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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2002

NORTECH SYSTEMS INCORPORATED

Commission file number 0-13257

State of Incorporation: Minnesota

IRS Employer Identification No. 41-16810894

Executive Offices: 1120 Wayzata Blvd E., Suite 201, Wayzata, MN 55391

Telephone number: (952) 345-2277

        Securities registered pursuant to Section 12(b) of the Act: None

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

        Common Stock, Par Value $.01 Per Share

        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 of file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of regulation S-K is not contained herein and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý

        Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) Yes o No ý.

        The aggregate market value of voting stock held by nonaffiliates of the registrant, based on the closing price of $7.25 per share, was $11,714,456 on March 14, 2003.

        Shares of common stock outstanding at March 1, 2003: 2,473,650

        (The remainder of this page was intentionally left blank.)

DOCUMENTS INCORPORATED BY REFERENCE

        The following documents are incorporated by reference to the parts indicated of the Annual Report on Form 10-K:

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NORTECH SYSTEMS INCORPORATED
ANNUAL REPORT ON FORM 10K
TABLE OF CONTENTS

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NORTECH SYSTEMS INCORPORATED
FORM 10-K
For the Year Ended December 31, 2002

PART I

ITEM 1. BUSINESS

Description of Business

        Nortech Systems Incorporated and Subsidiary (the "Company") is a Minnesota corporation organized in December 1990. Prior to December 1990, the Company operated as DSC Nortech, Inc., which filed a petition for reorganization under Chapter 11 of the United States Bankruptcy Code during 1990. The business and assets of DSC Nortech, Inc. were transferred to Nortech Systems Incorporated during 1990.

        The Company files annual reports, quarterly reports, proxy statements, and other documents with the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934 (Exchange Act). The public may read and copy any materials that the company files with the SEC at the SEC's Public Reference Room at 340 Fifth Street N.W., Washington, D.C. 20549. Also, the SEC maintains an Internet website that contains reports, proxy and information statements, and other information regarding issuers, including the Company, that file electronically with the SEC. The pubic can obtain any documents that the Company files with the SEC at http:\\www.sec.gov.

        The corporation also makes available free of charge through its Internet website (http:\\nortechsys.com) the Company's Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Press Releases, and Current Reports on Form 8-K.

        GENERAL

        The Company's headquarters are in Wayzata, Minnesota, a suburb of Minneapolis, Minnesota. The Company maintains various manufacturing facilities in Minnesota including Bemidji, Fairmont, Baxter, and Merrifield as well as Augusta, Wisconsin, and a newly acquired operation in Monterrey, Mexico. The Company manufactures wire harnesses, cables, electronic sub-assemblies and components, and printed circuit board assemblies. The Company provides a full "turnkey" contract manufacturing service to its customers. A majority of revenue is derived from products that are built to the customer's design specifications.

        The Company believes it provides a high degree of manufacturing sophistication. This includes the use of statistical process control to insure product quality, state-of-the-art materials management techniques, allowing just-in-time (JIT) delivery of products, and the systems necessary to effectively manage the business. This level of sophistication enables the Company to attract major original equipment manufacturers (OEM).

        The strategy of the Company has been to expand and diversify its customer base. The Company has added several new customers from various industries, some of which produce medical products, super computers, mid-size and micro computer business systems, products in the automotive and defense industries and industrial products. The Company's strategy is to develop a customer base spanning several industry segments to avoid the effects of fluctuations within a given industry. Some of the Company's major customers are G.E. Medical Systems, Raytheon, SPX Corporation, Kodak, Thermo King, Polaris, Cubic, Icon Systems, Allen-Bradley, Semitool, Silicon Graphics and United Defense.

        The Company believes that contract manufacturing will continue to grow and expand in the United States and overseas because contract manufacturing provides OEMs with a quality product at a price well below that available in the OEM's own facility. This is due primarily to the specialization available

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through the contract manufacturer with significantly lower overhead costs and ability to solve logistical problems with offshore manufacturing.

