UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

or

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 0-9318

SHOPSMITH, INC.

Registrant’s telephone number, including area code: (937) 898-6070

     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. [X] Yes [  ] No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date.

Common shares, without par value: 2,605,233 shares as of July 21, 2004.

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SHOPSMITH, INC. AND SUBSIDIARIES

INDEX

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Part I – FINANCIAL INFORMATION

Item 1. Financial Statements

SHOPSMITH, INC. AND SUBSIDIARIES

Continued

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SHOPSMITH, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

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SHOPSMITH, INC. AND SUBSIDIARIES

See notes to consolidated financial statements.

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SHOPSMITH, INC. AND SUBSIDIARIES

See notes to consolidated financial statements.

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SHOPSMITH, INC. AND SUBSIDIARIES

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

MANAGEMENT’S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

GENERAL

Shopsmith manufactures and sells woodworking products. Our core product, the Mark V, is sold directly to consumers through demonstration sales events and indirectly to consumers through distributors (primarily Lowe’s where Shopsmith also conducts sales demonstrations) along with smaller amounts through other efforts. Mark V sales demonstrations are performed in shopping malls, at home shows, and at state fairs. Other woodworking products and accessories are sold through mail and internet channels. Shopsmith recognizes revenue for these orders at the time of product shipment.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The financial condition and results of operations for Shopsmith presented in the Consolidated Financial Statements, accompanying notes , and management’s discussion and analysis are dependent upon the Company’s accounting policies. The selection and application of these accounting policies involve judgments, estimates, and uncertainties that are susceptible to change. The Company’s significant accounting policies are discussed in Note 2 of the notes to the Consolidated Financial Statements included in the Company’s annual report to shareholders for the year ended April 3, 2004. In management’s opinion, the Company’s critical accounting policies include the allowance for doubtful accounts, accrued recourse liability and deferred tax valuation allowance.

Allowance For Doubtful Accounts

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. Customer accounts are stratified by type of account, original credit rating, and recent payment history. Estimated loss rates are then applied to these groups. Deterioration of our customers’ ability to make payments could require additions to the allowance.

Accounts repurchased under the recourse provision, discussed below, are carried in trade accounts receivable, net of an allowance for doubtful accounts, while the Company attempts to collect them.

Accrued Recourse Liability

Certain retail installment contracts sold to financial institutions through the fiscal year ended March 31, 2001 included a recourse provision. Under this recourse provision, Shopsmith is obligated to purchase the installment contract if the customer defaults on their obligation to the financial institution. The Company’s liability for future recourse obligations has been estimated using factors based on the value and rate of change of the value of the outstanding accounts, the rate and changes in the rate of repurchases required under the recourse provision, as well as estimates of amounts collectable after the accounts are repurchased. If these factors would deteriorate, additional accruals would be necessary and would affect future operating results. The Company will be required to adopt Statement of Position 03-03 in April 2006. At that time, purchase of loans under a recourse provision will be recorded at fair value at repurchase date, instead of gross less an allowance for doubtful accounts.

Deferred Tax Valuation Allowance

The Company has recorded a full valuation allowance against its net deferred tax assets based on its evaluation of the realizability of the future tax benefits of deferred tax assets. The effect of the allowance is to reduce to zero the carrying value of the potential tax benefit arising from the possibility of offsetting the Company’s cumulative operating losses against future taxable income.

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Results of Operations

Fiscal 2005 first quarter sales decreased to $2,787,000, or 10.5%, from $3,113,000 during the same period a year ago. This decrease in the first quarter occurred primarily in our demonstration event Mark V sales.

Gross margin rates for the fiscal 2005 first quarter increased by 0.75 percentage points compared to the same period last year. Operating expenses increased by $208,000 to $1,840,000 in the fiscal 2005 first quarter from $1,632,000 in last year’s first quarter. The most significant reason for the increase in operating expenses was an increased expenditure on sales representative training costs. Training was done to both increase the number of Mark V sales representatives, as well as to increase the effectiveness of existing sales representatives.

Provisions for recoverable federal income taxes are based on estimated annual effective rates, less a valuation allowance. No tax benefit is reported for the quarters ended July 3, 2004 and July 5, 2003, as it was offset by a change in valuation allowance.

With the reduction in sales and increased operating expenses, the Company recorded a net loss of $457,000, or $.18 per diluted share, in the quarter ended July 3, 2004, compared to a net loss of $124,000, or $.05 per diluted share, for the same period of last year.

