ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our plan of operation should be read in conjunction with the financial statements and related notes that appear elsewhere in this Form 10-Q and the Company’s Annual Report on Form 10-K for the year ended December 31, 2014.

Certain statements in this Form 10-Q constitute “forward-looking statements.”  Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Factors that might cause such a difference include, among others, uncertainties relating to general economic and business conditions; industry trends; receipt or denial of marketing approval from the FDA and similar agencies; receipt or denial of reimbursement from government agencies and insurance companies; changes in demand for our products and services; uncertainties relating to customer plans and commitments and the timing of orders received from customers; announcements or changes in our pricing policies or that of our competitors; unanticipated delays in the development, market acceptance or installation of our products and services; changes in government regulations; availability of management and other key personnel; availability, terms and deployment of capital; relationships with third-party equipment suppliers; and worldwide political stability and economic growth. The words "believe", "expect", "anticipate", “will”, "intend" and "plan" and similar expressions identify forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date the statement was made. We undertake no obligation to update such statements to reflect events that occur or circumstances that exist after the date on which they are made.

Overview

Fresh Medical Laboratories, Inc. was incorporated under the laws of the State of Delaware on November 19, 2004 and does business under the trade name ProLungdx®. We are a medical device company that is developing, testing and commercializing its non-invasive lung cancer risk stratification test (the “Electro Pulmonary Nodule Scan” or “EPN Scan,”).  The EPN Scan is adjunctive to Computed Tomography (“CT”), or what is commonly referred to as a “CT scan” of the chest.  The EPN Scan assists in evaluating the risk associated with a CT finding in the lung that is suspicious for cancer.

As many patients at high risk of lung cancer have suspicious lung findings when evaluated by CT, clarifying the risk of the disease, or risk stratification, has the potential to reduce the cost, anxiety, and/or time associated with the inaccurate and/or delayed diagnosis of lung cancer.  Risk stratification may also play a role in identifying those patients who need to modulate the extent and frequency of follow-up.  On December 31, 2013, the U.S. Preventative Services Task Force recommended CT screening guidelines for lung cancer in adults aged 55 to 80 who have a 30 pack-year history and currently smoke or have quit smoking in the past 15 years.  This guideline is expected to increase the number of patients with suspicious findings in the lung that may be candidates for the EPN Scan.

On May 10, 2013, the EPN Scan received the “CE” mark in Europe for its Electro Pulmonary Nodule Scanner and Probe.  This marking is regulatory approval that clears the marketing and sale of the EPN Scan in the European Economic Area and European Free Trade Association Countries representing 509 million individuals and 31 member states.  The new screening guidelines and Medicare coverage recently announced in the U.S. for lung cancer screening are not available in Europe.

In the United States, we have submitted an application for marketing approval under Section 510(k) from the United States Food and Drug Administration, or FDA.  On February 27, 2015, we received a review letter from the FDA identifying a number of issues, concerns and weaknesses in our application, including the risk classification of the test, the study design and study analysis along with what we consider other less important questions.  On July 16, 2015, we met with the FDA to clarify and refine our understanding of the issues related to our pending application.  Before the FDA can grant approval of our application, we must resolve or negotiate the removal of all issues identified by the FDA and address possible issues to be identified in the future. Certain completed studies address some of the issues identified by the FDA, and we responded to the FDA regarding certain outstanding issues by August 27, 2015.  As of August 27, 2015, the Company, in consultation with the FDA, determined that the remaining issues would require additional time for submission.  Consequently, the device would undergo an automatic withdrawal followed by a re-application once the requested data was available for submission.  The Company is now preparing a response.  According to draft FDA guidelines, a response may be expected in up to 120 days from our submission.

From inception to date, we have generated limited revenues.  During the year ended December 31, 2014, we commenced selling the EPN Scan to customers in the European Union.

15

We plan to continue the development and deployment of medical devices and procedures specializing in the immediate, non-invasive evaluation of indeterminate masses in the lung seen in CT and radiography.  We anticipate the need to fund expansion and market growth by raising capital over the next two years.  The amount of capital needed could change based on the opportunities available to us and the ability to expand our markets.  

Results of Operations

The following discussion is included to describe our consolidated financial position and results of operations.  The consolidated financial statements and notes thereto contain detailed information that should be referred to in conjunction with this discussion.

Three Months Ended September 30, 2015 compared to the Three Months Ended September 30, 2014

Revenues and Cost of Revenue.   During the three months ended September 30, 2015, we sold two EPN scan units to our licensee in China for $10,450 pursuant to the pricing provisions of our license and recognized $7,763 in cost of sales related to the sale.  Cost of sales includes the cost of direct materials and labor for the assembly of the units, other indirect costs related to the purchase and assembly of inventory, plus the accrual of royalties under our technology license agreement.

Under the agreement with our licensee for China, we will be entitled to additional payments if the distributor achieves certain cumulative revenues and an annual royalty based on net sales.  However, as of September 30, 2015, there is no additional revenue due from either of these sources.

During the three months ended September 30, 2014, we sold three additional EPN Scan units and associated test kits in the European Union.  Total sales revenue for the three months ended September 30, 2014 was $116,600.  During the three months ended September 30, 2014, we recognized $22,658 in cost of sales related to the EPN Scan units and test kits sold in the European Union.  Cost of sales includes the cost of direct materials and labor for the assembly of the units, other indirect costs related to the purchase and assembly of inventory, plus the accrual of royalties under our technology license agreement.  Our gross margin reflects the uniqueness of our products, our position in this market, the sufficiency of revenue to recover our investment in research and development over the last several years, and the relative low cost of raw materials.

Operating Expenses. Total operating expenses for selling, general and administrative expense and for research and development expense for the three months ended September 30, 2015 were $788,069, compared to the total operating expenses for the three months ended September 30, 2014, of $492,050, representing an increase of $296,019.  This increase was due to 1) an increase of $221,872 for professional fees, principally for consulting services related to our increased clinical, regulatory, and business development activities; 2) an increase of $91,819 in travel costs also related to our increased clinical, regulatory, and business development activities; 3) an increase of $60,527 in other clinical expenses also related to our increased clinical activities; and 4) an increase of $68,697 in remaining operating expenses also related generally to our increased operational activities.  These increased expenses were offset by 1) a decrease in non-cash stock-based compensation of $92,896 that results based on the vesting arrangements of common stock and warrants that have been issued for services and 2) a decrease in non-cash expense of $54,000 for the provision for doubtful accounts for accounts receivable based on management’s estimates of the collectability of accounts receivable at each reporting date.  Operating expenses have been classified by management as either selling, general and administrative expense or as research and development expense based on an assignment of certain expenses directly to these classifications or based on management’s allocation of certain expenses between these classifications.

Other income/(expense).  Other income (expense) amounted to net expense of $81,335 for the three months ended September 30, 2015, as compared to net expense of $59,380 for the three months ended September 30, 2014.  Other income (expense) for the three months ended September 30, 2015 consists of interest expense of $79,004 and a foreign currency exchange loss of $2,331.  Other income (expense) for the three months ended September 30, 2014 consists of interest expense of $42,616 and a foreign currency exchange loss of $16,764.

The increase in interest expense during the three months ended September 30, 2015 principally relates to the interest accrued on the Convertible Debentures.  Otherwise, interest expense represents interest accrued on the notes to a former director and to a relative of an executive officer, as further described in Note 5 to the unaudited consolidated financial statements.

16

Accounts receivable for sales of the EPN Scan units and test kits in Europe are denominated in Euros and Swiss Francs, and translated into U.S. Dollars at the date of each sale and at each balance sheet date.  The foreign currency exchange losses of $2,331 and $16,764 for the three months ended September 30, 2015 and 2014, respectively, are the result of the changes in the exchange rates of Euros and Swiss Francs during the three month periods ended on September 30, 2015 and 2014.

Nine Months Ended September 30, 2015 compared to the Nine Months Ended September 30, 2014

Revenues and Cost of Revenue.   During the nine months ended September 30, 2015, we sold two EPN scan units to our licensee in China for $10,450 pursuant to the pricing provisions of our license and recognized $7,763 in cost of sales related to the sale.  Cost of sales includes the cost of direct materials and labor for the assembly of the units, other indirect costs related to the purchase and assembly of inventory, plus the accrual of royalties under our technology license agreement.  Additionally, during the nine months ended September 30, 2015, we provided certain services to our licensee in China and recognized revenue in the amount of $9,000.  We incurred costs related to these services in the amount of $7,800.

Under the agreement with our licensee for China, we will be entitled to additional payments if the distributor achieves certain cumulative revenues and an annual royalty based on net sales.  However, as of September 30, 2015, there is no additional revenue due from either of these sources.

During the nine months ended September 30, 2014, we commenced selling our EPN Scan units and test kits in the European Union.  We also sold additional units under the exclusive license of our technology for China.  Total sales revenue for the nine months ended September 30, 2014 was $331,405 and we recognized $48,317 in cost of sales related to the EPN Scan units and test kits sold in the European Union and in China.  Cost of sales includes the cost of direct materials and labor for the assembly of the units, other indirect costs related to the purchase and assembly of inventory, plus the accrual of royalties under our technology license agreement.  Our gross margin reflects the uniqueness of our products, our position in this market, the sufficiency of revenue to recover our investment in research and development over the last several years, and the relative low cost of raw materials.  

Operating Expenses. Total operating expenses for selling, general and administrative expense and for research and development expense for the nine months ended September 30, 2015 were $1,714,526, compared to the total operating expenses for the nine months ended September 30, 2014, of $1,686,004, representing an increase of $28,522.  This increase was due to 1) an increase of $314,601 for professional fees, principally for consulting services related to our increased clinical, regulatory, and business development activities; 2) an increase of $112,562 in other clinical expenses also related to our increased clinical activities; 3) an increase of $39,805 in travel costs also related to our increased clinical, regulatory, and business development activities; 4) an increase of $30,294 for insurance expense principally related to a new policy to provide director and officer liability insurance coverage; and 5) an increase of $65,017 in remaining operating expenses also related generally to our increased operational activities.  These increased expenses were offset by 1) a decrease in non-cash stock-based compensation of $486,572 (principally from the issuance in 2014 of 804,140 shares of our common stock to officers, directors, and a consultant as compensation for current services valued at $402,070) that results based on the vesting arrangements of common stock and warrants that have been issued for services and 2) a decrease in non-cash expense of $47,185 for the provision for doubtful accounts for accounts receivable based on management’s estimates of the collectability of accounts receivable at each reporting date.  Operating expenses have been classified by management as either selling, general and administrative expense or as research and development expense based on an assignment of certain expenses directly to these classifications or based on management’s allocation of certain expenses between these classifications.

Other income/(expense).  Other income (expense) amounted to net expense of $215,699 for the nine months ended September 30, 2015, as compared to net expense of $143,628 for the nine months ended September 30, 2014.  Other income (expense) for the nine months ended September 30, 2015 consists of interest expense of $193,412 and a foreign currency exchange loss of $22,287.  Other income (expense) for the nine months ended September 30, 2014 consists of interest expense of $126,864 and a foreign currency exchange loss of $16,764.

The increase in interest expense during the nine months ended September 30, 2015 principally relates to the interest accrued on the Convertible Debentures.  Otherwise, interest expense represents interest accrued on the notes to a former director and to a relative of an executive officer, as further described in Note 5 to the unaudited consolidated financial statements.

Accounts receivable for sales of the EPN Scan units and test kits in Europe are denominated in Euros and Swiss Francs, and translated into U.S. Dollars at the date of each sale and at each balance sheet date.  The foreign currency exchange losses of $22,287 and $16,764 for the nine months ended September 30, 2015 and 2014, respectively, are the result of the changes in the exchange rates of Euros and Swiss Francs during the corresponding periods ended on September 30, 2015 and 2014.

17

If we obtain FDA clearance to market in the United States of America, we plan to convert U.S. hospitals with existing investigational placements of our diagnostic to commercial installations selling our ProLung EPN Scan.  The funds required for the United States market launch are estimated to be approximately $4.0 million.  Funds for this purpose, and for ordinary operations, are expected to be obtained in part through the sales of our products and services in Europe but primarily from the sale of debt and equity securities.  During the nine months ended September 30, 2015, we offered and sold $2,000,000 in Convertible Debentures (the “Convertible Debentures”) and $807,960 in common stock.   We have no existing commitment to provide working capital, and given our early stage of development, we may be unable to raise sufficient capital when needed and may be required to pay a high price for capital.

Our future capital requirements and adequacy of available funds will depend on many factors including:

·

our ability to obtain regulatory approval in markets outside of Europe;

·

our ability to successfully commercialize our EPN Scan, EPN Scanner and related products and the market acceptance of these products;

·

the pace of our orders, if any, and the pricing and payment terms of those orders;

·

our ability to establish and maintain collaborative arrangements with corporate partners for the development and commercialization of certain product opportunities;

·

the cost of manufacturing and production scale-up;

·

our financial results;

·

the cost and availability of capital generally; and

·

the occurrence of unexpected adverse expenses or events.

Long-Term Debt

Since our inception, the principal source of our financing has come from the issuance of equity securities and from debt financing.  As of September 30, 2015, our outstanding debt financing includes the following borrowing arrangements.

Convertible Debentures

In February 2015, we commenced an offering of Convertible Debentures in an aggregate amount of up to $2,000,000.  As of April 30, 2015, we had completed the offering and issued Convertible Debentures totaling $2,000,000.  The Convertible Debentures bear interest at the rate 8% per annum commencing on the issuance date in April 2015.  Principal and accrued interest are due on the maturity date, which is May 1, 2018. The holder of the Convertible Debenture is entitled, at its option, to convert all or any portion of the outstanding principal of the Convertible Debenture into shares of our common stock at a conversion price of $0.65 per share.  Interest accruing from the date of issuance to the conversion date shall be paid on the maturity date.  

18

Note Payable to a Former Director and Founding Shareholder

As of December 31, 2014, we were obligated under the terms of a master note agreement to a founding stockholder and former member of our Board of Directors in the amount of $929,536, plus accrued interest of $223,742.  The note and accrued interest of $249,348 were due on April 30, 2015.  The note bore interest at 11.10% and was unsecured. On May 1, 2015, we and the noteholder entered into an Amended and Restated Master Loan Agreement and Promissory Note (the “Revised Note”) in the principal amount of $900,000, which terminated and replaced the previous note.  On April 30, 2015, in anticipation of entering into the Revised Note, we paid all accrued interest in the amount of $249,348 and principal of $29,536.  Interest under the Revised Note also accrues at the rate of 11.10% per annum and is payable monthly in arrears.  We are obligated to make a $250,000 principal payment on January 1, 2016, and the balance of the Revised Note matures on April 30, 2017.  The Revised Note is unsecured and includes standard creditor remedies in the event of default. The Revised Note and any accrued interest was paid off subsequent to September 30, 2015.

Note Payable to a Relative of an Executive Officer

At September 30, 2015, we were obligated under the terms of a master note agreement to an individual related to an executive officer of the Company in the amount of $356,931. The note is secured by all of our assets and bears interest at 15% per annum.  On March 27, 2014, we entered into an amendment of the master note to extend the due date for payment of the note and accrued interest to June 30, 2016.  The balance of accrued interest on this note at September 30, 2015 was $177,654.

Cash provided by (used in) operating, investing and financing activities for the nine months ended September 30, 2015 and 2014 is as follows:

Operating Activities

For the nine months ended September 30, 2015, the differences between our net loss and net cash used in operating activities were due to net non-cash charges totaling $293,347 included in our net loss for stock-based compensation, depreciation, and provision for doubtful accounts, less changes in non-cash working capital totaling $70,608.  For the nine months ended September 30, 2014, the differences between our net loss and net cash used in operating activities were due to net non-cash charges totaling $823,094 included in our net loss for stock-based compensation, depreciation, and provision for doubtful accounts, less changes in non-cash working capital totaling $407,748.  

Investing Activities

Net cash used in investing activities during the nine months ended September 30, 2015 and 2014 were $62,619 and $63,150, respectively, and was for the purchase of property and equipment.  We currently estimate the amount of capital expenditures for the year ending December 31, 2015 to be approximately $150,000.  

Financing Activities

During the nine months ended September 30, 2015, cash flows from financing activities totaled $2,738,424, related to 1) proceeds of $2,000,000 from the issuance of Convertible Debentures, 2) proceeds of $147,000 from the issuance of 294,000 shares of common stock ($0.50 per share), 3) proceeds of $660,960 from the issuance of 881,279 shares of common stock ($0.75 per share), and 4) the repayment of $69,536 of principal on notes payable and convertible notes payable.

19

Critical Accounting Policies and Estimates

The Company’s accounting policies are more fully described in Note 1 of the consolidated financial statements filed in our annual report on Form 10-K for the year ended December 31, 2014.

Estimates – The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect certain reported amounts and disclosures. Accordingly, actual results could differ from those estimates. The allowance for doubtful accounts is particularly susceptible to change in the near term.  

  Revenue Recognition – Revenue is recognized by the Company when a binding sales or service agreement exists between the parties, services have been rendered, the price for the services is fixed or determinable, collection is reasonably assured, and the Company has no significant obligations remaining with respect to the arrangement.

Trade Receivables and Credit Policies – Accounts receivable are recorded at the invoiced amount, with foreign currencies reflected in U.S. dollars (based on the exchange rate on the date of sale and adjusted to current exchange rates at the end of each reporting period), and do not bear interest.  The Company uses an allowance for doubtful accounts to reflect the Company’s best estimate of the amount of probable credit losses in accounts receivable.  Account balances will be charged off against the allowance when the account receivable is considered uncollectible. The allowance for doubtful accounts is an estimate that is particularly susceptible to change in the near term.  

Stock-based Compensation – The Company measures the cost of employee and consulting services received in exchange for an award of equity instruments based on the grant-date fair value of the award. The awards issued are valued using a fair value-based measurement method. The resulting cost is recognized over the period during which an employee or consultant is required to provide services in exchange for the award, usually the vesting period.

Off Balance Sheet Arrangements

The Company has not had any off balance sheet arrangements.

20