        ACQUISITIONS

        In June 2002, the Company acquired 100 percent of the outstanding common shares of Manufacturing Assembly Solutions of Monterrey, Inc. (MAS), a Mexican corporation, located in Monterrey, Mexico. The results of operations since this acquisition have been included in the consolidated financial statements. The primary reason for the acquisition was to enhance the Company's manufacturing capabilities in a low cost country. See consolidated financial statements Note 10 for more detail on this acquisition.

        In November 1996, the Company acquired the inventory and fixed assets of Zercom Corporation, a subsidiary of Communication Systems, Inc. (CSI). The Company has continued the business formerly conducted by CSI, which involves contract manufacturing of electronic sub-assemblies and components.

        In August 1995, the Company acquired all the assets of the Aerospace Division of Communication Cable, Inc. (CCI). The Company has continued the business formerly conducted by CCI, which involves the manufacturing of custom designed, high-technology electronic cable assemblies for various applications.

        BUSINESS SEGMENTS

        At December 31, 1998, the Company had reported segment information of its three identifiable segments; Contract Manufacturing, Display Products and Medical Management. However, on June 30, 1999, the Company formally adopted a plan to dispose of two of the segments, including Display Products and Medical Management. At December 31, 2002, Display Products and Medical Management segments have been sold. The Company's continuing operations fall within the Contract Manufacturing segment.

        BUSINESS STRATEGY

        The Company believes the electronic manufacturing sub-contracting business is emerging from a small job shop oriented business into a dynamic, high technology electronics industry. The Company operates mainly in the wire harness and cable assemblies, and printed circuit board assemblies markets, and intends to expand from this market segment into complete electromechanical assemblies. Many companies no longer perform this type of work on a captive, in-house basis, as they are finding that independent subcontractors can more cost effectively perform this specialized work.

        In accordance with the Company's total commitment to quality, a quality system based on the ISO 9000 standards has been adopted and implemented company-wide. Certification to the ISO standard began in 1995 at the Bemidji, MN facility, and has continued to the point at which all five domestic facilities have now been certified to the latest version of the ISO 9001 standard. The newest facility (Manufacturing Assembly Solutions of Monterrey, Inc. in Mexico) is currently undergoing the implementation phase and is scheduled for certification in June of 2003. The Company believes these certifications benefit its current customer base as well as attract new business opportunities.

        The Company will continue its commitment to quality, cost effectiveness and responsiveness to customer requirements. To achieve these objectives, the Company has adopted lean manufacturing supply chain management techniques at its facilities. The Company is committed to continuous improvement in order to provide world-class complete manufacturing services to its customers. The Company will also continue its efforts to diversify its customer base and expand into other segments of the electronic manufacturing subcontract business.

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        MARKETING

        The Company concentrates its marketing activities in the medical, industrial, automotive and military manufacturing industries. The emphasis continues to be on mature companies, which require a contract manufacturer with a high degree of manufacturing and quality sophistication, including statistical process control (SPC), statistical quality control (SQC), International Standards Organization (ISO) and Aerospace Systems 9100 (AS). The Company has initiated efforts to expand its markets beyond the Upper Midwest area. New market opportunities are being pursued in Mexico, Asia and Europe, as well as increased participation in industry publications and selected trade shows. The Company markets its products and services through internal sales people and manufacturers' representatives. The Company's marketing strategy emphasizes the sophistication of its manufacturing services. The basic systems, procedures, and disciplines normally associated with a mature corporate environment are in place. The Company's employees are well trained in SPC and SQC.

        SOURCES AND AVAILABILITY OF MATERIALS

        The Company is not dependent on any one supplier for materials for products sold to customers. Components utilized in the assembly of wire harnesses, cable assemblies and printed circuit assemblies are purchased directly from the component manufacturers or from their distributors. On occasion some components may be placed on a stringent allocation basis; however, due to the excess manufacturing capacity currently available at most component manufacturers, the Company does not anticipate any major material purchasing or availability problems occurring in the foreseeable future.

        PATENTS AND LICENSES

        The Company is not presently dependent on a proprietary product requiring licensing, patent, copyright or trademark protection. There are no revenues derived from a service-related business for which patents, licenses, copyrights and trademark protection are necessary for successful operations.

