UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

(Mark One)

Form 10-Q

For the transition period from __________________ to __________________________
Commission file number: 001-11991

PURADYN FILTER TECHNOLOGIES INCORPORATED

(Name of registrant as specified in its charter)

(561) 547-9499

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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  x   No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 (or for such shorter period that the registrant was required to submit and post such files).  Yes  o   No  o

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act)

Yes  o   No  x

Indicated the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.  45,970,437 shares of common stock are issued and outstanding as of August 14, 2010.

TABLE OF CONTENTS

OTHER PERTINENT INFORMATION

Our web site is www.puradyn.com.  The information which appears on our web site is not part of this report.

When used in this report, the terms “Puradyn,” the “Company,” “we,” “our,” and “us” refers to Puradyn Filter Technologies Incorporated, a Delaware corporation, and our subsidiaries.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

Certain statements in this report contain or may contain forward-looking statements that are subject to known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. These forward-looking statements were based on various factors and were derived utilizing numerous assumptions and other factors that could cause our actual results to differ materially from those in the forward-looking statements. These factors include, but are not limited to, our ability to operate as a going concern and to raise sufficient capital to fund our operations, acceptance of the Company’s products, the Company’s dependence on distributors and a few significant customers, risks associated with international operations and international distribution and other factors.  Most of these factors are difficult to predict accurately and are generally beyond our control.  You should consider the areas of risk described in connection with any forward-looking statements that may be made herein. Readers are cautioned not to place undue reliance on these forward-looking statements and readers should carefully review this report and our Annual Report on Form 10-K for the year ended December 31, 2009 in their entirety, including the risks described in Part I. Item 1A. Risk Factors. Except for our ongoing obligations to disclose material information under the Federal securities laws, we undertake no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events. These forward-looking statements speak only as of the date of this report, and you should not rely on these statements without also considering the risks and uncertainties associated with these statements and our business.

PART I - FINANCIAL INFORMATION

ITEM 1.  FINANCIAL STATEMENTS

Puradyn Filter Technologies Incorporated
Condensed Consolidated Balance Sheets
As of June 30, 2010 and December 31, 2009

See accompanying notes to condensed consolidated financial statements.

Puradyn Filter Technologies Incorporated
Condensed Consolidated Statements of Operations
For the Three Months and Six Months Ended June 30, 2010 and 2009
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

Puradyn Filter Technologies Incorporated
Consolidated Statements of Cash Flows
 For the Six Months Ended June 30, 2010 and 2009
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

Puradyn Filter Technologies Incorporated
Consolidated Statements of Changes in Stockholders’ Deficit
For the Six Months Ended June 30, 2010
(Unaudited)

See accompanying notes to condensed consolidated financial statements.

Puradyn Filter Technologies Incorporated
Notes to Condensed Consolidated Financial Statements
 (Unaudited)

1.     Basis of Presentation, Going Concern and Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim information and with the instructions to Form 10-Q and Regulation S-K. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. In the opinion of management, all adjustments consisting of a normal and recurring nature considered necessary for a fair presentation have been included. Operating results for the three-month and six-month periods ended June 30, 2010 may not necessarily be indicative of the results that may be expected for the year ending December 31, 2010.

For further information, refer to Puradyn Filter Technologies Incorporated’s (“the Company”) consolidated financial statements and footnotes thereto included in the Form 10-K for the year ended December 31, 2009.

Going Concern

The Company’s financial statements have been prepared on the basis that it will operate as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  The Company has incurred net losses each year since inception and has relied on the sale of its stock from time to time and loans from third parties and from related parties to fund its operations. 

These recurring operating losses, liabilities exceeding assets and the reliance on cash inflows from an institutional investor and current stockholder have led the Company’s independent registered public accounting firm Webb & Company, P.A. to include a statement in its audit report relating to the Company’s audited consolidated financial statements for the year ended December 31, 2009 expressing substantial doubt about the Company’s ability to continue as a going concern.

