● our ability to generate sufficient taxable income to realize the amount of our deferred tax assets; and

● the impact of competition and price erosion as well as supply and manufacturing constraints.

In light of these risks and uncertainties, there can be no assurance that the forward-looking information contained in this report will prove accurate. Accordingly, our actual results may differ materially from these forward-looking statements. The reader should not place undue reliance on forward-looking statements, which speak only as of the date of this report. We assume no obligation to publicly update any forward-looking statements made herein to reflect events after the date of this report, including unforeseen events.

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customer within the representative's assigned territory. Torotel also utilizes its engineering department in its direct sales efforts for the purpose of expanding its reach into new markets and/or customers. Other sales methods may include visits to customers, lunch-and-learn presentations to customers' engineers, catalog brochures, trade show exhibits and speaker presentations at trade shows.

Torotel is an approved source for magnetic components used in numerous military and commercial aerospace systems, which means Torotel is automatically solicited for any procurement needs for such applications. The magnetic components manufactured by Torotel are sold primarily in the United States, and most sales are awarded on a competitive bid basis.

Torotel currently has a primary base of approximately 10 customers that together provide 95% of its annual sales volume. This customer base includes many large prime defense and commercial aerospace companies. Torotel’s primary strategy focuses on providing superior service to this core group of customers, including engineering support and new product design. The objective is to achieve growth with these customers or other targeted companies that possess the potential for inclusion into this core group. During fiscal year 2020, sales to a single customer accounted for 31%, and sales to another customer accounted for 28% of the net sales of Torotel. A loss of, or material reduction in orders from, these customers could have a material adverse effect on sales.

Competition

The markets in which Torotel competes are highly competitive. A substantial number of companies utilizing similar resources sell components and assemblies of the type manufactured and sold by Torotel. In addition, Torotel sells to a number of customers who have the capability of manufacturing their own electronic components.

The principal methods of competition for electronic products in the markets served by Torotel include, among other factors, price, on-time delivery performance, lead times, customized product engineering and technical support, marketing capabilities, quality assurance, manufacturing efficiency, and existing relationships with customers' engineers. While it is believed that magnetic components are not susceptible to rapid technological change, Torotel’s sales, which do not represent a significant share of the industry's market, are susceptible to decline given the competitive nature of the market.

Manufacturing

Nearly all of Torotel’s sales consist of electronic products manufactured to customers' specifications. Aside from contractually required finished goods buffers, only a limited amount of finished goods is maintained in our inventory. Although special wire-winding machines and molding machines are used in the production process, the various electronic products are manually assembled, with numerous employees and some subcontractors contributing to the completion of the products.

Essential materials used by Torotel in the manufacturing process include magnetic materials, copper wire, plastic housings and epoxies. We believe these materials are available from many sources. Major suppliers include MK Magnetics, Magnetic Metals-Western Division, EIS, Inc., Parkway Products, API Technologies Corporation, Krayden Inc., and Exxelia Dearborn, Inc. Special contact plates purchased from Fotofab, LLC and polycarbonate materials purchased from Florida Custom Mold and Spectrum Plastics are used in manufacturing the potted coil assembly. Fotofab, Florida Custom Mold, and Spectrum Plastics are the only qualified approved sources for the materials they provide. As a result, Torotel maintains contingent business interruption insurance on these three suppliers' facilities, as well as the customers' production facility, to insure against loss of business income associated with a disruption in production by either supplier or at the customer as a result of a fire, tornado, explosion or other similar type loss.

Torotel has not experienced any significant curtailment of production because of material shortages, but any long lead times or high dollar minimum orders could have an adverse impact on sales bookings.  Torotel does not experience seasonal variations in its business.

Governmental Regulations

A significant portion of Torotel’s business is derived from subcontracts with prime contractors of the U.S. government. As a U.S. subcontractor, Torotel is subject to federal contracting regulations. These subcontracts may be terminated at any time at the convenience of the U.S. government. Upon such termination, adequate financial compensation

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is usually provided in such instances to protect Torotel from suffering a loss on a subcontract. These subcontracts also may be terminated for default for failure to perform a material obligation. In the event of a termination for default, the customer may have the unilateral right at any time to require Torotel to pay the excess, if any, of the cost of purchasing a substitute item from a third party. If the customer has suffered other ascertainable damages as a result of a sustained default, the customer could demand payment of such damages. Torotel has never experienced any terminations for default.

As a supplier of products for military applications, Torotel must comply with laws concerning the export of material used exclusively for military purposes. The export of those types of materials is covered under the International Traffic in Arms Regulations ("ITAR") and the Arms Export Control Act ("AECA"). Torotel is licensed with the U.S. Department of State making it eligible to provide defense-related components pursuant to ITAR and AECA. This license is renewed annually each October.