        COMPETITION

        The contract manufacturing industry is characterized by competition among a variety of sources, including small closely held companies, larger full-service manufacturers, company-owned facilities and foreign manufacturers. The Company does not believe that the small closely held operations pose significant competitive threat, as they generally do not appear to have the manufacturing capabilities required by target customers of the Company. The Company believes that foreign manufacturers do provide a substantial competitive threat as shown by the commoditization of PC/printer cable and "bargain basement" prices. Many OEM's have moved their manufacturing to foreign soil, and in doing so have minimized freight costs to ship to their foreign locations. Technical support from foreign competition has improved greatly along with their ability to be more responsive to engineering and schedule changes. The willingness of foreign manufacturers to "stock" finished product at warehouse locations in the United States is another competitive advantage. To mitigate foreign competition, the Company maintains a contractual agreement that allows its products to be manufactured in China. The Company also acquired a Mexican manufacturing facility in 2002, thereby making itself competitive with other foreign low cost providers.

        The Company will pursue acquisitions, mergers, or joint ventures of manufacturing companies in low cost countries to retain and grow its customer/revenue base and support its strategic vision to be a competitive world class Electronic Manufacturing Services provider.

        BACKLOG

        Historically, the Company's backlog has been running 60 to 90 days. However, because of the increased emphasis on just-in-time manufacturing (JIT), many of the Company's major customers are taking advantage of the Company's ability to service them adequately under the JIT concept.

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Additionally, because of the Company's quality history with customers, many products now go directly from the Company's shipping dock to the customer's production line.

        The Company's 90-day order backlog was approximately $10.8 million on December 31, 2001 and approximately $10.4 million on December 31, 2002. The Company expects this backlog will be realized as revenue during first quarter 2003.

        MAJOR CUSTOMERS

        The Company sells its products to companies in the computer, medical, governmental and various other industries. Historically, the Company has not experienced significant losses on customer receivable collections in any particular industry or geographic area.

        One customer, G.E. Medical, accounted for 31% and 24% of sales for the years ended December 31, 2002 and 2001, respectively. This reflects Nortech Systems, Inc. position as a key supplier to G.E. Medical.

        RESEARCH AND DEVELOPMENT

        The Company expended no dollars in 2002, 2001 or 2000, on Company-sponsored research and development. The Company has no proprietary research and development activities on an annual basis other than making improvements to its existing internal processes. However, the Company does perform research and development on a contract basis as requested by customers for development of conceptual engineering and design activities prior to manufacturing the products.

        ENVIRONMENTAL LAW COMPLIANCE

        Management believes that its manufacturing facilities are currently operating under compliance with local, state, and federal environmental laws. The Company has made, and plans to continue making, necessary expenditures for compliance with applicable laws. Any environmental-oriented equipment is capitalized and depreciated over a seven-year period. The annualized depreciation expense for this type of environmental equipment on a Company-wide basis is insignificant.

        EMPLOYEES

        The Company has 499 full-time, 100 part-time and 79 temporary employees as of December 31, 2002. Manufacturing personnel, including direct and indirect support functions, comprise 503 employees, while general administrative employees total 175.

ITEM 2. PROPERTIES

        ADMINISTRATION

        The Company's Corporate Headquarters consist of approximately 3,648 square feet located in Wayzata, Minnesota, a western suburb of Minneapolis, Minnesota. The Corporate Headquarters has a lease with a five-year term that expires in July 31, 2005.

        MANUFACTURING FACILITIES

        The Company owns its Bemidji, Minnesota facility consisting of eight acres of land and 60,000 square feet of office and manufacturing space.

        The Company has a capital lease on 20,000 square feet of manufacturing and office space in Augusta, Wisconsin, which the Company has an option to purchase in December 2003.

        The Company owns three buildings, which contain together approximately 46,900 square feet, located in Fairmont, Minnesota. The buildings contain the manufacturing activities of Aerospace Systems operation, including custom designed, high technology electronic cable assemblies.

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        The Company owns another 45,800 square feet building in Merrifield, Minnesota. This facility is used for the building of surface-mount printed circuit board assemblies and electro-mechanical assemblies.