The Company has been addressing the liquidity and working capital issues and continues to attempt to raise additional capital with institutional and private investors and current stockholders.  We also continue to implement cost reductions in an effort to improve margins and anticipate these cost reductions will positively impact our results of operations during the balance of 2010 and beyond.  As an ongoing measure, we review cost of material increases, some of which were passed through to our customers as product price increases over the past few years.   Due to the declining economy affecting all of our end-users, management elected not to increase product prices in the first two quarters of 2010; however, we may revisit this issue at a later date in 2010 if the market conditions are appropriate and raw material costs continue to increase.

Use of Estimates

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Basic and Diluted Loss Per Share

Financial Accounting Standards Board (FASB) ASC 260, Earnings Per Share, requires a dual presentation of basic and diluted earnings per share. However, because of the Company’s net losses, the effect of outstanding stock options and warrants would be anti-dilutive and, accordingly, is excluded from the computation of diluted loss per share. The number of such shares excluded from the computation of loss per share totaled 6,492,608 for the three-month and six-month period ended June 30, 2010 and 5,447,211 and 4,799,606 for the three and six-month periods ended June 30, 2009.

Stock Compensation

The Company adopted FASB ASC 718, Compensation – Stock Compensation, effective January 1, 2006 using the modified prospective application method of adoption which requires us to record compensation cost related to unvested stock awards as of December 31, 2005, recognizing the amortized grant date fair value in accordance with provisions of FASB ASC 718 on straight line basis over the service periods of each award.  We have estimated forfeiture rates based on our historical experience.  Stock option compensation expense for the periods ended June 30, 2010 and June 30, 2009 have been recognized as a component of cost of goods sold and general and administrative expenses in the accompanying Consolidated Financial Statements.

Stock options and warrants issued to consultants and other non-employees as compensation for services provided to the Company are accounted for based on the fair value of the services provided or the estimated fair market value of the option or warrant, whichever is more reliably measurable in accordance with FASB ASC 718 and FASB ASC 505 Equity, including related amendments and interpretations. The related expense is recognized over the period the services are provided.

Inventories

Inventories are stated at the lower of cost or market using the first in, first out (FIFO) method. Production costs, consisting of labor and overhead, are applied to ending inventories at a rate based on estimated production capacity and any excess production costs are charged to cost of products sold. Provisions have been made to reduce excess or obsolete inventories to their net realizable values.

Inventories consisted of the following at June 30, 2010 and December 31, 2009:

Deferred Financing Costs

The Company capitalizes financing costs and amortizes them using the straight-line method, which approximates the effective interest method, over the term of the related debt. Amortization of deferred financing costs is included in interest expense and totaled $1,007 and $1,007 the three-months ended June 30, 2010 and June 30, 2009 and $1,007 and $2,379 for the six-months ended June 30, 2010 and 2009, respectively.  Accumulated amortization of deferred financing costs as of June 30, 2010 and 2009 was $678,130 and $675,110, respectively.

Revenue Recognition

The Company recognizes revenue from product sales to customers, distributors and resellers when products that do not require further services or installation by the Company are shipped, when there are no uncertainties surrounding customer acceptance and when collectibility is reasonably assured in accordance with FASB ASC 605, Revenue Recognition, as amended and interpreted. Cash received by the Company prior to shipment is recorded as deferred revenue. Sales are made to customers under terms allowing certain limited rights of return and other limited product and performance warranties for which provision has been made in the accompanying condensed consolidated financial statements.

Amounts billed to customers in sales transactions related to shipping and handling, represent revenues earned for the goods provided and are included in net sales. Costs of shipping and handling are included in cost of products sold.

Product Warranty Costs

As required by FASB ASC 460, Guarantor’s Guarantees, the Company is including the following disclosure applicable to its product warranties.

The Company accrues for warranty costs based on the expected material and labor costs to provide warranty replacement products. The methodology used in determining the liability for warranty cost is based upon historical information and experience. The Company’s warranty reserve is calculated as the gross sales multiplied by the historical warranty expense return rate.