Intellectual Property

The products sold by Torotel are not protected by patents or licenses. Torotel relies on the expertise of its employees in both the design and manufacture of its products. Because of the highly competitive nature of the industry, it is possible that a competitor may also learn to design and produce products with similar performance characteristics. Torotel has been issued U.S. Trademark Registration #1,123,071 for "TOROTEL". This trademark registration expires July 24, 2029.  

Environmental Laws

In fiscal year 2020, Torotel incurred costs of approximately $42,000 to ensure compliance with federal, state and local regulations on the proper handling, storage, disposal, and discharge of hazardous materials into the environment, or otherwise relating to the protection of employees, the community, and the environment. Torotel anticipates similar costs to be incurred in the fiscal year ending April 30, 2020.

Employees

Torotel presently employs approximately 170 full-time employees. We believe an adequate supply of qualified personnel is available in our immediate vicinity. Torotel's employees are not affiliated with any union.

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Torotel owns a 24,000 square foot building located at 620 N. Lindenwood Drive in Olathe, Kansas. This facility was previously held for sale through February 2019.  A lease between Torotel and a tenant commenced on September 25, 2018, and continues through December 31, 2023.  The tenant began occupying the building in February 2019.  Through December 31, 2020, the monthly base rate is $12,500, and subsequently through December 31, 2021, the monthly base rate is $13,500, escalating annually thereafter.  

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other safety precautions. We expect to continue these changes for the foreseeable future.  As a result of the pandemic, there is significant uncertainty around the U.S. and global economy, U.S. Department of Defense spending as a result of potential budget cuts, future customer demand, supply chain availability, oil price fluctuations, cash collections, and costs related to our changes to help ensure the safety and well-being of our employees.  Late in the fourth quarter of fiscal 2020, we have experienced lower commercial aerospace sales as a result of COVID-19. Due to this change in sales and the significant uncertainties outlined above in April 2020, we applied for a loan under the Paycheck Protection Program (the “PPP”) of the 2020 Coronavirus Aid, Relief and Economic Security Act (the “CARES Act”) administered by the Small Business Association.  On April 15, 2020, Torotel received $1.9 million in PPP funds. We intend to use these funds from this loan only for the purposes included in the PPP, including payroll, employee benefits, rent, utilities and interest on certain finance agreements (See Liquidity and Capital Resources).

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Business and Industry Considerations

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Defense Markets

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During fiscal year 2020 and fiscal year 2019, the amount of consolidated revenues derived from contracts with prime contractors of the U.S. Department of Defense (as previously defined, the “DoD”) was approximately 58% for both periods. Our financial results in any period could be impacted substantially by spending cuts in the DoD budget and the funds appropriated for certain military programs.   

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Despite ongoing uncertainty and potential constraints associated with the DoD budget, we believe our overall defense business outlook remains favorable due to the present demand for the potted coil assembly and other existing orders from major defense contractors. As of April 30, 2020, our consolidated order backlog for the defense market was $19.4 million, which included approximately $13.4 million for the potted coil assembly.

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Commercial Aerospace and Industrial Markets

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We provide magnetic components and electro-mechanical assemblies for a variety of applications in the commercial aerospace and industrial markets. The primary demand drivers for these markets include commercial aircraft production orders, oil and gas drilling exploration activity, and general economic growth.  Each of these could have an ongoing impact due to the effects of the pandemic on commercial aircraft production, oil prices and general economic turmoil and uncertainty.  Producers of commercial aircraft have announced a decrease in the production of multiple models of aircraft.  This reduction adversely impacted our commercial aerospace backlog and is expected to further impact our commercial aerospace business throughout fiscal year 2021.  Other threats to our near-term and long-term market outlook in these markets include delays on the development and production of new commercial aircraft and competition from international suppliers.  As of April 30, 2020, our consolidated order backlog for the aerospace and industrial markets was $3.7 million.

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Business Outlook

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Our backlog as of April 30, 2020 as compared to April 30, 2019 increased to $23.0 million from $14.7 million, a 56% increase.  This increase was driven primarily by growth in new programs.  We anticipate that net sales for fiscal year 2021 will remain consistent with fiscal year 2020.  This is primarily due to an expectation that a reduction of net sales within the commercial aerospace industry, may be offset by growth within the defense industry orders for our products.  We anticipate that 22% and 47% of our $23.0 million backlog as of April 30, 2020 is expected to ship and be converted to sales in the first quarter of fiscal 2021, and in the ensuing nine months of fiscal 2021, respectively.  As noted previously, there are multiple uncertainties within our business associated with the COVID-19 pandemic; however, we believe that our large sales backlog and current defense industry opportunities will help maintain a positive business outlook.