        The Company leases a building in Aitkin, Minnesota, which provides 10,750 square feet, that was used for video cable assembly and storage. The lease is scheduled to expire December 1, 2005 at which time the Company has an option to purchase the associated land and building.

        The Company leases a 7,500 square foot building in Baxter, Minnesota for electronic board repair for medical equipment. The lease is scheduled to expire on June 30, 2006.

        The Company leases a 15,000 square foot building in Monterrey, Mexico for office and manufacturing space resulting from the newly acquired subsidiary, Manufacturing and Assembly Solutions of Monterrey, Mexico. The lease expires in June of 2004.

        The Company believes that each of these locations is adequate and that space is available if needed in the foreseeable future for their manufacturing needs. The Company's facilities are highly suitable for the purposes for which they were designed.

ITEM 3. LEGAL PROCEEDINGS

        The Company has litigation pending, arising from the conduct of its business, none of which are expected to have any material effect on the Company's financial position.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        None.

PART II

ITEM 5. MARKET PRICE OF STOCK AND RELATED STOCKHOLDER MATTERS

        As of March 9, 2003, there were approximately 879 shareholders of record. The Company's stock is listed on the National Association of Securities Dealers Automated Quotation System ("NASDAQ") Small Cap Market under the symbol "NSYS". The Company intends to invest its profits into the growth of the Company and, therefore, does not plan to pay out dividends to shareholders. Stock price comparisons follow.

        Stock price comparisons (NASDAQ):

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ITEM 6. SELECTED FINANCIAL DATA

        The following selected historical financial data set forth below have been derived from, and are qualified by reference to the audited Consolidated Financial Statements of Nortech Systems Incorporated and Subsidiary as of December 31, 2002 and 2001 and for each of the three years ended December 31, 2002, 2001 and 2000. The audited consolidated financial statements of Nortech Systems Incorporated and Subsidiary referred to above is included elsewhere herein. The selected historical financial data set forth below as of December 31, 2000, 1999 and 1998 and for each of the years ended December 31, 1999 and 1998 have been derived from the audited consolidated financial statements of Nortech Systems Incorporated and Subsidiary not included herein. The selected financial data set forth below should be read in conjunction with, and are qualified by reference to, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Consolidated Financial Statements and accompanying notes thereto of Nortech Systems Incorporated and Subsidiary included elsewhere herein.

*

Certain amounts have been restated to reflect the results of continuing operations.

        For additional financial data (2002 and 2001 by quarter information), see Note 13 of the Consolidated Financial Statements.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        FORWARD-LOOKING STATEMENTS

        This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Such statements generally will be accompanied by words such as "anticipate," "believe," "estimate," "expect," "forecast," "intend," "possible," "potential," "predict," "project," or other similar words that convey the uncertainty of future events or outcomes. Although Nortech Systems, Incorporated. believes these forward-looking statements are reasonable, they are based upon a number of assumptions concerning future conditions, any or all of which may ultimately prove to be inaccurate. Forward-looking statements involve a number of risks and uncertainties. Important factors that could cause actual results to differ materially from the forward-looking statements include, without limitation:

•

Volatility in the marketplace which may affect market supply and demand of the Company's products;



•

Increased competition;



•

Changes in the reliability and efficiency of the Company's operating facilities or those of third parties;

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•

Risks related to availability of labor;



•

General economic, financial and business conditions that could effect the Company's financial condition and results of operations.

        The factors identified above are believed to be important factors (but not necessarily all of the important factors) that could cause actual results to differ materially from those expressed in any forward-looking statement made by the Company. Unpredictable or unknown factors not discussed herein could also have material adverse effects on forward-looking statements. All forward-looking statements included in this Form 10-K are expressly qualified in their entirety by the forgoing cautionary statements. The Company undertakes no obligations to update publicly any forward-looking statement (or its associated cautionary language) whether as a result of new information or future events.

        CRITICAL ACCOUNTING ESTIMATES

        As stated in our significant accounting policies in Note 1 to the consolidated financial statements, the preparation of financial statements requires management to make estimates and assumptions. The Company believes its most critical accounting estimates relate to inventory reserves, long-lived and intangible asset impairment, deferred tax balances, and self-insured health claim reserves.