The following table shows the changes in the aggregate product warranty liability for the six-months ended June 30, 2010:

Comprehensive Income

FASB ASC 220, Comprehensive Income establishes rules for reporting and displaying of comprehensive income and its components. Comprehensive income is the sum of net loss as reported in the consolidated statements of operations and other comprehensive income transactions. Other comprehensive income transactions that currently apply to the Company result from changes in exchange rates used in translating the financial statements of its wholly owned subsidiary, Puradyn Filter Technologies, Ltd. (“Ltd.”). Comprehensive loss as of June 30, 2010 and 2009 is not shown net of taxes because the Company’s deferred tax asset has been fully offset by a valuation allowance.

Comprehensive loss consisted of the following for the three and six-months ended June 30, 2010 and 2009:

New Accounting Standards

In October 2009, the FASB issued an Accounting Standard Update (“ASU”) No. 2009-13, which addresses the accounting for multiple-deliverable arrangements to enable vendors to account for products or services separately rather than as a combined unit and modifies the manner in which the transaction consideration is allocated across the separately identified deliverables. The ASU significantly expands the disclosure requirements for multiple-deliverable revenue arrangements. The ASU will be effective for the first annual reporting period beginning on or after June 15, 2010, and may be applied retrospectively for all periods presented or prospectively to arrangements entered into or materially modified after the adoption date. Early adoption is permitted, provided that the guidance is retroactively applied to the beginning of the year of adoption. The Company does not expect the adoption of ASU No. 2009-13 to have any effect on its financial statements upon its required adoption on January 1, 2011.

In December 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities” (“ASU 2009-17”). ASU 2009-17 changes how a reporting entity determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a reporting entity is required to consolidate another entity is based on, among other things, the other entity’s purpose and design and the reporting entity’s ability to direct the activities of the other entity that most significantly impact the other entity’s economic performance. ASU 2009-17 requires a number of new disclosures, including additional disclosures about the reporting entity’s involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A reporting entity is required to disclose how its involvement with a variable interest entity affects the reporting entity’s financial statements. ASU 2009-17 is effective at the start of a reporting entity’s first fiscal year beginning after November 15, 2009, or January 1, 2010, for a calendar year-end entity. Based on the Company’s evaluation of ASU 2009-17, the adoption of this standard did not impact the Company’s consolidated financial statements.

In January 2010, FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (ASC Topic 820) — Improving Disclosures About Fair Value Measurements. The ASU requires new disclosures about transfers into and out of Levels 1 and 2 and separate disclosures about purchases, sales, issuances, and settlements relating to Level 3 measurements. It also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure fair value. The new disclosures and clarifications of existing disclosures are effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  Other than requiring additional disclosures, the adoption of this new guidance will not have a material impact on the Company’s consolidated results of operations and financial position.

On February 24, 2010, the FASB issued an update to address certain implementation issues related to Accounting Standards Codification, or ASC, 855-10-50, Subsequent Events—Disclosure, regarding an entity’s requirement to perform and disclose subsequent events procedures. Effective upon its issuance, the update exempts Securities and Exchange Commission registrants from disclosing the date through which subsequent events have been evaluated. This update affected disclosure only and had no impact on our consolidated financial position or consolidated results of operations.

2.     Issues Affecting Liquidity and Management’s Plans

The Company’s financial statements have been prepared on the basis that it will continue as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business. The Company has sustained losses since inception and used net cash in operations of approximately $595,577 and $582,343 during the six-months ended June 30, 2010 and 2009, respectively. As a result, the Company has had to rely principally on private equity investments, including the conversion of debt into stock, as well as stockholder loans to fund its activities to date.

These recurring operating losses, liabilities exceeding assets and the reliance on cash inflows from an institutional investor and current stockholder led the Company’s independent registered public accounting firm, Webb & Company, P.A., to include a statement in its audit report relating to the Company’s audited consolidated financial statements for the year ended December 31, 2009 expressing substantial doubt as to the Company’s ability to continue as a going concern.

The Company has been addressing the liquidity and working capital issues and continues to attempt to raise additional capital with institutional and private investors and current stockholders.  We also continue to implement cost reductions in purchasing raw materials, overhead expenses and administrative expenses in an effort to improve margins and operating efficiencies. We anticipate these costs reductions will positively impact our results of operations during the balance of 2010 and beyond.   