Liquidity and Financial Position

Cash used in operations totaled $218,000 for the quarter ended July 3, 2004, compared with $360,000 for the same period of the preceding year. On June 29, 2004,the Company refinanced a mortgage note on its building with a balance of $2,356,000 with a mortgage note from Provident Bank in the amount of $2,000,000. $615,000 was also borrowed on the Company’s revolving line of credit during the first quarter of fiscal 2005, of which $356,000 was used to reduce the above note prior to refinancing. Interest on this new mortgage note is at one-quarter percent over the bank’s prime rate. The note requires monthly payment of interest and from $8,000 to $10,000 of principal. In August 2009, the remaining balance of approximately $1,477,000 will become due.

On December 31, 2002, Shopsmith entered into a line of credit agreement with Provident Bank. On June 29, 2004, this agreement was amended to allow borrowings up to $1,000,000, down from $1,400,000 available from the previous amendment. The agreement requires compliance with certain net income, net worth, and miscellaneous covenants. Substantially all personal property is pledged as collateral. At July 3, 2004, $615,000 was outstanding under this agreement.

Both the mortgage agreement and the Company’s line of credit agreement with Provident Bank require compliance with certain net income, net worth, and miscellaneous covenants. As of July 3, 2004, the Company was not in compliance with the net worth and fixed charge covenants of these agreements. The covenants required a consolidated tangible net worth of not less than $1,800,000 and a fixed charge coverage ratio at all times greater than 1.2:1 on a rolling twelve month basis. At July 3, 2004, the Company has a consolidated tangible net worth of $1,668,796 and a fixed charge coverage ratio of 0.6:1. The Company has reached agreement with Provident Bank to waive the violation of the covenants and to amend the covenants going forward. The amended covenants require a consolidated tangible net worth of not less than $1,450,000 and a fixed charge coverage ratio of 1.1:1 on a quarterly basis. The Company expects to remain in compliance with its amended covenants through the remainder of fiscal 2005 as well as through June 2005.

The current ratio was 1.16 to 1 at July 3, 2004 and 1.47 to 1 at April 3, 2004. The debt to equity ratio increased to 2.84 to 1 from 2.15 to 1 at April 3, 2004.

The Company believes that profitability is critical to ensuring adequate liquidity in both the current and future fiscal years.

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Contractual Obligations

Forward Looking Statements

The foregoing discussion and the Company’s consolidated financial statements contain certain forward-looking statements that involve risks and uncertainties, including but not limited to the following: (i) the operating cash flows together with currently available working capital may be inadequate to finance the operating needs of the Company; (ii) cancellation by Lowe’s of the in-store sales program; (iii) the Company may fail to meet the amended financial covenants contained in its Loan Agreements dated December 31, 2002 and June 29, 2004 with Provident Bank, in which event the bank may declare all amounts owed by the Company to the bank to be immediately due and payable; and (iv) actual losses related to doubtful accounts and recourse liabilities (discussed under Critical Accounting Policies and Estimates) may exceed current estimates.

Item 3. Defaults Upon Senior Securities.

See “Liquidity and Financial Position” in Item 2 above for a discussion of certain violations by the Company under financial covenants contained in the loan agreements to which the Company is a party. The lender has agreed to waive the violations.

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Item 4. Controls and Procedures.

(a) Evaluation of Disclosure Controls and Procedures

     The Company’s Chairman and Chief Executive Officer, John R. Folkerth, and the Company’s Chief Financial Officer, Mark A. May, have evaluated the Company’s disclosure controls and procedures within 90 days of the filing of this report. Messrs. Folkerth and May have concluded that the Company’s disclosure controls and procedures are functioning effectively to provide reasonable assurance that the Company can meet its disclosure obligations. The reporting process is designed to ensure that information required to be disclosed by the Company in the reports that it files or submits with the Commission is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms.

(b) Changes in Internal Controls

     There were no significant changes in the Company’s internal controls over financial reporting that could materially affect these controls subsequent to the date of the above reference evaluation.

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PART II. OTHER INFORMATION

Item 2. Changes in Securities and Use of Proceeds

     The Loan Agreement between the Company and Provident Bank prohibits the payment of dividends.

Item 6. Exhibits and Reports on Form 8-K

     (a) Exhibits:

     (b) Reports on Form 8-K:

     During the quarter ended July 3, 2004, the Company filed the following report on Form 8-K:

A Form 8-K filed on June 21, 2004 included the text of the Company’s press release reporting the results of its operations for the year ended April 3, 2004.

SIGNATURES

     Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

Date: August 17, 2004

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