        Inventory Reserves:

        Inventory reserves are maintained for the estimated value of the inventory that may have a lower value than stated or in excess of production needs. These values are estimates and may differ from actual results. The Company has an evaluation process that is used to assess the value of the inventory that is slow moving, excess or obsolete. This process is reviewed on a quarterly basis.

        Long-Lived and Intangible Asset Impairment:

        The Company evaluates long-lived assets and intangible assets with definite lives for impairment, as well as the related amortization periods, to determine whether adjustments to these amounts or useful lives are required based on current events and circumstances. The evaluation is based on the Company's projection of the undiscounted future operating cash flows of the underlying assets. To the extent such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amounts of related assets, a charge is recorded to reduce the carrying amount to equal estimated fair value.

        The test for impairment requires the Company to make several estimates about fair value, most of which are based on projected future cash flows. The estimates associated with the asset impairment tests are considered critical due to the judgments required in determining fair value amounts, including projected future cash flows. Changes in these estimates may result in the recognition of an impairment loss.

        Income taxes:

        Management's estimate of the tax rates utilized in the calculation of the deferred tax balances is based on historical taxable income and expected future taxable income and corresponding rates. Further, management's consideration of a valuation allowance for deferred tax assets is based upon estimates of taxable income in future periods. These are estimates and may differ from actual results.

        Self-Insured Health Claim Reserves:

        Management estimates its reserve for employee health claims based on health claims incurred, historical lag times and an analysis of claims activity during the period, while taking into consideration insurance limits and coverage.

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        Based on a critical assessment of its accounting policies and the underlying judgements and uncertainties affecting the application of those policies, management believes that the Company's consolidated financial statements provide a meaningful and fair perspective of the Company. This is not to suggest that other general risk factors, such as changes in worldwide economic conditions, fluctuations in foreign currency exchange rates, changes in materials costs, performance of acquired businesses and others, could not adversely impact the Company's consolidated financial position, results of operations and cash flows in future periods.

        No matters have come to Management's attention since December 31, 2002 that would cause the estimates included in the consolidated financial statements to be significantly misstated.

        OPERATING RESULTS

        Revenues:

        For the years ended December 31, 2002 and 2001, the Company had sales of $60.7 million and $58.5 million, respectively. The increase of $2.2 million or 3.8%, resulted primarily from internal growth of our current customer base. The major increases were in the medical and defense industries. The Company's emphasis is to continually seek mature companies that require a contract manufacturer with a high degree of manufacturing and quality sophistication. For the year ended December 31, 2000 the Company had sales of $54.8 million. The approximate 6.8% increase in sales in 2001 was attributable primarily to internal growth of our current customer base. The Company expects revenue growth to continue at a moderate rate for the year 2003.

        Gross Profit:

        For the years ended December 31, 2002, 2001 and 2000, the Company had gross profit of $10.5 million, $10.4 million, and $10.3 million, respectively. Gross profits as a percentage of gross sales were 17.3%, 17.9%, and 18.7% for the years ended December 31, 2002, 2001 and 2000, respectively. As revenues grow, the Company continues to strive to hold down cost levels by improving productivity and reducing material costs in order to help offset the request for price reductions from customers. The price competitive nature of the business requires the use of service, quality and timely delivery to help attract customers.

        Selling:

        Selling expenses were $2.5 million, $2.8 million, and $2.2 million for the years ended December 31, 2002, 2001 and 2000, respectively. The decrease in selling expenses from 2001 to 2002 reflects a larger portion of revenues being derived from non-commissioned sales. The majority of the increase from 2000 to 2001 reflected the costs related to additional internal sales force and commissioned sales on revenue growth.

        General and Administrative:

        For the years ended December 31, 2002, 2001 and 2000, general and administrative expenses were $3.8 million, $3.4 million and $4.0 million, respectively. The increase in expenses from 2001 to 2002 reflects increased employee benefits and incentives for employees. The reduction in expenses from 2000 to 2001 reflected the use of cost cutting methods and a reduction in administrative staff.