The Company continues to address liquidity concerns because of inadequate revenue growth.  As a result, cash flow from operations is insufficient to cover our liquidity needs for the immediate future.  The Company has continued the process of aggressively seeking to raise capital and continues to explore financing availability and options with investment bankers, funds, private sources, members of management and existing shareholders.  The Company has implemented measures to preserve its ability to operate, including organizational changes, deferral of salaries, reduction in personnel and renegotiating creditor and collection arrangements.  There can be no assurance that we will be able to raise the additional capital needed or reduce the level of expenditures in order to sustain operations.

Beginning on March 28, 2002, the Company executed a binding agreement with one of its stockholders, who is also its CEO and a Board member, to fund up to $6.1 million.  The original loan agreements, dated March 28, 2002 and March 14, 2003, were due and payable on December 31, 2003 and December 31, 2004. 

On February 2, 2004, this executive officer, director and stockholder amended the original loan agreements to extend the maturity dates to December 31, 2005 and to waive the funding requirement mandating maturity terms until such time as the Company has raised an additional $7.0 million over the $3.5 million raised in the Company’s private placement offering; or until such time as the Company is operating within sufficient cash flow parameters, as defined, to sustain its operations; or until a disposition of the Company occurs.

In April 2005, the maturity date of the loan agreement was extended to December 31, 2006.  As consideration of this extension, this executive officer, director and stockholder was granted an additional 100,000 common stock purchase warrants at an exercise price equal to the closing market price of the Company’s stock on the date of grant.  In March of 2006 and in subsequent March’s through 2010, the executive officer, director and stockholder extended the maturity date of the loan agreement annually, which currently expires on December 31, 2011.  As of June 30, 2010, the Company had drawn a total of $6.3 million of the available funds, net of repayments.  

The Company anticipates increased cash flows from 2010 sales activity; however, additional cash will still be needed to support operations.  If additional capital is not raised, budgeted sales levels are not achieved and/or significant unanticipated expenditures occur, the Company will have to modify its business plan, reduce or discontinue some of its operations or seek a buyer for part of its assets to continue as a going concern through 2010.  There can be no assurance that the Company will be able to raise the additional capital needed to continue as a going concern.

3.     Common Stock

On January 5, 2010 the Company agreed to pay to Emerging Markets, LLC, 60,000 shares of common stock valued at $0.23 per share plus 20,000 shares of the Company’s common stock payable at the end of each month while the agreement is in effect during 2010. Pursuant to this agreement, on April 1, 2010 and May 1, 2010, the Company issued 20,000 shares on each of those dates, of common stock valued at $0.20 per share and on June 1, 2010, the Company issued 20,000 shares of common stock valued at $0.17 per share.

4.     Stock Options

During the three-month periods ended June 30, 2010 and June 30, 2009, the Company recognized compensation expense of approximately $-0- and $46,000, respectively. 

On May 15, 2010, the Company received proceeds of $2,100 from a terminated employee for the exercise of 15,000 incentive stock options priced at $0.14 per share of common stock.

At June 30, 2010, approximately 4,326,025 warrants with an average exercise price of $0.99 remain outstanding and were fully vested.

For the three months ended June 30, 2010 and June 30, 2009, respectively, the Company recorded stock-based compensation expense of $14,364 and $13,190, relating to unvested employee stock options.  

Stock options and warrants issued to consultants and other non-employees as compensation for services provided to the Company are accounted for based on the fair value of the services provided or the estimated fair market value of the option or warrant, whichever is more reliably measurable in accordance with FASB ASC 505, Equity, and FASB ASC 718, Compensation – Stock Compensation. The related expense is recognized over the period the services are provided.