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Consolidated net sales in fiscal year 2020 increased $5,578,000, or 27%, as compared to fiscal year 2019, primarily due to higher demand for magnetic components and electro-mechanical assemblies.  The increase was expected as there were increases in new commercial aerospace products and advances in production automation of our magnetic components.

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Consolidated net sales in fiscal year 2019 increased $2,159,000, or 12%, as compared to fiscal year 2018, primarily due to higher demand for magnetic components and electro-mechanical assemblies along with the change in revenue recognition policy (described in Note 1).  The change in revenue recognition policy caused and impact of $1,104,000 increase from fiscal year 2018 to fiscal year 2019.  The increase was expected as a number of products had an increase in demand from customers.

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Gross profit as a percentage of net sales in fiscal year 2020 remained consistent at 34% when compared to fiscal year 2019. The gross profit percentage for fiscal year 2020 increased primarily due to higher demand for magnetic components and electro-mechanical assemblies and lower manufacturing costs and scrap.

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Gross profit as a percentage of net sales in fiscal year 2019 increased 8% as compared to fiscal year 2018.  The gross profit percentage for fiscal year 2019 increased primarily due to higher demand for magnetic components and electro-mechanical assemblies, lower manufacturing costs and scrap, and the change in revenue recognition policy (described in Note 1).  The change in the revenue recognition policy increased gross profit by $546,000 from fiscal year 2018 to fiscal year 2019.

Engineering expense increased 11%, or $146,000, in fiscal year 2020 as compared to fiscal year 2019. This increase primarily resulted from the hiring of additional engineers to provide expanded technical capabilities.

Engineering expense increased 22%, or $234,000, in fiscal year 2019 as compared to fiscal year 2018. This increase primarily resulted from the hiring of additional engineers to provide expanded technical capabilities.

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Selling, general and administrative expenses increased 36%, or $1,781,000, in fiscal year 2020 as compared to fiscal year 2019. The increase for administrative expenses in fiscal year 2020 primarily resulted from incurring transactional fees relating to the potential acquisition of Torotel in fiscal year 2020.  No transactional fees were incurred in fiscal year 2019.

Selling, general and administrative expenses decreased 2%, or $86,000, in fiscal year 2019 as compared to fiscal year 2018. The decrease resulted from a decrease in income tax expense.

For the reasons discussed in the Net Sales, Gross Profit, and Operating Expenses above, consolidated earnings from operations increased by $118,000, in fiscal year 2020 as compared to fiscal year 2019, and increased by $2,035,000, in fiscal year 2019 as compared to fiscal year 2018.

Interest expense decreased by 14%, or $16,000, in fiscal year 2020 as compared to fiscal year 2019, primarily due to lower levels of outstanding indebtedness for most of the year.  Income tax provision increased by $62,000 in fiscal year 2020 as compared to fiscal year 2019.

Interest expense increased by 51%, or $38,000, in fiscal year 2019 as compared to fiscal year 2018, primarily due to higher levels of outstanding indebtedness for most of the year.  Income tax provision decreased by $668,000 in fiscal year 2019 as compared to fiscal year 2018, with our income tax provision for fiscal year 2018 being related primarily to tax reform that became effective in January 2018 and an increase in deferred tax asset valuation allowance in fiscal year 2018, with no corresponding tax provisions for fiscal year 2019.

We evaluate the appropriateness of our deferred income tax asset valuation allowance on a quarterly basis and continue to consider positive and negative trends in our industry that affect our determination.  During the fourth quarter of fiscal year 2018, we determined we were no longer in a positive cumulative earnings position which is significant negative evidence indicating the need for a valuation allowance. As a result, we concluded it unlikely the full benefit of our deferred tax assets will more-likely-than-not be fully realized and our valuation allowance has been increased accordingly.   Our evaluation in fiscal years 2020 and 2019 were consistent with our 2018 conclusions.  See Note 6 in the consolidated financial statements for further details.

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Financial Condition and Liquidity

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The following table highlights the funds available to us as of April 30, 2020 and 2019:

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Operating Activities

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The increase of $2,257,000 of net cash provided by operating activities between fiscal year 2020 and fiscal year 2019 is primarily due to increases in operating ROU assets, inventories and trade accounts payable.  

Investing Activities

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The increase of $357,000 of net cash used in investing activities during fiscal year 2020 as compared to fiscal year 2019 was due to an increase in capital expenditures in fiscal year 2020 as compared to fiscal year 2019.  We expect capital expenditure spending will continue to increase during fiscal year 2021 as compared to fiscal year 2020.

Financing Activities

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The increase of $822,000 in net cash used in financing activities between fiscal year 2020 and fiscal year 2019 is due to an increase in loan proceeds during fiscal year 2020.  

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Off-Balance Sheet Arrangements

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There are no off-balance sheet arrangements.

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Critical Accounting Policies

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The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect certain reported amounts and disclosures. Such judgments affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. We continuously evaluate our estimates and assumptions including those related to computing the carrying value of equipment, allowance for doubtful accounts receivable, the valuation allowance on deferred tax assets and the reserve for warranty costs. Accordingly, actual results could differ from those estimates, and such differences may be material. Any changes in estimates are recorded in the period in which they become known.  As previously described in the “Information” section, there are several risks and uncertainties which could impact our estimates.  Management continues to monitor the pandemic and adjust estimates as deemed appropriate.

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The following is a summary of the most critical accounting policies used in the preparation of our consolidated financial statements.

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Leases

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The Company adopted the guidance of ASU No. 2016-02, Leases, (“ASC 842”) as of May 1, 2019 using the modified retrospective transition approach with the cumulative effect recognized at the date of initial application. The comparative information in the prior year has not been adjusted and continues to be reported under ASC 840, Leases, which was the accounting standard in effect for that period. ASC 842 requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements. The new standard establishes a right-of-use model (“ROU”) that requires a lessee to recognize a ROU asset and lease liability on the balance sheet for all leases with a term longer than 12 months. Leases are classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the statement of operations and presentation of cash flows. See Note 4—Leases for the required disclosures of the nature, amount, timing, and uncertainty of cash flows arising from leases.

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Revenue Recognition

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We determine revenue recognition through the following steps:

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Performance Obligations Satisfied Over Time

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We recognize revenue on agreements for the sale of customized goods including magnetic components, consisting of transformers, inductors, reactors, chokes, toroidal coils, high voltage transformers, dry-type transformers and electro-mechanical assemblies for use in commercial aerospace and military electronics on an over time basis.

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Commercial Aerospace and Defense Parts

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Performance obligations under long-term agreements are considered to be under contract at the time that authorization to ship has been obtained from the customer, except for one long-term agreement which provides a contract for two specific parts if the ship date is within 21 days. Performance obligations under standalone purchase orders are considered to be under contract at the time that the purchase order is received. Parts manufactured for customers in our aerospace and defense product revenue stream must be built to certain

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specifications that are then qualified by the customer. Due to the proprietary nature of our custom-built products designed for a specific use by our aerospace and defense customers, control is considered to be with the customer as the products are finalized and placed into finished goods. Goods within this revenue stream do not provide simultaneous receipt and benefit to the customer. The goods are controlled by our customers once the finished parts are created. The customers prevent any alternative use of the asset and an enforceable right to payment does exist. We provide for potential losses on any of these agreements when it is probable that we will incur the loss.

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Our billing terms for these over-time contracts vary, but are generally based on ship date.  Control is transferred as products are completed and closed to finished goods.

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Product fees and engineering and design services

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For product fees along with engineering and design services, transfer of control is determined by the revenue stream of the associated product. Percentage-of-completion revenue recognition is utilized when revenue recognized exceeds the amount billed to the customer for any project-related services, utilizing labor as the input method.

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Performance Obligations Satisfied at a Point in Time

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We recognize revenue on agreements for the sale of customized goods including magnetic components, consisting of transformers, inductors, reactors, chokes, toroidal coils, high voltage transformers, dry-type transformers and electro-mechanical assemblies for use in the industrial and commercial market on point in time basis.

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Industrial and Commercial Parts

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Performance obligations under long-term agreements are considered to be under contract at the time that authorization to ship has been obtained from the customer. Performance obligations under standalone purchase orders are considered to be under contract at the time that the purchase order is received. For our commercial customers, control of the underlying product design is retained by Torotel, therefore the products are considered in our control until the moment of shipment. Also, upon shipment the customers have an obligation to pay for the asset and we have an enforceable right to payment. We provide for potential losses on any of these agreements when it is probable that we will incur the loss.

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Our billing terms for these point in time sales are generally based on ship date.  Control is transferred as products are shipped to the customers.

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Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer, are excluded from revenue.  Shipping and handling costs do not have a material impact to the financial statements.  No impairment losses were recognized in fiscal years 2020 and 2019 relating to receivables or contract assets arising from contracts with customers.

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Allowance for Doubtful Accounts

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Gross trade accounts receivable are offset with an allowance for doubtful accounts. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable. We review the allowance for doubtful accounts on a regular basis, and all past due balances are reviewed individually for collectability. Account balances are charged against the allowance when placed for collection. Recoveries of receivables previously written off are recorded when received. The majority of the customer accounts are considered past due after the invoice becomes older than the customer's normal credit terms. Interest is not charged on past due accounts. The allowance for doubtful accounts was $41,000 and $12,000 at the end of fiscal year 2020 and 2019, respectively.

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Inventories

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Inventories are stated at the lower of cost or net realizable value. Cost is determined using a FIFO approximated weighted average costing method of valuation. Our industry is characterized by short-term customer commitments and changes in demand, as well as other market considerations. Provisions for obsolete and excess inventory are based on reviews of inventory usage, quantities on hand and latest product demand information from customers. Inventories are reviewed in detail utilizing a 12-month time horizon. Individual part numbers that have not had any usage or purchases in a 12-month time period and do not have any known usage requirements are categorized as obsolete; individual part numbers having more than a 12-month supply based on the current year's usage are categorized as excess. Once specific inventory has been identified as excess or obsolete, the cost of the identified inventory is fully reserved and the cost of the inventory is not recovered until it is sold. The reserve balance is analyzed for adequacy as part of the inventory review each quarter.

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Income Taxes

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Our annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax rate and in evaluating our tax positions. An estimated effective tax rate for a year is applied to our quarterly operating results. In the event there is a significant or unusual item recognized in our quarterly operating results, the tax attributable to that item is separately calculated and recorded at the same time as that item. Tax law requires items to be included in our tax returns at different times than the items are reflected in our financial statements. As a result, our annual tax rate reflected in our financial statements is different than that reported in our tax returns (our cash tax rate). Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax returns in future years for which we have already recorded the tax benefit in our income statement. We establish valuation allowances for our deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expense for which we have already taken a deduction in our tax return but have not yet recognized as expense in our financial statements. The accounting for uncertainty in income taxes requires a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. If necessary, we record a liability for the difference between the benefit recognized and measured for financial statement purposes and the tax position taken or expected to be taken on our tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. If applicable in a given year, tax-related interest and penalties are classified as a component of income tax expense.

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Report Of Independent

Registered Public Accounting Firm

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Shareholders and Board of Directors

Torotel, Inc.

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Opinion On The Financial Statements

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We have audited the accompanying consolidated balance sheets of Torotel, Inc. and subsidiary (collectively, the Company) as of April 30, 2020 and 2019, the related consolidated statements of operations, changes in stockholders’ equity, and cash flows, for each of the two years in the period ended April 30, 2020 and the related notes (collectively referred to as the financial statements). In our opinion, the financial statements present fairly, in all material respects, the financial position of the Company as of April 30, 2020 and 2019, and the results of its operations and its cash flows for each of the two years in the period ended April 30, 2020, in conformity with accounting principles generally accepted in the United States of America.

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Adoption of New Accounting Pronouncements

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As discussed in Notes 1 and 4 to the consolidated financial statements, the Company changed its method of accounting for leases beginning on May 1, 2019 due to the adoption of ASC Topic 842, Leases.

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Basis For Opinion

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These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

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We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We believe that our audits provide a reasonable basis for our opinion.

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/s/ RubinBrown LLP

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We have served as the Company's auditor since 2012.

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Kansas City, Missouri

July 28, 2020

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The accompanying notes are an integral part of these statements.

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The accompanying notes are an integral part of these statements.

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The accompanying notes are an integral part of these statements.

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The accompanying notes are an integral part of these statements.

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TOROTEL, INC.

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Performance Obligations Satisfied Over Time

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We recognize revenue on agreements for the sale of customized goods including magnetic components, consisting of transformers, inductors, reactors, chokes, toroidal coils, high voltage transformers, dry-type transformers and electro-mechanical assemblies for use in commercial aerospace and military electronics on an over time basis.

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Commercial Aerospace and Defense Parts

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Performance obligations under long-term agreements are considered to be under contract at the time that authorization to ship has been obtained from the customer, except for one long-term agreement which provides a contract for two specific parts if the ship date is within 21 days. Performance obligations under standalone

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purchase orders are considered to be under contract at the time that the purchase order is received. Parts manufactured for customers in our aerospace and defense product revenue stream must be built to certain specifications that are then qualified by the customer. Due to the proprietary nature of our custom-built products designed for a specific use by our aerospace and defense customers, control is considered to be with the customer as the products are finalized and placed into finished goods. Goods within this revenue stream do not provide simultaneous receipt and benefit to the customer. The goods are controlled by our customers once the finished parts are created. The customers prevent any alternative use of the asset and an enforceable right to payment does exist. We provide for potential losses on any of these agreements when it is probable that we will incur the loss.

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Our billing terms for these over-time contracts vary, but are generally based on ship date.  Control is transferred as products are completed and closed to finished goods.

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Product fees and engineering and design services

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For product fees along with engineering and design services, transfer of control is determined by the revenue stream of the associated product. Percentage-of-completion revenue recognition is utilized when revenue recognized exceeds the amount billed to the customer for any project-related services, utilizing labor as the input method.

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Performance Obligations Satisfied at a Point in Time

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We recognize revenue on agreements for the sale of customized goods for use in the industrial and commercial market on point in time basis.

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Industrial and Commercial Parts

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Performance obligations under long-term agreements are considered to be under contract at the time that authorization to ship has been obtained from the customer. Performance obligations under standalone purchase orders are considered to be under contract at the time that the purchase order is received. For our commercial customers, control of the underlying product design is retained by Torotel, therefore the products are considered in our control until the moment of shipment. Also, upon shipment the customers have an obligation to pay for the asset and we have an enforceable right to payment. We provide for potential losses on any of these agreements when it is probable that we will incur the loss.

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Our billing terms for these point in time sales are generally based on ship date.  Control is transferred as products are shipped to the customers.

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Taxes assessed by a governmental authority that are both imposed on and concurrent with a specific revenue-producing transaction, that are collected by the Company from a customer, are excluded from revenue.  Shipping and handling costs do not have a material impact to the financial statements.  No impairment losses were recognized in fiscal year 2020 relating to receivables or contract assets arising from contracts with customers.

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Allowance for Doubtful Accounts

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Gross trade accounts receivable are offset with an allowance for doubtful accounts. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable. We review the allowance for doubtful accounts on a regular basis, and all past due balances are reviewed individually for collectability. Account balances are charged against the allowance when placed for collection. Recoveries of receivables previously written off are recorded when received. The majority of the customer accounts are considered past due after the invoice becomes older than the customer's credit terms. Interest is not charged on past due accounts. The allowance for doubtful accounts as of  April 30, 2020 and 2019 was $41,000 and $12,000, respectively.

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Inventories

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Inventories are stated at the lower of cost or net realizable value. Cost is determined using a FIFO approximated weighted average cost method of valuation. Our industry is characterized by short-term customer commitments and changes in demand, as well as other market considerations. Provisions for obsolete and excess inventory are based on reviews of inventory usage, quantities on hand and latest product demand information from customers. Inventories are reviewed in detail utilizing a 12-month time horizon. Individual part numbers that have not had any usage or purchases in a 12-month time period and do not have any known usage requirements are categorized as obsolete; individual part numbers having more than a 12-month supply based on the current year's usage are categorized as excess. Once specific inventory has been identified as excess or obsolete, the cost of the identified inventory is fully reserved and the cost of the inventory is not recovered until it is sold. The reserve balance is analyzed for adequacy as part of the inventory review each quarter.  The reserve for inventory as of April 30, 2020 and 2019 was $406,000 and $332,000, respectively.

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Property, Plant and Equipment

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               Property, plant and equipment are carried at cost. Depreciation and amortization are provided in amounts sufficient to relate the costs of depreciable assets to operations primarily using the straight-line method over estimated useful lives of three to ten years for equipment and three and a half to twenty years for buildings and improvements.

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Cash

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For purposes of the consolidated statements of cash flows, we consider all short-term investments and demand deposits purchased with original maturity dates of three months or less to be cash.

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Income Taxes

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Our annual tax rate is based on our income, statutory tax rates and tax planning opportunities available to us in the various jurisdictions in which we operate. Significant judgment is required in determining our annual tax rate and in evaluating our tax positions. An estimated effective tax rate for a year is applied to our quarterly operating results. In the event there is a significant or unusual item recognized in our quarterly operating results, the tax attributable to that item is separately calculated and recorded at the same time as that item. Tax law requires items to be included in our tax returns at different times than the items are reflected in our financial statements. As a result, our annual tax rate reflected in our financial statements is different than that reported in our tax returns (our cash tax rate). Some of these differences are permanent, such as expenses that are not deductible in our tax return, and some differences reverse over time, such as depreciation expense. These temporary differences create deferred tax assets and liabilities. Deferred tax assets generally represent items that can be used as a tax deduction or credit in our tax returns in future years for which we have already recorded the tax benefit in our statement of operations. We establish valuation allowances for our deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax liabilities generally represent tax expense recognized in our financial statements for which payment has been deferred, or expense for which we have already taken a deduction in our tax return but have not yet recognized as expense in our financial statements. The accounting for uncertainty in income taxes requires a more-likely-than-not threshold for financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. If necessary, we record a liability for the difference between the benefit recognized and measured for financial statement purposes and the tax position taken or expected to be taken on our tax return. To the extent that our assessment of such tax positions changes, the change in estimate is recorded in the period in which the determination is made. If applicable in a given year, tax-related interest and penalties are classified as a component of income tax expense.  

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Advertising Costs

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Advertising costs are expensed as incurred. For the year ended April 30, 2020 advertising costs were $9,000.  For the year ended April 30, 2019 there were no advertising costs.

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Warranty Costs

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We maintain a reserve for estimated warranty costs associated with products returned from customers. A limited warranty is provided for a period of one year which requires us to repair or replace defective products at no cost to the customer. The warranty reserve is based on historical experience and reflects management's best estimate of probable liability under the product warranties.

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Share-Based Compensation

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We have a share-based compensation plan that provides for awards of restricted stock, which is described more fully in Note 8 of the Notes to the Consolidated Financial Statements. We account for the share-based compensation plan in accordance with authoritative guidance under which the estimated fair value of share-based awards granted under our share-based compensation plan is recognized as compensation expense over the vesting period of the award.

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Paycheck Protection Program

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We received funding from the Small Business Administration relating to the Paycheck Protection Program in the amount of $1,985,000 through a promissory note.  The loan and the related interest are recorded as a financial liability.  As of April 30, 2020, we have not obtained sufficient reasonable assurance that forgiveness conditions have been satisfied.  For subsequent reporting periods, we will reevaluate if there is reasonable assurance that forgiveness conditions have been satisfied. Upon obtaining reasonable assurance that the forgiveness conditions have been satisfied, the earnings will be recorded on a systematic basis over the periods in which we recognize the expenses for which the funds are intended to compensate.  In April 2020, we incurred $440,000 of eligible Paycheck Protection Program expenses.  These expenses are classified as nondeductible for income tax purposes and are recorded as permanent differences.

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Accounting Pronouncements Recently Adopted

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The Company adopted the guidance of ASU No. 2016-02, Leases, (“ASC 842”) as of May 1, 2019 using the modified retrospective transition approach with the cumulative effect recognized at the date of initial application. The comparative information in the prior year has not been adjusted and continues to be reported under ASC 840, Leases, which was the accounting standard in effect for that period. ASC 842 requires lessees to recognize leases on-balance sheet and disclose key information about leasing arrangements. The new standard establishes a right-of-use model (“ROU”) that requires a lessee to recognize a ROU asset and lease liability on the balance sheet for all leases with a term longer than 12 months. Leases are classified as finance or operating, with classification affecting the pattern and classification of expense recognition in the statement of operations and presentation of cash flows. See Note 4—Leases for the required disclosures of the nature, amount, timing, and uncertainty of cash flows arising from leases.

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Accounting Pronouncements Issued, Not Yet Adopted

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In June 2016, the FASB issued ASU No. 2016-13 Measurement of Credit Losses on Financial Instruments. Under this guidance, a financial asset is required to be measured at amortized cost basis to be presented at the net amount expected to be collected.  The allowance for credit losses is a valuation account that is deducted from the amortized cost basis of the financial asset to present the net carrying value at the amount expected to be collected on the financial asset.  The measurement of expected credit losses will be based on current, historical, and forecasted information that impacts the collectability of the reported amount.  Additional disclosures will be required to provide information regarding significant estimates and judgments used in estimating credit losses, as well as the credit quality and underwriting standards of an organization's portfolio.  The original effective date for this guidance, including subsequently issued amendments, was for fiscal years beginning after December 15, 2020 and interim periods within those fiscal years. In November 2019, the FASB deferred the effective date of this guidance to fiscal years beginning after December 15, 2022, including interim periods within those fiscal years.  We are currently evaluating this guidance.

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In December 2019, the FASB issued ASU No. 2019-12, Income Taxes (Topic 740): Simplifying the Accounting for Income Taxes.  This update removes certain exceptions and implements new requirements to help simplify the accounting for income taxes. This guidance is effective for fiscal years beginning after December 15, 2020. We are currently evaluating this guidance.

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All other new accounting standards and updates of existing standards issued through the date of this filing were considered by management and did not relate to accounting policies and procedures pertinent to us at this time or were not expected to have a material impact to the consolidated financial statements.

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NOTE 2—INVENTORIES

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The following table summarizes the components of inventories, as of April 30 of each year:

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Torotel currently has a primary base of approximately 10 customers that historically provide nearly 95% of its annual sales volume.  Sales to two major customers as a percentage of consolidated net sales for the fiscal year ended April 30, 2020 was 31% and 28% respectively. Sales to two major customers as a percentage of consolidated net sales for the fiscal year ended April 30, 2019 was 30% and 21% respectively. Trade receivables from three major customers as a percentage of consolidated net trade receivables for the fiscal year ended April 30, 2020 was 48%. Trade receivables from one major customer as a percentage of consolidated net trade receivables for the fiscal year ended April 30, 2019 was 15%.

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Contract balances

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All receivable balances relate to customer contracts entered into during the fiscal year 2020.  We have no contract liabilities other than customer deposits which represent prepaid consideration for contracts with customers (see Note 13).  There have been no significant adjustments to contract asset balances related to contract modifications.  In fiscal year 2020 and 2019, we had certain customers totaling revenue of $7,973,000 and $4,301,000, respectively, with variable payment terms related to discounts in the amount of $59,000 and $32,000, respectively.

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Remaining performance obligation

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As of April 30, 2020, the aggregate amount of the contracted revenues allocated to our unsatisfied (or partially unsatisfied) performance obligations was $10,726,000. The balance of unsatisfied performance obligations excludes contracts with original maturities of one year or less.  We expect to recognize revenue as we satisfy our remaining performance obligations.  Total remaining performance obligation to be recognized in fiscal year 2021 is expected to be $4,659,000.  Total remaining performance obligation to be recognized in fiscal year 2022 is expected to be $6,067,000.

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As of April 30, 2019, the aggregate amount of the contracted revenues allocated to our unsatisfied (or partially unsatisfied) performance obligations was $4,591,000. The balance of unsatisfied performance obligations excludes contracts with original maturities of one year or less.  We expect to recognize revenue as we satisfy our remaining performance obligations.  Total remaining performance obligation to be recognized in fiscal year 2020 is expected to be $4,571,000.  Total remaining performance obligation to be recognized in fiscal year 2021 is expected to be $20,000.

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NOTE 4—LEASES

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The Company adopted ASC 842 on May 1, 2019 using the modified retrospective transition method; and therefore, the comparative information has not been adjusted for the year ended April 30, 2019. Upon transition to the new standard, the Company elected the package of practical expedients, which permitted the Company not to reassess under the new standard its prior conclusions about lease identification, lease classification and initial direct costs.

The Company leases buildings and equipment under operating and finance leases. The majority of the Company’s operations are conducted in premises occupied under lease agreements with initial base terms ranging from 5 to 15 years, with certain leases containing options to extend the leases for up to an additional 10 years. The Company typically does not believe that exercise of the renewal options is reasonably assured at the inception of the lease agreements and, therefore, considers the initial base term as the lease term. Lease terms vary but generally the leases provide for fixed and escalating rentals or contingent escalating rentals based on the Consumer Price Index.

Operating lease ROU assets and lease liabilities were recognized at commencement date based on the present value of minimum lease payments over the remaining lease term less the balance of our ASC 840 deferred rent liability. The minimum lease payments include base rent payments. The Company’s leases have remaining lease terms of approximately 1 year to 7 years, with an option to extend the lease. The present value of the lease payments is calculated using the incremental borrowing rate for operating leases, which was determined using a portfolio approach based on the rate of interest that the Company would have to pay to borrow an amount equal to the lease payments on a collateralized basis over a similar term. Operating lease expense is recognized on a straight-line basis over the lease term.

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The Company’s lease agreements do not contain any material residual value guarantees. The Company elected the practical expedient to not separate lease and non-lease components and also elected the short-term practical expedient for all leases that qualify. As a result, the Company will not recognize ROU assets or liabilities for short-term leases that qualify for the short-term practical expedient, but instead will recognize the lease payments as lease cost on a straight-line basis over the lease term.

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As a result of adopting ASC 842, the Company’s consolidated balance sheet includes additional operating ROU lease assets and total operating lease liabilities of $2,008,000 and $2,274,000, respectively, at April 30, 2020. The initial measurement occurring on May 1, 2019, resulted in operating lease ROU assets of $2,267,000, finance lease ROU assets of $98,000, current operating lease liabilities of $380,000, current finance lease liabilities of $73,000, noncurrent operating lease liabilities of $2,093,000, and noncurrent finance lease liabilities of $25,000. The difference of $206,000 between the ROU assets and the lease liabilities results from a reclassification of deferred rent to the operating lease ROU asset of $206,000.

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The following table provides the operating and finance ROU assets and lease liabilities at April 30:

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The components of lease expense were as follows at April 30:

The supplemental components of cash flows were as follows at April 30:

The following table represents the weighted-average remaining lease term and discount rate as of April 30, 2020:

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