        Interest Income:

        Interest income for the years ended December 31, 2002, 2001 and 2000 was $0.005 million, $0.018 million and $0.028 million, respectively. The interest income was realized as a result of various highly liquid interest bearing accounts readily convertible to of cash.

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        Miscellaneous Income:

        Miscellaneous income was $0.017 million, $0.003 million and $0.016 million for the years ended December 31, 2002, 2001 and 2000, respectively. The miscellaneous income resulted primarily from charges for miscellaneous services that vary by year.

        Interest Expense:

        Interest expense was $0.43 million, $0.78 million, and $1.0 million for the years ended December 31, 2002, 2001 and 2000, respectively. The Company has maintained consistent levels of debt by reinvesting the profits in the growth of the Company. However, average annual prime lending rates have continually decreased from 2000 resulting in lower interest expense in 2002 and 2001.

        Income Taxes

        Income tax expense was $1.4 million, $1.4 million, and $1.1 million for the years ended December 31, 2002, 2001 and 2000, respectively.

        The Company utilized operating loss carryforwards of $1.5 million for the years ended December 31, 2000 to offset federal taxable income. The Company also utilized $.001million of an expiring investment tax credit to offset federal tax and forfeited an additional $.039 million of credits due to expiration in 2000. As of December 31, 2002, the Company had no net operating loss or tax credit carr forwards.

        Net Income:

        The Company's net income from operations in 2002 was $2.4 million or $1.00 per basic common share, or $0.95 per diluted common share. The Company's net income from operations in 2001 was $2.1 million or $0.89 per basic common share, or $0.86 per diluted common share. The Company's net income from operations in 2000 was $2.0 million or $0.86 per basic common share, or $0.83 per diluted common share. The Company believes that the effect of inflation on past operations has not been significant and anticipates that inflation will not have a significant impact on future operations. The Company believes it is noteworthy that our net income growth significantly outpaced our sales growth, we attribute this to cost reduction efforts and lean manufacturing activities.

        Accounting Pronouncements:

        In 2002, the Company adopted the following new Financial Accounting Standards Board (FASB) issued Statements of Financial Accounting Standards (SFAS) accounting pronouncements:

        SFAS No. 142, "Goodwill and Other Intangible Assets", which replaces the requirement to amortize intangible assets with indefinite lives and goodwill with a requirement for a transitional impairment test. Statement 142 requires an evaluation of intangible assets and their useful lives. The transitional impairment test was performed effective as of January 1, 2002

        SFAS 144, "Accounting for the Impairment of Disposal of Long-Lived Assets", which addresses financial accounting and reporting for the impairment or disposals of long-lived assets. While Statement 144 supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of", it retains many of the fundamental provisions of that Statement. Statement 144 also supersedes the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions", for the disposal of a segment of a business. However, it retains the requirement in Opinion No. 30 to report separately discontinued operations and extends the reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in distributions to owners) or is classified as held for sale.

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        SFAS No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure" amends the FASB Statement No. 123, "Accounting for Stock-Based Compensation", to provide alternative methods for a voluntary change to the fair value method of accounting for stock-based compensation. In addition, this Statement amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements. Certain of the disclosures are required for fiscal years ending after December 15, 2002 and are included in the notes to these consolidated financial statements.

        FINANCIAL CONDITION AND LIQUIDITY

        As of December 31, 2002, the Company's cash and cash equivalent balances totaled $448,751. The capital resources existing at December 31, 2002 were derived from operations during the year ended December 31, 2002.

        On December 31, 2002, the Company had working capital of approximately $14.4 million. During year 2002, the Company generated approximately $2.9 million of cash flow from operating activities. This improvement in cash was primarily attributable to operations profit. The Company's Investing and Financing activities decreased cash by $2.6 million reflecting the reinvesting of cash into the operation for equipment and the expansion of operations into Mexico.

        The Company currently has a line of credit arrangement ($6.0 million) in place with Wells Fargo Bank for general working capital needs, and no material unused sources of liquidity other than the cash, accounts receivables, inventory and other current assets.