A summary of the Company’s stock option plans as of June 30, 2010, and changes during the six-month period then ended is presented below:

A summary of the Company’s stock option plans as of June 30, 2010, and changes during the three-month period then ended is presented below:

Changes in the Company’s unvested options for the six months ended June 30, 2010 are summarized as follows:

Changes in the Company’s unvested options for the three months ended June 30, 2010 are summarized as follows:

A summary of the Company’s warrant activity as of June 30, 2010 and changes during the six month and three month periods then ended is presented below:

5.     Notes Payable to Stockholders

As of June 30, 2010, the Company had drawn all of the $6.3 million from the available line-of-credit, which is provided by an executive officer, director and stockholder of the Company (see Note 2). Amounts drawn bear interest at a weighted average between two facilities, one is based on a minimum of 2.75% or the prime rate minus one-half percent and the other is based on Libor plus 1.40 (a weighted average of 2.64% as of June 30, 2010) payable monthly and become due and payable on December 31, 2011, or upon a change in control of the Company or consummation of any other financing over $7.0 million.  Previously, this executive officer, director and stockholder waived this funding requirement. On February 23, 2010, the maturity date of the stockholder loan was extended from December 31, 2010 to December 31, 2011.

For the three-months ended June 30, 2010 and 2009, the Company recorded $39,971 and $39,131, respectively; and for the six-months ended June 30, 2010 and 2009, the Company recorded $75,679 and $75,361, respectively, of interest expense related to the notes payable to stockholder, which is included in interest expense in the accompanying condensed consolidated statements of operations.

6.     Commitments and Contingencies and Concentrations

Sales to two customers individually accounted for approximately 22% and 19% (combined total of 41%) for the six-months ended June 30, 2010.

7.     Subsequent Events

In preparing these financial statements, the Company has evaluated events and transactions for potential recognition or disclosure through August 16, 2010 the date the financial statements were issued.

On July 7, 2010, the Company awarded a consultant 75,000 shares of common stock, which were issued as restricted shares under SEC Rule 144 at a price of $0.18 for legal services on behalf of the Company. 

On July 9, 2010 the Company received proceeds of $100,000 from the sale of 571,429 shares of common stock restricted under SEC Rule 144,  at a price of $0.175 per share and, as part of the offering, issued warrants to purchase 57,143 shares of common stock at an exercise price of $0.50, which expire on July 9, 2015.

On July 20, 2010 the Company received proceeds of $50,000 from the sale of 303,030 shares of common stock restricted under SEC Rule 144,  at a price of $0.165 per share and, as part of the offering, issued warrants to purchase 30,303 shares of common stock at an exercise price of $0.50, which expire on July 20, 2015.

On July 21, 2010, the Company received proceeds of $50,000 from the sale of 304,878 shares of common stock restricted under SEC Rule 144,  at a price of $0.164 per share and, as part of the offering, issued warrants to purchase 30,488 shares of common stock at an exercise price of $0.50, which expire on July 21, 2015.

On July 30, 2010, the Company received proceeds of $50,000 from the sale of 253,807 shares of common stock restricted under SEC Rule 144,   at a price of $0.197 per share and, as part of the offering, issued warrants to purchase 25,381 shares of common stock at an exercise price of $0.50, which expire on July 30, 2015.

On August 4, 2010, the Company received proceeds of $50,000 from the sale of 210,084 shares of common stock restricted under SEC Rule 144,  at a price of $0.238 per share and, as part of the offering, issued warrants to purchase 21,008 shares of common stock at an exercise price of $0.50, which expire on August 4, 2015.

On August 4, 2010, the Company received proceeds of $50,000 from the Company’s Chairman and CEO, for the sale of 210,084 shares of common stock restricted under SEC Rule 144,  at a price of $0.238 per share and, as part of the offering, issued warrants to purchase 21,008 shares of common stock at an exercise price of $0.50, which expire on August 4, 2015.

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

Cautionary Statements Regarding Forward Looking Information

Certain statements in this report contain or may contain forward-looking statements that are subject to known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.  These forward-looking statements were based on various factors and were derived utilizing numerous assumptions and other factors that could cause the Company’s actual results to differ materially from those in the forward-looking statements.  These factors include, but are not limited to, the Company’s ability to operate as a going concern and to raise sufficient capital to fund its operations, its ability to satisfy its obligations as they become due, acceptance of the Company’s products, the Company’s dependence on distributors and a few significant customers, risks associated with international operations and international distribution and other factors.  Most of these factors are difficult to predict accurately and are generally beyond our control.  You should consider the areas of risk described in connection with any forward-looking statements that may be made herein.  Readers are cautioned not to place undue reliance on these forward-looking statements and readers should carefully review this report in its entirety.  Except for the Company’s ongoing obligations to disclose material information under the Federal securities laws, we undertake no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events. These forward-looking statements speak only as of the date of this report and you should not rely on these statements without also considering the risks and uncertainties associated with these statements and our business.