        The Company's liquidity and capital resources are strong, and the Company believes that its future financial requirements can be met with funds generated from the operating activities and its operating line of credit.

        Set forth below is information about the Company's long-term contractual obligations and other commercial commitments outstanding as of December 31, 2002. It brings together data for easy reference from the consolidated balance sheet and from individual notes to the consolidated financial statements. This information is important in understanding the financial position of the Company.

ITEM 7a. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK

        Market risk is the potential change in an instrument's value caused, for example, by fluctuations in interest and currency exchange rates. The Company's primary market risk exposures are interest rate and unfavorable movements in exchange rates between the U.S. dollar and the Mexican peso. Monitoring and managing these risks is a continual process carried out by senior management. Market risk is managed based on an ongoing assessment of trends in interest rates, foreign exchange rates, and economic developments, giving consideration to possible effects on both total return and reported earnings. The Company's financial advisors, both internal and external, provide ongoing advice regarding trends that affect management's assessment.

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        Exchange Rate Sensitivity:

        In 2002, the Company launched operations in Mexico. Accordingly, exposure exists to potentially adverse movements in foreign currency rates. The Company does not use foreign exchange forward contracts to hedge the risk of change in foreign currency exchange rates. The Company's consolidated financial statements are denominated in U.S. dollars and accordingly, changes in the exchange rates between Company subsidiary's local currency and the U.S. dollar will affect the translation of such subsidiary's financial results into U.S. dollars for the purposes of reporting the consolidated financial results. The Company does not hedge these matters because cash flows from international operations are generally re-invested locally. It is estimated that a 10% change in foreign exchange rates would have an immaterial impact on reported net earnings.

        Interest Rate Sensitivity:

        The effective interest rate on the Company's credit facilities are influenced by the actions of the Federal Reserve in establishing from time to time the Federal Funds Interest Rate which is the rate banks borrow from the Federal Reserve Bank. During 2002 and 2001, the Federal Reserve implemented a number of reductions in the Federal Funds Interest Rate in an effort to stimulate the U.S. economy. As a result the effective interest rate that the Company paid on its borrowings under the facilities declined leading to a corresponding reduction in interest expense. To the extent that the Federal Reserve increases the Federal Funds Interest Rate in the future, the effective interest rate on the Company's facilities will increase. The Company's interest expense will increase accordingly if borrowing levels remain constant. Based on the balance outstanding under our interest-bearing Facilities at year-end, a percentage point change in the effective interest rate would have changed interest expense by $90,231.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA

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INDEPENDENT AUDITORS' REPORT

Board of Directors and Shareholders
Nortech Systems Incorporated:

        We have audited the accompanying consolidated balance sheet of Nortech Systems Incorporated and subsidiary as of December 31, 2002, and the related consolidated statements of income, shareholders' equity and cash flows for the year ended December 31, 2002. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

        We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

        In our opinion, the 2002 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nortech Systems Incorporated and subsidiary as of December 31, 2002, and the results of their operations and their cash flows for the year ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.

/s/  KPMG LLP      

Minneapolis, Minnesota
March 10, 2003

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INDEPENDENT AUDITORS' REPORT

Board of Directors
Nortech Systems Incorporated and Subsidiary
Bemidji, Minnesota

        We have audited the accompanying consolidated balance sheet of Nortech Systems Incorporated and Subsidiary as of December 31, 2001, and the related consolidated statements of income, shareholders' equity, and cash flows for each of the years ended December 31, 2001 and 2000. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

        We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Nortech Systems Incorporated and Subsidiary as of December 31, 2001, and the results of their operations and their cash flows for each of the years ended December 31, 2001 and 2000, in conformity with accounting principles generally accepted in the United States of America.

LARSON, ALLEN, WEISHAIR, & CO., LLP

St. Cloud, Minnesota
February 13, 2002

17

NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED BALANCE SHEETS

DECEMBER 31, 2002 AND 2001

See accompanying Notes to Consolidated Financial Statements.

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NORTECH SYSTEMS INCORPORATED AND SUBSIDIARY

CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000