Overview

Our History

The patents issued on the oil filtration system that evolved into the current Puradyn bypass oil filtration system were issued in the early 1980s.  In 1988, the Company was incorporated in Delaware under the name “Econology Systems, Inc.” In 1990, the name was changed to “T/F Purifiner, Inc.”  In February 1998, the company changed its name from T/F Purifiner, Inc. to Puradyn Filter Technologies Incorporated.

Our Product

Puradyn Filter Technologies Incorporated designs, manufactures, markets and distributes worldwide the puraDYN^® bypass oil filtration system (the “Puradyn”) for use with substantially all internal combustion engines and hydraulic equipment that use lubricating oil.  Working in conjunction with an engine’s full-flow oil filter, the Puradyn system cleans oil by continually removing solid, liquid and gaseous contaminants from the oil through a sophisticated and unique filtration and evaporation process.  For engine lubricating oil, our filters incorporate an additive package.  Because Puradyn-filtered lubricating oil is kept in a continually clean state, our system has been used effectively to extend oil-drain intervals and the time between engine overhauls. We are the exclusive manufacturer of the disposable replacement filter elements (“Element”) for the Puradyn.

The patented Puradyn bypass oil filtration system can be attached to almost any engine and hydraulic system.  The concept of bypass filtration is similar to a dialysis machine that filters blood to rid it of impurities, keeping the oil continually clean.  Whenever the engine or machinery is operating, the Puradyn is extracting from the oil solid particles down to less than one micron (1/39 millionth of an inch), as well as gaseous and liquid contaminants, while protecting the engine or hydraulic equipment from harmful wear caused by contaminants in the oil.  Additive packages in which chemicals are added to the filtering media replenish spent additives in the oil, helping to maintain the oil’s proper chemical balance and viscosity.

All Puradyn systems are compatible with virtually all standard and synthetic oils on the market and they work with engines using gasoline, diesel, propane or natural gas.  The Puradyn system cannot be used on engines that do not have a pressurized lubricating system, and none of the products can be used on any engines that mix oil with fuel.  Potential savings are achieved from utilizing the Puradyn, which generally has a relatively short payback period of, on average, six to 14 months, depending upon the application. 

By continually removing contaminants and replacing vital additives through a patented time-release additive package to keep oil constantly clean, the Puradyn Element substantially extends intervals between oil changes.

Sales

Sales of the Company’s products, the puraDYN^® bypass oil filtration system (the “Puradyn”) and replaceable filter elements will depend principally upon end user demand for such products and acceptance of the Company’s products by original equipment manufacturers (“OEMs”).  The oil filtration industry has historically been competitive and, as is typically the case with innovative products, the ultimate level of demand for the Company’s products is subject to a high degree of uncertainty. Developing market acceptance for the Company’s existing and proposed products will require substantial marketing and sales efforts and the expenditure of a significant amount of funds to inform customers of the perceived benefits and cost advantages of its products.  As a result of our limited resources, to date we have not had adequate funds available to undertake these necessary marketing efforts.

Currently no bypass oil filtration system has captured a substantial share of the estimated recurring $15 billion potential market, based upon figures supplied by The Rhein Report, a diesel engine industry consulting, publishing and market research company.  We believe we are in a unique position to capitalize on the growing acceptance of bypass oil filtration given that our product and our Company are positioned as, including, but not limited to:

We focus our sales strategy on direct sales and distribution efforts as well as on the development of a strong nationwide distribution network that will not only sell but also install and support our product.  We currently have approximately 106 active distributors in the U.S. and internationally.  The number of distributors will constantly change as we add new distributors as well as when OEMs come onboard with their distribution network.

We continue to focus our sales and marketing efforts to target industries more open to innovative methods to reduce oil maintenance operating costs.  These industries are searching for new and progressive ways, including bypass oil filtration, to maintain their equipment.

While this is a long-term and ongoing commitment, we believe we have achieved growing industry acceptance based on recent accomplishments:

We believe that the renewed interest shown in the technology of bypass oil filtration as an economic alternative to significantly rising oil prices, dependence upon foreign oil, coupled with the added benefits of being environmentally beneficial and a means to conserve oil, has timely and favorably positioned the Company as a manufacturer of a cost efficient “green” product. 

Our customers have found that bypass oil filtration technology affords the same benefits of the claims made by alternative energy source providers – reduce significant oil consumption and minimize a company’s carbon footprint. 

Recognizing that a level of oil consumption is not 100% avoidable, we promote our technology as environmentally-friendly in that it provides a practical and more intelligent use of oil as opposed to the accepted norm of oil as a disposable and infinite resource.  By keeping engine and hydraulic oil continuously clean, equipment runs at optimum efficiency and the oil can be re-used, extending the life of the oil several cycles. 

Consequently, the Puradyn system significantly reduces maintenance costs by decreasing oil consumption, engine wear, and certain other types of general maintenance as well as reducing environmental concerns and costs associated with the storage and disposal of waste oil.

We also believe that industry acceptance will continue to grow in 2010 as evidenced by increased sales activity in the first half of 2010; however, there can be no assurance that any of our sales efforts or strategic relationships will meet management’s expectations or result in actual revenues.  

The Company’s sales effort not only involves educating the potential customer on the benefits of our product, but also allowing the end-user to test and evaluate the Puradyn system on its fleet equipment.  While set for a specific period of time, typically ranging from three to twelve months, evaluations are often influenced by a number of variables including equipment type and applications downtime or servicing, which may extend the evaluation period.  Consequently, the sales cycle can be relatively long. 

We believe international sales are especially well suited to our product given that much of the equipment is located in remote areas, therefore, due solely to logistics of manpower resources and physically being able to reach the equipment in a timely manner to perform the necessary oil related maintenance.  In addition, in certain countries, fuel and emission regulations are not as stringent as in North America, causing engines to operate under more severe conditions.  Certain applications representing a higher and more immediate return on investment are prevalent in use outside of North America and end-users consequently are more receptive to the total maintenance package including the use of oil analysis, which the Puradyn system requires to verify oil condition. 

Our focus on specific industries throughout 2009 has begun to pay dividends in the first and second quarters of 2010, with these certain niche industries representing nearly 50% of sales as compared to 20% in the comparable period in 2009.

Optimizing our limited resources and obtaining sufficient capital will be key to accomplishing our goals.  We will need to remain focused on working with OEMs, continue developing the independent distributors we have onboard and maintain growth within the major accounts using our system.  To accomplish these tasks, we will need to obtain capital funding and add appropriate sales and marketing support to be sure our distributors and customers are served.  In early 2010, we hired an additional sales person and anticipate the need for at least one more sales person plus one sales support person.  We also added an application engineer in the last quarter of 2009 and will need a product engineer as we grow our OEM account list.  The expansion into the OEM area is rewarding in the aspect that it provides a steady flow of material requirements for our manufacturing facility.  Additionally, OEM business allows us more stability in retaining trained manufacturing personnel, a stronger supply chain with steady production, economies of scale, and the ability to better utilize our overhead with higher average material turn rates.

We continue to address our liquidity and working capital issues as we continue to seek additional capital from institutional and private investors and current stockholders.  Historically, we have faced difficulties in raising adequate capital and we anticipate that those efforts will continue given the current uncertainties facing the capital markets in the U.S.  We also continue to implement cost reductions in an effort to improve margins, including securing alternative suppliers for raw materials and manufacturing and anticipate these costs reductions will positively impact our results of operations during the balance of 2010 and beyond.  As an ongoing measure, we review cost of material increases, some of which were passed through to our customers as product price increases, ranging from 3% to 7%, beginning January in each of the past few years. However, due to the declining economy affecting all of our end-users, management elected not to increase product prices in the first quarter of 2010; however, we may revisit this issue at a later date in 2010 if market conditions are appropriate and raw material costs increase. 

Going Concern

Our financial statements have been prepared on the basis that we will operate as a going concern, which contemplates the realization of assets and satisfaction of liabilities in the normal course of business.  We have incurred net losses each year since inception and have relied on the sale of our stock from time to time and loans from third parties and from related parties to fund our operations.  These recurring operating losses, liabilities exceeding assets and the reliance on cash inflows from an institutional investor and current stockholder have led our independent registered public accounting firm Webb & Company P.A. to include a statement in its audit report relating to ours audited consolidated financial statements for the years ended December 31, 2009 and 2008 expressing substantial doubt about our ability to continue as a going concern.  Our ability to continue as a going concern is dependent upon our ability to obtain the necessary financing to meet our obligations and repay our liabilities when they become due and to generate profitable operations in the future.  We plan to continue to provide for our capital requirements through the sale of equity securities, however, we have no firm commitments from any third party to provide this financing and we cannot assure you we will be successful in raising working capital as needed.  There are no assurances that we will have sufficient funds to execute our business plan, pay our obligations as they become due, or generate positive operating results.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to product returns, bad debts, inventories, financing operations, warranty obligations and contingencies and litigation.  We base our estimates on historical experience and various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

Allowance for doubtful accounts

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial conditions of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.  We provide for potential uncollectible accounts receivable based on customer specific identification and historical collection experience. If market conditions continue to decline, actual collection experience may not meet expectations and may result in decreased cash flows and increased bad debt expense.

The policy for determining past due status is based on the contractual payment terms of each customer, which is generally net 30 or net 60 days. Once collection efforts by us and our collection agency are exhausted, the determination for charging off uncollectible receivables is made.

Estimation of Product Warranty Cost

We provide for the estimated cost of product warranties at the time revenue is recognized. While we engage in product quality programs and processes, including actively monitoring and evaluating the quality of our component suppliers, our warranty obligation is affected by product failure rates, material usage and service delivery costs incurred in correcting a product failure. Should actual product failure rates, material usage or service delivery costs differ from our estimates, revisions to the estimated warranty liability would be required.

Inventory and estimation of inventory obsolescence

Inventories are valued at the lower of cost or market using the first in, first out (FIFO) method. Valuation allowances for obsolete and excess inventory and shrinkage are also recorded. Shrinkage is estimated as a percentage of sales for the period from the last physical inventory date to the end of the applicable period. Such estimates are based on experience and the most recent physical inventory results. The valuation allowances for obsolete and excess inventory in multiple stages of processing, requires management judgment and estimates that may impact the ending inventory valuation and valuation allowances that may affect the reported gross margin for the period.

We provide for estimated inventory obsolescence or unmarketable inventory in amounts equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than those projected by management, additional inventory write-downs may be required.

Impairment of long-lived assets

We periodically evaluate the recoverability of the carrying amount of our long-lived assets under the guidelines of FASB ASC 360, Property, Plant and Equipment.  Factors that we consider in making this evaluation include estimating the undiscounted net cash flows estimated to result from the assets over their remaining useful life. Should our estimates of these factors change, our results of operations and financial condition could be adversely impacted.

Revenue recognition

Revenue is recognized when earned.  Our revenue recognition policies are in compliance with the provisions issued in FASB ASC 605, Revenue Recognition. Revenue from product sales to customers, distributors and resellers is recorded when products that do not require further services or installation by us are shipped, when there are no uncertainties surrounding customer acceptance and for which collectibility is reasonably assured.  We provide for sales returns based on an historical analysis of returns. The estimate is updated for current return activity and the provision is adjusted accordingly. Should actual returns exceed management’s estimates, the provision may require further adjustment and accordingly, net sales may decrease.

Results of Operations for the Three-months Ended June 30, 2010 Compared to the Three-months Ended June 30, 2009

The following table sets forth the amount of increase or decrease represented by certain items reflected in our condensed consolidated statements of operations in comparing the three-months ended June 30, 2010 to the three-months ended June 30, 2009: