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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q/A



Amendment No. 2



|x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
|- |  | -------------------------------------------------------

| |  | SECURITIES EXCHANGE ACT OF 1934
| |  | -------------------------------



| |  | For the quarterly period ended June 30, 2003
| |  | --------------------------------------------



OR



| ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
|- |  | --------------------------------------------------------

| |  | SECURITIES EXCHANGE ACT OF 1934
| |  | -------------------------------



Commission file number 0-21982



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Diametrics Medical, Inc.

Incorporated pursuant to the Laws of Minnesota



Internal Revenue Service  Employer Identification No. 41-1663185

2658 Patton Road,
Roseville, Minnesota 55113

(651) 639-8035



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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 ̈



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



As of July 31, 2003, 27,204,705 shares of Common Stock were outstanding.



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EXPLANATORY NOTE:



This amendment No. 2 amends the registrants quarterly report on Form 10-Q for the quarter ended June 30, 2003,
filed with the Securities and Exchange Commission on August 14, 2003 and amended on Form10-Q/A filed September 4, 2003 (the Form 10-Q), for the sole purpose of refiling Exhibit 10.5 filed herewith. This quarterly report on Form 10-Q/A is
identical to the Form 10-Q, as previously amended, in all other respects. Except as otherwise specifically noted, all information contained herein is as of June 30, 2003 and does not reflect any events or changes in information that may have
occurred subsequent to that date.



Diametrics Medical, Inc.



|                               |  | Page                                                                                 
|------------------------------ |  | -------------------------------------------------------------------------------------
|Part I  FINANCIAL INFORMATION |  |                                                                                      
|Item 1.                        |  | Consolidated Financial Statements (unaudited)                                        
|                               |  |                                                                                      
|                               |  | Consolidated Statements of Operations:                                               
|                               |  | Three Months Ended June 30, 2003 and 2002                                            
|                               |  | Six Months Ended June 30, 2003 and 2002                                              
|                               |  |                                                                                      
|                               |  | Consolidated Balance Sheets asof June 30, 2003 and December 31, 2002                 
|                               |  |                                                                                      
|                               |  | Consolidated Statements of Cash Flows:                                               
|                               |  | Six Months Ended June 30, 2003 and 2002                                              
|                               |  |                                                                                      
|                               |  | Notes to Consolidated Financial Statements                                           
|                               |  |                                                                                      
|Item 2.                        |  | Managements Discussion and Analysis of Results of Operations and Financial Condition
|                               |  |                                                                                      
|Item 3.                        |  | Quantitative and Qualitative Disclosure About Market Risk                            
|                               |  |                                                                                      
|Item 4.                        |  | Controls and Procedures                                                              
|                               | 
|Part II  OTHER INFORMATION    |  |                                                                                      
|                               |  |                                                                                      
|Item 1.                        |  | Legal Proceedings                                                                    
|                               |  |                                                                                      
|Item 2.                        |  | Changes in Securities                                                                
|                               |  |                                                                                      
|Item 3.                        |  | Defaults Upon Senior Securities                                                      
|                               |  |                                                                                      
|Item 4.                        |  | Submission of Matters to a Vote of Security Holders                                  
|                               |  |                                                                                      
|Item 5.                        |  | Other Information                                                                    
|                               |  |                                                                                      
|Item 6.                        |  | Exhibits and Reports on Form 8-K                                                     
|                               | 
|Signatures                     |  | 44                                                                                   



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PART I  FINANCIAL INFORMATION



Item 1. Consolidated Financial Statements (unaudited)



DIAMETRICS MEDICAL, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)



|                                                                      |  | Three Months Ended June 30, |            |   | Six Months Ended June 30, |  
|--------------------------------------------------------------------- |  | --------------------------- | ---------- | - | ------------------------- | -
|                                                                      |  | 2003                        |            |   | 2002                      |  
|Net revenue                                                           |  | $                           | 2,827,251  |   |                           | $
|                                                                      |  |                             |            |  
|Cost of revenue                                                       |  |                             | 2,197,889  |   |                           |  
|                                                                      |  |                             |            |   |                           |  
|Gross profit                                                          |  |                             | 629,362    |   |                           |  
|                                                                      |  |                             |            |   |                           |  
|Operating expenses:                                                   |  |                             |            |   |                           |  
|Research and development                                              |  |                             | 1,025,240  |   |                           |  
|Selling, general and administrative                                   |  |                             | 1,976,389  |   |                           |  
|Restructuring and other charges                                       |  |                             |           |   |                           |  
|                                                                      |  |                             |            |   |                           |  
|Total operating expenses                                              |  |                             | 3,001,629  |   |                           |  
|                                                                      |  |                             |            |   |                           |  
|Operating loss                                                        |  |                             | (2,372,267 | ) |                           |  
|                                                                      |  |                             |            |  
|Interest income                                                       |  |                             | 3,199      |   |                           |  
|Interest expense                                                      |  |                             | (340,711   | ) |                           |  
|Gain on modification of convertible notes                             |  |                             | 1,500,000  |   |                           |  
|Other expense, net                                                    |  |                             | (16,225    | ) |                           |  
|                                                                      |  |                             |            |   |                           |  
|Net loss                                                              |  |                             | (1,226,004 | ) |                           |  
|                                                                      |  |                             |            |  
|Beneficial conversion featurepreferred stock dividend (note 3)       |  |                             | (958,962   | ) |                           |  
|                                                                      |  |                             |            |   |                           |  
|Net loss available to common shareholders                             |  | $                           | (2,184,966 | ) |                           | $
|                                                                      |  |                             |            |   |                           |  
|Basic and diluted net loss per share available to common shareholders |  | $                           | (0.08      | ) |                           | $
|                                                                      |  |                             |            |   |                           |  
|Weighted average number of common shares outstanding                  |  |                             | 26,852,847 |   |                           |  
|                                                                      |  |                             |            |   |                           |  



See
accompanying notes to consolidated financial statements.



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DIAMETRICS MEDICAL, INC.

CONSOLIDATED BALANCE SHEETS



|                                                                                                                                                                  |  | June 30, 2003 |              |   | December 31, 2002 |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------------ | - | ----------------- | -
|ASSETS                                                                                                                                                            |  |               |              |   |                   |  
|Current assets:                                                                                                                                                   |  |               |              |   |                   |  
|Cash and cash equivalents                                                                                                                                         |  | $             | 1,271,339    |   |                   | $
|Accounts receivable                                                                                                                                               |  |               | 1,160,447    |   |                   |  
|Inventories                                                                                                                                                       |  |               | 2,917,965    |   |                   |  
|Prepaid expenses and other current assets                                                                                                                         |  |               | 103,970      |   |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|Total current assets                                                                                                                                              |  |               | 5,453,721    |   |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|Property and equipment                                                                                                                                            |  |               | 20,641,368   |   |                   |  
|Less accumulated depreciation and amortization                                                                                                                    |  |               | (16,544,820  | ) |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|                                                                                                                                                                  |  |               | 4,096,548    |   |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|Other assets                                                                                                                                                      |  |               | 42,588       |   |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|                                                                                                                                                                  |  | $             | 9,592,857    |   |                   | $
|                                                                                                                                                                  |  |               |              |   |                   |  
|LIABILITIES AND SHAREHOLDERS EQUITY (DEFICIT)                                                                                                                    |  |               |              |   |                   |  
|Current liabilities:                                                                                                                                              |  |               |              |   |                   |  
|Accounts payable                                                                                                                                                  |  | $             | 1,288,248    |   |                   | $
|Accrued expenses                                                                                                                                                  |  |               | 1,349,132    |   |                   |  
|Convertible senior secured fixed rate notes                                                                                                                       |  |               |             |   |                   |  
|Capital lease obligations and other borrowings                                                                                                                    |  |               | 195,601      |   |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|Total current liabilities                                                                                                                                         |  |               | 2,832,981    |   |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|Long-term liabilities:                                                                                                                                            |  |               |              |   |                   |  
|Convertible senior secured fixed rate notes                                                                                                                       |  |               | 5,193,213    |   |                   |  
|Long-term liabilities, excluding current portion                                                                                                                  |  |               | 169,064      |   |                   |  
|Accrued retirement plan benefit                                                                                                                                   |  |               | 2,563,201    |   |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|Total liabilities                                                                                                                                                 |  |               | 10,758,459   |   |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|Shareholders equity (deficit):                                                                                                                                   |  |               |              |   |                   |  
|Preferred stock, $.01 par value: 5,000,000 authorized, 15,000 and no shares issued and outstanding at June 30, 2003 and December
31, 2002, respectively           |  |               | 150          |   |                   |  
|Common stock, $.01 par value: 60,000,000 authorized, 27,204,705 and 27,165,336 shares issued and outstanding at June 30, 2003 and
December 31, 2002, respectively |  |               | 272,047      |   |                   |  
|Additional paid-in capital                                                                                                                                        |  |               | 151,469,159  |   |                   |  
|Accumulated deficit                                                                                                                                               |  |               | (148,494,073 | ) |                   |  
|Deferred compensation                                                                                                                                             |  |               | (446,718     | ) |                   |  
|Accumulated other comprehensive loss                                                                                                                              |  |               | (3,966,167   | ) |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|Total shareholders equity (deficit)                                                                                                                              |  |               | (1,165,602   | ) |                   |  
|                                                                                                                                                                  |  |               |              |   |                   |  
|                                                                                                                                                                  |  | $             | 9,592,857    |   |                   | $
|                                                                                                                                                                  |  |               |              |   |                   |  



See
accompanying notes to consolidated financial statements.



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DIAMETRICS MEDICAL, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS



|                                                                            |  | Six Months Ended June 30, |           
|--------------------------------------------------------------------------- |  | ------------------------- | ----------
|                                                                            |  | 2003                      |           
|Cash flows from operating activities:                                       |  |                           |           
|Net loss                                                                    |  | $                         | (4,116,625
|Adjustments to reconcile net loss to net cash used in operating activities: |  |                           |           
|Depreciation and amortization                                               |  |                           | 783,737   
|Gain on modification of convertible notes                                   |  |                           | (1,500,000
|Accretion of convertible notes balance                                      |  |                           | 193,213   
|Stock-based compensation                                                    |  |                           | 206,178   
|Loss (gain) on disposal of property and equipment                           |  |                           | 3,781     
|Changes in operating assets and liabilities:                                |  |                           |           
|Accounts receivable                                                         |  |                           | (69,967   
|Inventories                                                                 |  |                           | 652,550   
|Prepaid expenses and other current assets                                   |  |                           | 255,581   
|Accounts payable                                                            |  |                           | 84,283    
|Accrued expenses                                                            |  |                           | 66,474    
|Deferred credits and revenue                                                |  |                           |          
|                                                                            |  |                           |           
|Net cash used in operating activities                                       |  |                           | (3,440,795
|                                                                            |  |                           |           
|Cash flows from investing activities:                                       |  |                           |           
|Purchases of property and equipment                                         |  |                           | (331,298  
|Proceeds from maturities of marketable securities                           |  |                           |          
|Other                                                                       |  |                           |          
|                                                                            |  |                           |           
|Net cash provided by (used in) investing activities                         |  |                           | (331,298  
|                                                                            |  |                           |           
|Cash flows from financing activities:                                       |  |                           |           
|Principal payments on borrowings and capital leases                         |  |                           | (104,763  
|Debt extension costs                                                        |  |                           | (40,194   
|Net proceeds from the issuance of preferred stock                           |  |                           | 1,210,775 
|Net proceeds from the issuance of common stock                              |  |                           | 20,289    
|                                                                            |  |                           |           
|Net cash provided by (used in) financing activities                         |  |                           | 1,086,107 
|                                                                            |  |                           |           
|Effect of exchange rate changes on cash and cash equivalents                |  |                           | (7,466    
|                                                                            |  |                           |           
|Net decrease in cash and cash equivalents                                   |  |                           | (2,693,452
|                                                                            |  |                          
|Cash and cash equivalents at beginning of period                            |  |                           | 3,964,791 
|                                                                            |  |                           |           
|Cash and cash equivalents at end of period                                  |  | $                         | 1,271,339 
|                                                                            |  |                           |           
|Supplemental disclosure of cash flow information:                           |  |                           |           
|Cash paid during the period for interest                                    |  | $                         | 25,531    
|                                                                            |  |                           |           



Supplemental disclosure of noncash
investing and financing activities:



| |  |  | The Company entered into capital lease obligations for equipment of $39,371 during the six months ended June 30, 2003.
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | As further described in note 3, effective April 7, 2003, the Company completed the renegotiation of the terms of its $7.3 million Convertible Senior Secured Fixed Rate Notes. The
modified notes and associated warrants to purchase 4.3 million shares of common stock were recorded in the second quarter 2003 as debt and equity, respectively, at their respective fair values of $5 million and $800,000, and the $7.3 million
carrying value of the original notes was retired.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | As further described in note 4, effective May 12, 2003, the Company completed a $1.5 million interim financing through the sale of 15,000 shares of Series E convertible preferred
stock. A beneficial conversion feature embedded in the preferred stock was calculated at $958,962 and was recorded as a noncash charge to retained earnings and treated as a reconciling item on the Statements of Operations to adjust the reported net
loss to net loss available to common shareholders.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | During the three months ended June 30, 2003, the Company disposed of various obsolete assets in property and equipment with a recorded cost of $3,351,500 and accumulated
depreciation of $3,347,719.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



See accompanying notes to consolidated financial statements.



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DIAMETRICS MEDICAL, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2003

(UNAUDITED)



(1) UNAUDITED FINANCIAL STATEMENTS



The interim consolidated financial statements of Diametrics Medical, Inc. (the
Company) are unaudited and have been prepared by the Company in accordance with accounting principles generally accepted in the United States of America for interim financial information, pursuant to the rules and regulations of the
Securities and Exchange Commission. Pursuant to such rules and regulations, certain financial information and footnote disclosures normally included in the financial statements have been condensed or omitted. However, in the opinion of management,
the financial statements include all adjustments, consisting of normal recurring accruals, necessary for a fair presentation of the interim periods presented. Operating results for these interim periods are not necessarily indicative of results to
be expected for the entire year, due to seasonal, operating and other factors.



The Company has identified certain of its significant accounting policies that it considers particularly important to the portrayal of the Companys results of operations and financial position and which may require the application of
a higher level of judgment by the Companys management, and as a result are subject to an inherent level of uncertainty. These are characterized as critical accounting policies and address revenue recognition and accounts
receivable, inventories, foreign currency translation and transactions, impairment of long-lived assets and retirement plan funding, each more fully described under Managements Discussion and Analysis of Results of Operations and
Financial Condition in the Companys Annual Report on Form 10-K for the year ended December 31, 2002. The Companys accounting policy on the recognition of research and development funding, which is also described in the
Companys Form 10-K, is no longer considered a critical accounting policy in 2003 as the Companys recognition of funding from Philips Medical Systems ceased as of November 1, 2002 with the termination of the exclusive agreement with
Philips.



During the quarter ended June 30, 2003, the Company identified a new
critical accounting policy, Accounting for Debt and Equity Instruments. As discussed in notes 3 and 4, during the second quarter 2003, the Company completed the renegotiation of the terms of its Convertible Senior Secured Fixed Rate
Notes and completed a $1.5 million interim financing through the sale of 15,000 shares of Series E convertible preferred stock. Both transactions also included the issuance of warrants for the purchase of the Companys common stock. The
accounting for these debt and equity related transactions was complex and required the Company to make certain judgements regarding their accounting treatment. The Companys significant conclusions related to these transactions included: 1) the
accounting applicable to the modification of the convertible notes falls primarily under the treatment prescribed by EITF 96-19, Debtors Accounting for a Modification or Exchange of Debt Instruments, 2) the determination of the
respective fair values to use as a basis for recording the carrying values of the convertible notes, Series E preferred stock and warrants issued in connection with each transaction and 3) the classification of the warrants as equity versus debt
based upon an assessment under EITF 00-19 of the Companys contractual obligations for registration of the related common shares issuable upon exercise of the warrants. The Company engaged an outside valuation firm to assist management in the
measurement of the fair value of the modified notes. Management has reviewed and agrees with the assumptions used in the determination of fair value. The primary element of that measurement was the calculation of the estimated present value of the
cash flows associated with the notes, including interest and principal payments from the effective date of modification of the notes of April 7, 2003 through the maturity date of the notes of August 4, 2005. A discount rate of approximately 25% was
used to calculate the present value of the remaining cash flows associated with the notes. The 25% discount rate represents an estimate of the Companys cost of capital, and was based upon market studies of venture capitalists required
return on investment and current trends within the venture capital markets as of the valuation date, with consideration of the Companys history, status, prospects and risks.



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Diametrics Medical, Inc. is an established business with proven technological platforms. However, given the
Companys historic losses and recent changes in its exclusive distribution agreement with Philips, perceived equity investor risk would likely be higher than an alternative equity investment in a larger, profitable business enterprise.
Therefore, the most likely investor in the Company would expect venture capital rates of return commensurate with the Companys business history, status, prospects and risks.



Based upon a review of various independent studies, including a survey by QED Research of 300 venture capitalists (QED Report on Venture
Capital Financial Analysis, 1989); Pratts Guide to Venture Capital Financial Sources; an analysis of investors expected annual returns of companies at various stages of development by William Rygrave, Professor of Free Enterprise at
Babson College in Massachusetts; and an analysis of actual annual returns of companies at those stages by Houlihan Valuation Advisors and Venture One, a base required rate of return for a company at a development stage similar to the Companys
would be 25-40% before consideration of company specific factors and the trends in the venture capital markets as of the valuation date. Following are company specific factors and market trends considered in arriving at an appropriate discount rate:



The Companys technology platforms are proven and viable, and the
marketplace has demonstrated an interest in and demand for the Companys products. Perceived investor risk would likely relate to recent changes in the Companys distribution channels and methods and managements ability to execute an
alternative and successful marketing and distribution plan, rather than on development of the market. Further, the modified notes are interest bearing and are secured by the assets of the Companys U.K. subsidiary. Additionally, deteriorating
economic conditions over the past two to three years have led to a large scale-back in venture capital investments, with the reduced level of investing activity shifting away from start-up stage companies to companies at a stage of development
similar to the Companys or a later stage. Along with this, venture capitalists have generally reduced their expectations of required rates of return on investment. Consideration of these factors led to the conclusion that investors would
likely require returns towards the low end of the 25-40% range discussed above. Therefore, for purposes of determining the fair value of the modified notes, the Company applied a discount rate at the low end of this range of 25% to arrive at the
present value of the cash flows associated with the modified notes.



Use of a
25% discount rate resulted in a present value calculation for the remaining interest and principal cash flows of approximately $4.9 million. The fair value of the notes conversion rights was calculated at approximately $100,000, determined
through use of the Black Scholes Option Pricing Model, resulting in a total estimated fair value of the modified notes of $5 million, as further discussed in note 3. The valuation of the modified notes directly affected the calculation of the amount
of the gain recognized on the modification of the notes of $1.5 million. If the Companys estimate of the appropriate discount rate had been 20% higher or lower, resulting in a discount rate of 30% and 20% at the high and low end of the range,
respectively, the present value calculation would have decreased by approximately $400,000 and increased by approximately $460,000, respectively. The impact of such a change in estimate would have increased and decreased by the same amounts the
amount of gain recognized on modification of the notes to approximately $1.9 million and $1 million, respectively.



No other changes to the Companys critical accounting policies have been made during the quarter ended June 30, 2003. The Company has, however, made changes to
manage its exposure associated with future funding of its Retirement Plan, and has provided information on the financial impact of applying different assumptions to the valuation of the Retirement Plan, as further discussed under Item 3,
Quantitative and Qualitative Disclosure About Market Risk.



These
statements should be read in conjunction with the financial statements and related notes which are part of the Companys Annual Report on Form 10-K for the year ended December 31, 2002.



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(2) SUBSEQUENT EVENT AND UNAUDITED PRO FORMA FINANCIAL STATEMENTS



On July 18, 2003, the Company announced that it had entered into an asset purchase agreement
with International Technidyne Corporation (ITC), a wholly owned subsidiary of Thoratec Corporation, whereby ITC will acquire substantially all of the assets used in the operation of the Companys intermittent testing business.
Pursuant to the terms of the agreement, ITC will pay the Company approximately $5.2 million in cash, which may be adjusted downward if any purchase price adjustments are required, and assume certain liabilities, including up to $550,000 in trade
payables. Of the $5.2 million cash payment, $780,000 will be placed in escrow by ITC for 180 days after the closing of the transaction to cover any shortfall in collected receivables or any indemnification claims. The asset sale is subject to
customary closing conditions, including approval by the Companys shareholders, and is expected to close in the third quarter of 2003. Based upon a review of SFAS No. 144, Accounting for the Impairment of Long-lived Assets, the
Company has assessed the measurement date for the sale transaction as the date of shareholder approval, which, as noted, is expected to occur in the third quarter. Financial results for the Companys intermittent testing business will be
recorded as discontinued operations upon the receipt of shareholder approval for sale of that business through the date the sale transaction is closed. Proceeds from the sale of the Companys intermittent testing business will be used to fund
and grow the Companys continuous monitoring business.



The following
unaudited pro forma financial statements give effect to the sale of the Companys intermittent testing business.



The unaudited pro forma consolidated balance sheet and statements of operations filed with this report are presented for illustrative purposes only. The pro forma balance
sheet as of June 30, 2003 has been prepared to reflect the sale of the assets and liabilities of the Companys intermittent testing business to ITC as if such sale had taken place on June 30, 2003, and is not necessarily indicative of the
financial position of Diametrics Medical, Inc. had such sale occurred on that date. The pro forma results of operations for the six months ended June 30, 2003 and the years ended December 31, 2002, 2001 and 2000 have been prepared assuming that the
sale of the Companys intermittent testing business occurred as of the beginning of each of these periods, and are not necessarily indicative of the results of operations for future periods or the results that actually would have been realized
had the Company sold its intermittent testing business as of those dates. The pro forma financial statements, including notes thereto, should be read in conjunction with the historical financial statements of Diametrics Medical, Inc. included in the
Companys filings on Form 10-K for the years ended December 31, 2002, 2001 and 2000 and the unaudited financial statements included in this Form 10-Q for the quarter ended June 30, 2003.



The intermittent testing business is the primary operation of the Companys U.S. entity
located in Roseville, Minnesota, along with the Companys corporate headquarters. The continuous monitoring business is the primary operation of the Companys wholly-owned subsidiary located in the United Kingdom. Due to this separation,
most amounts attributable to the intermittent testing business are readily identifiable. Costs of the U.S. field sales organization were allocated based on the estimated level of effort applied to sell the respective product lines. The payment
received in lieu of product purchases from Philips in 2002 was not specifically attributable to products. Therefore, that amount was allocated based on the relative ratio of products purchased by Philips year-to-date in 2002, prior to making that
payment.



Costs and expenses attributed to the intermittent testing business
are specific, direct costs primarily associated with that business. As such, they do not reflect general corporate allocations or other non-direct cost savings that may occur as a result of the Company focusing its efforts exclusively on the
continuous monitoring business going forward. The Company intends to make additional business changes, not reflected in the following pro forma financial statements, with the objective of reducing its cost structure to be more in line with the
reduced size of its ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating
leases associated with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs, which are not reflected in the pro forma financial



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statements. Given the evolving nature of these and potentially other business changes, the Company is unable to provide
an estimate of the associated charges at this time.



As described in note 4,
the Companys Series E convertible preferred stock holders have the option to put back to the Company 50% of their original $1.5 million investment plus a return of 1% per month in the event of the Companys completion of the sale of the
intermittent testing business. The potential impact of this transaction, if it occurred, has not been reflected in the pro forma financial statements.



The following unaudited pro forma statements represent the June 30, 2003 balance sheet adjusted to reflect the sale of the assets and liabilities of the intermittent
testing business to ITC as if such sale had taken place on June 30, 2003:



PRO FORMA CONSOLIDATED BALANCE SHEET

AS OF JUNE 30, 2003

(UNAUDITED)



|                                                 |  |                           |              |   | Pro Forma Adjustments                      |   |            |                  | 
|------------------------------------------------ |  | ------------------------- | ------------ | - | ------------------------------------------ | - | ---------- | ---------------- | 
|                                                 |  | ConsolidatedJune 30, 2003 |              |   | Net Assets ToBe Sold/ConsiderationReceived |   |            | OtherAdjustments | 
|ASSETS                                           |  |                           |              |   |                                            |   |            |                  | 
|Current assets:                                  |  |                           |              |   |                                            |   |            |                  | 
|Cash and cash equivalents                        |  | $                         | 1,271,339    |   |                                            | $ | 4,420,000  | (a)              | 
|Accounts receivable                              |  |                           | 1,160,447    |   |                                            |   | (843,911   | )(b)             | 
|Amounts due from ITC                             |  |                           |             |   |                                            |   | 780,000    | (d)              | 
|Inventories                                      |  |                           | 2,917,965    |   |                                            |   | (998,152   | )(b)             | 
|Prepaid expenses and other current assets        |  |                           | 103,970      |   |                                            |   | (6,510     | )(b)             | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|Total current assets                             |  |                           | 5,453,721    |   |                                            |   | 3,351,427  |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|Property and equipment, net                      |  |                           | 4,096,548    |   |                                            |   | (1,737,942 | )(b)             | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|Other assets                                     |  |                           | 42,588       |   |                                            |   |           |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|                                                 |  | $                         | 9,592,857    |   |                                            | $ | 1,613,485  |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|LIABILITIES AND SHAREHOLDERS EQUITY (DEFICIT)   |  |                           |              |   |                                            |   |            |                  | 
|Current liabilities:                             |  |                           |              |   |                                            |   |            |                  | 
|Accounts payable                                 |  | $                         | 1,288,248    |   |                                            | $ | (347,536   | )(b)             | 
|Accrued expenses                                 |  |                           | 1,349,132    |   |                                            |   | (30,000    | )(b)             | 
|Capital lease obligations and other borrowings   |  |                           | 195,601      |   |                                            |   |           |                  | 
|Deferred gain                                    |  |                           |             |   |                                            |   | 780,000    | (d)              | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|Total current liabilities                        |  |                           | 2,832,981    |   |                                            |   | 402,464    |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|Long-term liabilities:                           |  |                           |              |   |                                            |   |            |                  | 
|Convertible senior secured fixed rate notes      |  |                           | 5,193,213    |   |                                            |   |           |                  | 
|Long-term liabilities, excluding current portion |  |                           | 169,064      |   |                                            |   |           |                  | 
|Accrued retirement plan benefit                  |  |                           | 2,563,201    |   |                                            |   |           |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|Total liabilities                                |  |                           | 10,758,459   |   |                                            |   | 402,464    |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|Shareholders equity (deficit):                  |  |                           |              |   |                                            |   |            |                  | 
|Capital stock                                    |  |                           | 272,197      |   |                                            |   |           |                  | 
|Additional paid-in capital                       |  |                           | 151,469,159  |   |                                            |   |           |                  | 
|Accumulated deficit                              |  |                           | (148,494,073 | ) |                                            |   | 1,211,021  | (c)              | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|Deferred compensation                            |  |                           | (446,718     | ) |                                            |   |           |                  | 
|Accumulated other comprehensive loss             |  |                           | (3,966,167   | ) |                                            |   |           |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|Total shareholders equity (deficit)             |  |                           | (1,165,602   | ) |                                            |   | 1,211,021  |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 
|                                                 |  | $                         | 9,592,857    |   |                                            | $ | 1,613,485  |                  | 
|                                                 |  |                           |              |   |                                            |   |            |                  | 



9



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##### Table of Contents

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:



|a) |  | Proceeds to be received at the closing of the sale of the Companys intermittent testing business.
|-- |  | --------------------------------------------------------------------------------------------------



|b) |  | Assets sold to and liabilities assumed by ITC under the asset purchase agreement.
|-- |  | ---------------------------------------------------------------------------------



|c) |  | The net consideration to be received at closing of $4,420,000 (see adjustment a above) less the net assets sold of $3,208,979 (see adjustment b above)
represents the pro forma gain at closing, assuming the transaction occurred on June 30, 2003.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|d) |  | Fifteen percent of the total transaction consideration ($780,000) placed in escrow by ITC for 180 days after closing to fund indemnification obligations, if any, that arise. At the
time amounts in escrow are released, the Company will recognize additional gain on the transaction.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|e) |  | Includes payment at the closing date of $416,728, representing accrued salaries ($65,966), accrued vacation ($237,632) and accrued retention bonus ($113,130) earned by employees of
the Companys intermittent testing business that are either transferring to ITC or leaving Diametrics. The cash reduction also includes payment of severance totaling $99,571 for personnel reductions in the Companys intermittent testing
business which will occur as a result of the transaction.
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|f) |  | Accrual of estimated legal and accounting fees associated with the transaction, based upon billings to date and estimated remaining charges for these services.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------



|g) |  | Reflects adjustments to record the impact on equity and deferred compensation of transferring the employees of the Companys intermittent testing business to ITC who are
participants in the Companys retention agreement.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Companys retention agreement, which became effective August 1, 2002, included the grant of restricted stock to certain key employees who remain employed by the Company for at least one year from the agreements effective
date. The stock grants consisted of the issuance of an aggregate of 329,885 shares of restricted stock, of which 85,692 shares were issued to four employees of the intermittent testing business. The restricted stock vests over a 24-month period,
with 50% vesting after 12 months and pro rata vesting of shares over the remaining 12 months to achieve 100% vesting after 24 months. As described in note 11, the aggregate fair value of the restricted common stock on the date of grant, August 1,
2002, was $824,711, which was recognized as restricted stock with a corresponding charge to deferred compensation, a contra equity account. Of this amount, $214,230 corresponds to the fair value of the 85,692 shares issued to employees of the
intermittent testing business. The deferred compensation for the restricted stock grants is being recognized as expense ratably over the 24-month vesting period. Under the terms of the retention agreement, in the event of involuntary termination of
employment from the Company (such as the transfer of employees to ITC), 50% of restricted shares vest if termination occurs prior to August 1, 2003 and a pro rata portion of shares vest if termination occurs on or after August 1, 2003. The retention
agreement requires cancellation of remaining unvested shares. Assuming the transaction occurred on June 30, 2003, restricted shares held by employees of the intermittent testing business that are transferring to ITC would be eligible for one month
of accelerated vesting to achieve the minimum 50% vesting under the retention agreement, and the remaining 50% of unvested shares held by these employees would be cancelled. The noted adjustments to capital stock and additional paid-in-capital
totaling $107,115 reflect the cancellation of 50% of the original $214,230 fair value of the restricted stock held by employees of the intermittent testing business, and the $116,041 adjustment to deferred compensation reflects the acceleration of
one month of vesting of the fair value of such restricted stock ($8,926) and write-off of the remaining 50% of fair value associated with the cancelled restricted stock ($107,115).



Note: As described in note 4, the Companys Series E convertible preferred stock holders have the option to put back to the Company 50%
of their original $1.5 million investment plus a return of 1% per month in the event of the Companys completion of the sale of the intermittent testing business. The potential impact of this transaction, if it occurred, has not been reflected
in the pro forma financial statements.



10



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##### Table of Contents

The following pro forma and unaudited statement of operations for the six months ended June 30, 2003, represents the
results of operations as if the sale to ITC occurred on December 31, 2002:



PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE SIX MONTHS ENDED JUNE 30, 2003

(UNAUDITED)



|                                                         |  | Six Months Ended June 30, 2003 |           
|-------------------------------------------------------- |  | ------------------------------ | ----------
|                                                         |  | As Reported                    |           
|Net revenue                                              |  | $                              | 5,003,918 
|Cost of revenue                                          |  |                                | 3,955,635 
|                                                         |  |                                |           
|Gross profit                                             |  |                                | 1,048,283 
|                                                         |  |                                |           
|Operating expenses:                                      |  |                                |           
|Research and development                                 |  |                                | 2,156,746 
|Selling, general and administrative                      |  |                                | 4,024,882 
|                                                         |  |                                |           
|Total operating expenses                                 |  |                                | 6,181,628 
|                                                         |  |                                |           
|Operating loss                                           |  |                                | (5,133,345
|Interest income                                          |  |                                | 10,685    
|Interest expense                                         |  |                                | (479,238  
|Other income, net                                        |  |                                | 1,485,273 
|                                                         |  |                                |           
|Net loss                                                 |  |                                | (4,116,625
|Beneficial conversion feature  preferred stock dividend |  |                                | (958,962  
|                                                         |  |                                |           
|Net loss available to common shareholders                |  | $                              | (5,075,587
|                                                         |  |                                |           
|Basic and diluted net loss per common share              |  | $                              | (0.19     
|                                                         |  |                                |           
|Weighted average number of common shares outstanding     |  |                                | 26,844,197
|                                                         |  |                                |           

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:



|a) |  | Elimination of operating results of the intermittent testing business.
|-- |  | ----------------------------------------------------------------------

|b) |  | The Company intends to make additional business changes, not reflected in the adjusted amounts above, with the objective of reducing its cost structure to be more in line with the
reduced size of its ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating
leases associated with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs, which are not reflected in the pro forma financial statements. Given the
evolving nature of these and potentially other business changes, the Company is unable to provide an estimate of the associated charges at this time.
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



11



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##### Table of Contents

The following pro forma and unaudited statement of operations for the year ended December 31, 2002 represents the results
of operations as if the sale to ITC occurred on December 31, 2001.



PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

(UNAUDITED)



|                                                     |  | Year ended December 31, 2002 |           
|---------------------------------------------------- |  | ---------------------------- | ----------
|                                                     |  | As Reported                  |           
|Revenue                                              |  |                              |           
|Product revenue                                      |  | $                            | 15,962,187
|Other revenue                                        |  |                              | 2,736,000 
|                                                     |  |                              |           
|                                                     |  |                              | 18,698,187
|                                                     |  |                              |           
|Cost of revenue                                      |  |                              | 14,714,856
|                                                     |  |                              |           
|Gross profit                                         |  |                              | 3,983,331 
|                                                     |  |                              |           
|Operating expenses:                                  |  |                              |           
|Research and development                             |  |                              | 4,772,775 
|Selling, general and administrative                  |  |                              | 5,379,967 
|Restructuring and other charges                      |  |                              | 886,744   
|                                                     |  |                              |           
|Total operating expenses                             |  |                              | 11,039,486
|                                                     |  |                              |           
|Operating loss                                       |  |                              | (7,056,155
|                                                     |  |                              |           
|Interest income                                      |  |                              | 86,441    
|Interest expense                                     |  |                              | (545,976  
|Other expense, net                                   |  |                              | (15,326   
|                                                     |  |                              |           
|Net loss                                             |  | $                            | (7,531,016
|                                                     |  |                              |           
|Basic and diluted net loss per common share          |  | $                            | (0.28     
|                                                     |  |                              |           
|Weighted average number of common shares outstanding |  |                              | 26,804,451
|                                                     |  |                              |           

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:

|a) |  | Elimination of operating results of the intermittent testing business.
|-- |  | ----------------------------------------------------------------------

|b) |  | The Company intends to make additional business changes, not reflected in the amounts above, with the objective of reducing its cost structure to be more in line with the reduced
size of its ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating leases
associated with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs which are not reflected in the pro forma financial statements. Given the evolving
nature of these and potentially other business changes, the Company is unable to provide an estimate of the associated charges at this time.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



12



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##### Table of Contents

The following pro forma and unaudited statement of operations for the year ended December 31, 2001 represents the results
of operations as if the sale to ITC occurred on December 31, 2000.



PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

(UNAUDITED)



|                                                     |  | Year ended December 31, 2001 |           
|---------------------------------------------------- |  | ---------------------------- | ----------
|                                                     |  | As Reported                  |           
|Revenue                                              |  |                              |           
|Product revenue                                      |  | $                            | 23,888,928
|Other revenue                                        |  |                              | 600,000   
|                                                     |  |                              |           
|                                                     |  |                              | 24,488,928
|                                                     |  |                              |           
|Cost of revenue                                      |  |                              | 17,984,341
|                                                     |  |                              |           
|Gross profit                                         |  |                              | 6,504,587 
|                                                     |  |                              |           
|Operating expenses:                                  |  |                              |           
|Research and development                             |  |                              | 5,137,974 
|Selling, general and administrative                  |  |                              | 4,944,599 
|                                                     |  |                              |           
|Total operating expenses                             |  |                              | 10,082,573
|                                                     |  |                              |           
|Operating loss                                       |  |                              | (3,577,986
|                                                     |  |                              |           
|Interest income                                      |  |                              | 323,490   
|Interest expense                                     |  |                              | (572,618  
|Other expense, net                                   |  |                              | (48,785   
|                                                     |  |                              |           
|Net loss                                             |  | $                            | (3,875,899
|                                                     |  |                              |           
|Basic and diluted net loss per common share          |  | $                            | (0.14     
|                                                     |  |                              |           
|Weighted average number of common shares outstanding |  |                              | 26,762,684
|                                                     |  |                              |           

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:

|a) |  | Elimination of operating results of the intermittent testing business.
|-- |  | ----------------------------------------------------------------------

|b) |  | We intend to make additional business changes, not reflected in the adjusted amounts above, with the objective of reducing our cost structure to be more in line with the reduced
size of our ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating leases
associated with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs, which are not reflected in the pro forma financial statements. Given the evolving
nature of these and potentially other business changes, the Company is unable to provide an estimate of the associated charges at this time.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



13



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##### Table of Contents

The following pro forma and unaudited statement of operations for the year ended December 31, 2000 represents the results
of operations as if the sale to ITC occurred on December 31, 1999.



PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000

(UNAUDITED)



|                                                     |  | Year ended December 31, 2000 |           
|---------------------------------------------------- |  | ---------------------------- | ----------
|                                                     |  | As Reported                  |           
|Revenue                                              |  |                              |           
|Product revenue                                      |  | $                            | 22,998,407
|Other revenue                                        |  |                              | 2,260,000 
|                                                     |  |                              |           
|                                                     |  |                              | 25,258,407
|                                                     |  |                              |           
|Cost of revenue                                      |  |                              | 17,738,103
|                                                     |  |                              |           
|Gross profit                                         |  |                              | 7,520,304 
|                                                     |  |                              |           
|Operating expenses:                                  |  |                              |           
|Research and development                             |  |                              | 4,962,348 
|Selling, general and administrative                  |  |                              | 5,300,918 
|                                                     |  |                              |           
|Total operating expenses                             |  |                              | 10,263,266
|                                                     |  |                              |           
|Operating loss                                       |  |                              | (2,742,962
|                                                     |  |                              |           
|Interest income                                      |  |                              | 787,396   
|Interest expense                                     |  |                              | (586,616  
|Other expense, net                                   |  |                              | (105,435  
|                                                     |  |                              |           
|Net loss                                             |  | $                            | (2,647,617
|                                                     |  |                              |           
|Basic and diluted net loss per common share          |  | $                            | (0.10     
|                                                     |  |                              |           
|Weighted average number of common shares outstanding |  |                              | 26,490,826
|                                                     |  |                              |           

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:

|a) |  | Elimination of operating results of the intermittent testing business.
|-- |  | ----------------------------------------------------------------------

|b) |  | We intend to make additional business changes, not reflected in the adjusted amounts above, with the objective of reducing our cost structure to be more in line with the reduced
size of our ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating leases
associated with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs, which are not reflected in the pro forma financial statements. Given the evolving
nature of these and potentially other business changes, the Company is unable to provide an estimate of the associated charges at this time.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



14



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##### Table of Contents

(3) CONVERTIBLE SECURED FIXED RATE NOTES



Effective April 7, 2003, the Company completed the renegotiation of the terms of its $7.3 million Convertible Senior Secured Fixed Rate
Notes due August 4, 2003, to extend repayment of the notes to August 4, 2005. In exchange for the extension of repayment, the Company agreed to reduce the conversion price for $6.9 million principal value of the notes from $8.40 to $3.51 per share,
and to use 50% of the net proceeds in excess of $10 million received prior to August 4, 2005 from the issuance of any equity securities to pay down the principal value of the notes. In addition, the Company issued the note holders five-year warrants
for 4,255,837 shares of its common stock at an exercise price of $.94 per share. The warrants become exercisable over a one-year period starting April 7, 2004, and fully vest by April 7, 2005. This transaction requires accounting treatment
prescribed under EITF 96-19, Debtors Accounting for a Modification or Exchange of Debt Instruments. As such, the modified notes and associated warrants were recorded in the second quarter as debt and equity, respectively, at their
respective individual fair values of $5 million and $800,000 (see following paragraph for additional discussion of the valuation of the modified notes). The $7.3 million carrying value of the original notes was retired, and the residual amount of
$1.5 million was recorded in the second quarter in other income as a gain on modification of the notes. The Company will accrete the initial $5 million carrying value of the modified notes to their redemption value of $7.3 million over the remaining
term of the notes using the effective interest method at an effective interest rate of approximately 17%. This will result in the recording of $2.3 million of additional interest expense over the remaining term of the notes, of which $193,213 was
recorded in the second quarter 2003.



The Company engaged an outside valuation
firm to assist management in the measurement of the fair value of the modified notes. Management has reviewed and agrees with the assumptions used in the determination of fair value. The primary element of that measurement was the calculation of the
estimated present value of the cash flows associated with the notes, including interest and principal payments from the effective date of modification of the notes of April 7, 2003 through the maturity date of the notes of August 4, 2005. A discount
rate of approximately 25% was used to calculate the present value of the remaining cash flows associated with the notes. The 25% discount rate represents an estimate of the Companys cost of capital, and was based upon market studies of venture
capitalists required return on investment and current trends within the venture capital markets as of the valuation date, with consideration of the Companys history, status, prospects and risks.



Diametrics Medical, Inc. is an established business with proven technological platforms.
However, given the Companys historic losses and recent changes in its exclusive distribution agreement with Philips, perceived equity investor risk would likely be higher than an alternative equity investment in a larger, profitable business
enterprise. Therefore, the most likely investor in the Company would expect venture capital rates of return commensurate with the Companys business history, status, prospects and risks.



Based upon a review of various independent studies, including a survey by QED Research of 300
venture capitalists (QED Report on Venture Capital Financial Analysis, 1989); Pratts Guide to Venture Capital Financial Sources; an analysis of investors expected annual returns of companies at various stages of development by William
Rygrave, Professor of Free Enterprise at Babson College in Massachusetts; and an analysis of actual annual returns of companies at those stages by Houlihan Valuation Advisors and Venture One, a base required rate of return for a company at a
development stage similar to the Companys would be 25-40% before consideration of company specific factors and the trends in the venture capital markets as of the valuation date. Following are company specific factors and market trends
considered in arriving at an appropriate discount rate:



The Companys
technology platforms are proven and viable, and the marketplace has demonstrated an interest in and demand for the Companys products. Perceived investor risk would likely relate to recent changes in the Companys distribution channels and
methods and managements ability to execute an alternative and successful marketing and distribution plan, rather than on development of the market. Further, the modified notes are interest bearing and are secured by the assets of the
Companys U.K. subsidiary. Additionally, deteriorating economic conditions over the past two to three



15



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##### Table of Contents

years have led to a large scale-back in venture capital investments, with the reduced level of investing activity shifting away from start-up stage companies
to companies at a stage of development similar to the Companys or a later stage. Along with this, venture capitalists have generally reduced their expectations of required rates of return on investment. Consideration of these factors led to
the conclusion that investors would likely require returns towards the low end of the 25-40% range discussed above. Therefore, for purposes of determining the fair value of the modified notes, the Company applied a discount rate at the low end of
this range of 25% to arrive at the present value of the cash flows associated with the modified notes.



In August 2003, the note holders agreed to further amend the Note Purchase Agreement to defer the timing of interest payments on the notes for the first and second quarters of 2003, amounting to approximately
$254,000, as well as increase their security position to include all unencumbered assets of the Company. The deferred interest will be paid in September 2003, with specific timing dependent upon the occurrence of certain events, but no later than
September 30, 2003.



(4) SERIES E CONVERTIBLE PREFERRED STOCK INTERIM
FINANCING



On May 12, 2003, the Company completed a $1.5 million interim
financing through the sale of 15,000 shares of Series E convertible preferred stock at a price of $100 per share. The preferred stock is convertible at any time into the Companys common stock at 88% of the volume weighted average trading price
of the common stock for the five consecutive trading days before the conversion date, subject to a maximum and minimum conversion price of $.75 per share and $.35 per share, respectively. The preferred stock is callable by the Company during the
first 12 months at the original purchase price plus a return of 2% per month from the date of investment, and 50% may be put back to the Company in the event of the Companys completion of the sale of its intermittent testing business, at the
original purchase price plus a return of 1% per month. Five-year warrants to purchase 735,000 shares of the Companys common stock at $.35 per share were also issued in conjunction with the financing. The warrants are exercisable after the
conversion of the preferred stock. The holders of the Series E preferred stock have the right to place a lien on the assets of the Companys intermittent testing business if the sale of that business is not completed by September 19, 2003.
Accounting for this transaction falls primarily under EITF 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios, and EITF 00-27, Application of Issue 98-5 to
Certain Convertible Instruments. The Company allocated the net investor proceeds of $1,350,000 from the issuance of the Series E convertible preferred stock to the preferred stock and associated warrants based upon their estimated relative
fair values. The resulting fair value allocations of $958,962 and $391,038 for the preferred stock and warrants, respectively, were recorded as equity in the second quarter 2003. The beneficial conversion feature embedded in the preferred stock was
calculated at $958,962 and was limited to the fair value allocated to the preferred stock. The beneficial conversion feature of $958,962 was treated as a deemed dividend to preferred shareholders, and was charged to retained earnings, with the
offsetting credit to additional paid-in-capital. Additionally, the Company treated the beneficial conversion feature of $958,962 as a reconciling item on the statement of operations to adjust its reported net loss to net loss available to
common shareholders, which is used in the numerator in the loss per share calculation for the second quarter 2003.



(5) LIQUIDITY



The accompanying financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities and other commitments in the normal course of business.
The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that may be necessary if the Company is unable to continue as a
going concern.



At June 30, 2003, the Company had working capital of
$2,620,740, an increase of $3,625,956 from the working capital reported at December 31, 2002. The increase is impacted primarily by the reclassification as of March 31, 2003 of $7.3 million of Convertible Senior Secured Fixed Rate Notes from current
to long-term liabilities, as a result of the extension effective April 7, 2003 of the due date of the notes from August 4, 2003 to August 4, 2005, and net proceeds of approximately $1.2 million from



16



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##### Table of Contents

the Companys Series E convertible preferred stock interim financing. A net loss before non-cash items of approximately $4.4 million and capital
expenditures of $331,298 partially offset the impact of the increase in working capital.



The Company incurred net losses of $4,116,625 and $3,189,579 for the six months ended June 30, 2003 and 2002, respectively, incurred a net loss of $7,531,016 for the year ended December 31, 2002, and has incurred net
losses since inception. The 2003 year-to-date net loss is net of a $1.5 million gain recognized as a result of the modification of the Companys Convertible Senior Secured Fixed Rate Notes, further described in note 3. Financial results for the
year ending December 31, 2003 are expected to show an increase in net loss relative to 2002 due to lower expected revenue and increased sales and marketing expenses, primarily impacted by the Companys transition to its new distribution and
direct sales force channel model. The unfavorable financial impact of this transition on 2003 results, however, will be partially offset by the gain realized in the second quarter from the refinancing of the Companys convertible notes and an
expected reduction in the operating loss of the Companys intermittent testing business and net gain stemming from the pending sale of that business.



Cash and marketable securities decreased by approximately $2.7 million during the six months ended June 30, 2003 to approximately $1.3 million. The Company is monitoring
its cash position carefully and is evaluating its future operating cash requirements in the context of its strategy, business objectives and expected business performance. As part of this, the Company has elected to delay project spending and
capital expenditures, and is implementing other cost-cutting measures across all areas of the Companys operations, including personnel, facilities and discretionary spending. A significant amount of instrument inventory available to the
Company will allow a reduction of inventory purchases and production requirements during 2003. Further, the Company is positioning its business for future sales and earnings growth with the pursuit of strategic partners for its business as well as
the expansion of its global distribution channels, including a direct sales force in the United States, the United Kingdom and Germany, and third-party distributors outside of these countries. Proceeds from the expected sale in the third quarter
2003 of the Companys intermittent testing business will increase the Companys cash reserves, and the sale of this business will reduce the Companys cash usage rate. The Company is also pursuing interim financing options to bridge
it to completion of the sale of the intermittent testing business, if necessary. While the Company believes it will be successful in securing interim financing, there can be no assurance that adequate funds will be available or on acceptable terms.
Once the transaction for the sale of the intermittent testing business closes, the Company expects proceeds from the sale to meet the Companys funding requirements for support of its operations for approximately the next twelve months. This
period could be shortened if the holders of the Companys Series E convertible preferred stock elect to exercise their put option to sell up to 7,500 shares of the outstanding Series E convertible preferred stock back to the Company after
completion of the sale of the intermittent testing business. The Company will be required to raise additional capital during this twelve month period in order to sustain and fund its operations over the long term. Such funding could include the
issuance of additional equity or debt securities to the extent funding raised from other strategic business alternatives is not sufficient to meet the Companys funding requirements. In May 2003, the Company received shareholder approval to
increase its number of authorized shares of common stock by 15 million shares, enhancing the Companys ability to pursue additional financing. As of June 30, 2003, the primary funding for the operations of the Company has been approximately
$150 million raised through public and private sales of its equity securities and issuance of convertible promissory notes.



On July 1, 2003, the Company received a notice from the Nasdaq Stock Market indicating that, following a review of the appeal the Company presented on June 5, 2003, the
Nasdaq Listing Qualifications Panel determined to delist the Companys common stock from the Nasdaq SmallCap Market effective with the open of business on Wednesday, July 2, 2003. The Companys common stock became immediately eligible to
trade on the Over-the-Counter Bulletin Board effective with the open of business on July 2, 2003 under the symbol DMED. Trading of the Companys common stock through the Over-the-Counter Bulletin Board may be more difficult because
of lower trading volumes, transaction delays and reduced security analyst and news media coverage of the Company. These factors could contribute to lower prices and larger spreads in the bid and ask prices for the Companys



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common stock. Trading of its common stock in an over-the-counter market may also attract a different type of investor in the Companys common stock,
which may limit the Companys future equity funding options.



The
Companys long-term capital requirements will depend upon numerous factors, including the impact of changes in distribution relationships and methods on revenue, the rate of market acceptance of the Companys products, the level of
resources devoted to expanding the Companys business and manufacturing capabilities, and the level of research and development activities. While there can be no assurance that adequate funds will be available when needed or on acceptable
terms, management believes that the Company will be able to raise adequate funding to meet its operational requirements. If the Company is unable to raise an adequate level of additional capital or generate sufficient cash flows from operations, the
Companys ability to execute its business plan and remain a going concern will be significantly impaired.



(6) NET LOSS PER COMMON SHARE



Basic
earnings per share (EPS) is calculated by dividing net loss available to common shareholders by the weighted average common shares outstanding during the period. Diluted EPS reflects the potential dilution to basic EPS that could occur
upon conversion or exercise of securities, options, or other such items, to common shares using the treasury stock method based upon the weighted average fair value of the Companys common shares during the period. For each period presented,
basic and diluted loss per share amounts are identical, as the effect of potential common shares is antidilutive. The following is a summary of outstanding securities which have been excluded from the calculation of diluted EPS because the effect on
net loss per common share would have been antidilutive:



|                                            |  | June 30, 
|------------------------------------------- |  | ---------
|                                            |  | 2003     
|Common stock options                        |  | 4,270,555
|Common stock warrants                       |  | 6,166,414
|Convertible senior secured fixed rate notes |  | 2,013,431
|Convertible preferred stock                 |  | 2,000,000
|Restricted stock                            |  | 329,885  

---

|(1) |  | Based upon a ceiling conversion rate of $.75 per share.
|--- |  | -------------------------------------------------------



(7) COMPREHENSIVE LOSS



|                                            |  | Three Months Ended June 30, |            |   | Six Months Ended June 30, |  
|------------------------------------------- |  | --------------------------- | ---------- | - | ------------------------- | -
|                                            |  | 2003                        |            |   | 2002                      |  
|Net loss                                    |  | $                           | (1,226,004 | ) |                           | $
|Change in cumulative translation adjustment |  |                             | 101,900    |   |                           |  
|                                            |  |                             |            |   |                           |  
|Comprehensive loss                          |  | $                           | (1,124,104 | ) |                           | $
|                                            |  |                             |            |   |                           |  



|(8) |  | INVENTORIES
|--- |  | -----------



|                |  | June 30, |           | December 31,
|--------------- |  | -------- | --------- | ------------
|                |  | 2003     |           | 2002        
|Raw materials   |  | $        | 958,156   |             
|Work-in-process |  |          | 566,389   |             
|Finished goods  |  |          | 1,393,420 |             
|                |  |          |           |             
|                |  | $        | 2,917,965 |             
|                |  |          |           |             



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(9) STOCK-BASED COMPENSATION



The Company applies the intrinsic-value method prescribed in Accounting Principles Board (APB) Opinion No. 25, Accounting
for Stock Issued to Employees, to account for the issuance of stock incentives to employees and directors. No compensation expense related to employees and directors stock incentives has been recognized in the financial statements
as all options granted under stock incentive plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Had compensation costs for the Companys stock incentive plans been determined based on the
fair value of the awards on the date of grant, consistent with the provisions of SFAS No. 123, Accounting for Stock-Based Compensation, the Companys net loss per share would have increased to the pro forma amounts indicated below:



|                                                    |  | Three Months Ended June 30, |            |   | Six Months Ended June 30, |  
|--------------------------------------------------- |  | --------------------------- | ---------- | - | ------------------------- | -
|                                                    |  | 2003                        |            |   | 2002                      |  
|Actual net loss available to common shareholders    |  | $                           | (2,184,966 | ) |                           | $
|Pro forma stock-based compensation expense          |  | $                           | (404,869   | ) |                           | $
|                                                    |  |                             |            |   |                           |  
|Pro forma net loss available to common shareholders |  | $                           | (2,589,835 | ) |                           | $
|                                                    |  |                             |            |   |                           |  
|Actual basic and diluted net loss per share         |  |                             | (0.08      | ) |                           |  
|Pro forma stock-based compensation expense          |  |                             | (0.02      | ) |                           |  
|                                                    |  |                             |            |   |                           |  
|Pro forma basic and diluted net loss per share      |  |                             | (0.10      | ) |                           |  
|                                                    |  |                             |            |   |                           |  



The per share weighted-average fair
value of options granted under the Companys stock option plans for both the three and six months ended June 30, 2003 was $.72, compared to $3.28 and $3.04 for the same periods in 2002, determined using the Black Scholes option-pricing model
with the following assumptions: for both years, an expected life of five years and no dividends, and for 2003, an annualized volatility of 97.5% and a risk-free interest rate of 2.3%, and for 2002, an annualized volatility of 91.5% and a risk-free
interest rate of 3.76%.



(10) PRODUCT WARRANTY



The Company, in general, warrants its new hardware and operating system software products to
be free from defects in material and workmanship under normal use and service for a period of eighteen months after date of shipment in the case of distributors, and one year after date of sale in the case of end-user customers. The Company warrants
its disposable products to be free from defects in material and workmanship under normal use until its stated expiration date. Under the terms of these warranties, the Company is obligated to repair or replace the products it deems to be defective
due to material or workmanship. Provisions are made for the estimated cost of maintaining product warranties for the hardware, software and disposable products based on an estimated average per unit repair or replacement cost applied to the
estimated number of units under warranty. The estimated average per unit repair or replacement cost reflects historical warranty incidence over the preceding twelve-month period. Evaluation of the reserve also includes consideration of other
factors, including sales levels and types of warranty claims received. While warranty claims have not been material to the Companys consolidated financial statements, the warranty reserve is evaluated on a quarterly basis to ensure its
adequacy. Warranty provisions and claims for the six months ended June 30, 2003 and 2002 are summarized as follows:



|     |  | Balance at beginning of period |        | Warranty provisions |        | Warrantyclaims |         |   | Balance at end ofperiod
|---- |  | ------------------------------ | ------ | ------------------- | ------ | -------------- | ------- | - | -----------------------
|2003 |  | $                              | 30,000 |                     | 27,760 |                | (23,760 | ) |                        
|2002 |  | $                              | 30,000 |                     | 15,047 |                | (15,047 | ) |                        



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(11) DEFERRED COMPENSATION



In July 2002, the Compensation Committee of the Companys Board of Directors approved a retention plan for certain of the
Companys key employees. The plan, which became effective August 1, 2002, provides for a cash bonus and restricted stock grants for certain key employees who remain employed by the Company for at least one year from the plans effective
date. The stock grants consisted of the issuance of an aggregate of 329,885 shares of restricted common stock to 14 key employees. The fair value of the common stock on the date of grant, August 1, 2002, was $824,711, which was recognized as
restricted stock with a corresponding charge to deferred compensation, a contra equity account. The deferred compensation for the restricted stock grants will be recognized as expense ratably over the two-year vesting period. Expense associated with
the cash bonus approximates $400,000, and is being accrued and recognized over a one-year vesting period. Compensation expense of approximately $424,000 was recognized during the six months ended June 30, 2003, in connection with the cash bonus and
restricted stock grants.



(12) RELATED PARTY TRANSACTIONS



In August 1998, the Company issued Convertible Senior Secured Fixed Rate Notes, with
proceeds aggregating $7,300,000, which were used to retire other debt of the Company. The investor group was led by BCC Acquisition II LLC. Effective April 7, 2003, the Company and the note holders completed a modification of the terms of the notes,
including a two-year extension of repayment of the notes to August 4, 2005 and a reduction in the conversion price for $6,900,000 of the notes from $8.40 to $3.51 per share. Additionally, the note holders received five-year warrants for 4,255,837
shares of the Companys common stock, at an exercise price of $.94 per share.



Two of the directors of the Company are affiliated with BCC Acquisition II LLC, and one of these directors participated in the issuance and subsequent modification in terms of the Convertible Senior Secured Fixed Rate Notes, although the
conversion price of the note held by the director was not reduced from $8.40 per share. This director is also a director of DVI, Inc., a health care finance company with which the Company has an outstanding capital lease. As of June 30, 2003, the
outstanding balance of the capital lease was approximately $209,000.



Two of
the Companys distributors, Philips and Codman, are shareholders of the Company. Philips has an approximate 7% beneficial ownership interest (including outstanding warrants) in the Company, and Codman has an approximate 3% ownership interest.
Codman distributes the Companys Neurotrend cerebral tissue monitoring system under an exclusive global distribution agreement entered into effective October 1998. The Companys exclusive global distribution agreement with Philips for sale
of the Companys TrendCare continuous blood gas monitoring systems and intermittent testing blood analysis systems ended effective November 1, 2002, and provided for minimum annual purchase amounts, market development commitments and research
and development funding through October 31, 2002. As provided for under the terms of an amended agreement between the parties, completed on April 10, 2003, and discussed further under Managements Discussion and Analysis of Results of
Operations and Financial Condition, Philips maintains a nonexclusive right to sell the Companys disposable cartridges, sensors and related accessories to its existing customer base through October 31, 2004. Philips also has a
nonexclusive right through October 31, 2004 to distribute the Companys Blood Analysis Portal measurement module as a component of Philips Blood Analysis Portal System. Sales to Philips and Codman for the six months ended June 30, 2003
and 2002 were approximately $1.9 million and $10.2 million, respectively. Outstanding accounts receivable with these parties represented 34% and 71% of total outstanding accounts receivable as of June 30, 2003 and December 31, 2002, respectively.



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(13) NEW ACCOUNTING PRONOUNCEMENTS



In November 2002, the Emerging Issues Task Force (EITF) finalized its tentative consensus on EITF Issue 00-21, Revenue
Arrangements with Multiple Deliverables, which provides guidance on the measurement and allocation of revenue from sales undertakings to deliver more than one product or service. The Company is required to adopt the provisions of EITF 00-21
effective July 1, 2003. Sales of the Companys hardware and disposable cartridges and sensors are priced and sold separately and have readily determined fair market values based upon sales histories of these products. As such, the hardware and
disposable cartridges and sensors have stand-alone value to the customer. Sales to distributors and existing end-user customers are specifically priced for each product and have no right of return, except for standard warranty provisions. Revenue
for these customers is recognized upon shipment of the products. As the Company implements its new sales distribution model, sales to new direct end-user customers will become a significant portion of total sales. Sales to these customers are
similar to other sales, except these customers may require training on the products. This usually occurs during a product evaluation period completed prior to the customer making the purchase. Revenue for these sales transactions is recognized when
the purchase is made at the end of the evaluation period. In the event more than an insignificant amount of post-sales training is required as part of the sale to an end-user customer, the Company will defer the greater of the relative fair value of
that training or any contingent payments until the training is completed in accordance with EITF 00-21. Completion of the training is probable and under the Companys control, so it should not result in a delay in the timing of revenue
recognition for the hardware or disposable cartridges and sensors. Further, the relative fair value of the training bundled with a sales transaction can be readily determined based on prices charged to customers in sale transactions where service is
not bundled. As the Company implements its new sales distribution model and expands its sales to new direct end-user customers, the impact of applying EITF 00-21 will become more evident, but the Company does not expect the application of EITF 00-21
to have a significant impact on its financial statements.



In April 2003, the
FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends and clarifies financial accounting and reporting for derivative instruments embedded in other contracts (collectively
referred to as derivatives) and for hedging activities under FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 is effective for contracts entered into or modified after June 30, 2003 and
for hedging relationships designated after June 30, 2003. The Company is currently evaluating the impact of the adoption of SFAS No. 149 on its financial statements.



In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and
Equity, which establishes standards for how an issuer classifies and measures in its statement of financial position certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a
financial instrument that is within its scope as a liability (or an asset in some circumstances) because that financial instrument embodies an obligation of the issuer. For example, the Statement requires liability classification for a financial
instrument issued in the form of shares that are mandatorily redeemable, e.g., includes an unconditional obligation requiring the issuer to redeem it by transferring its assets at a specified or determinable date or dates or upon an event that is
certain to occur. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The Company has evaluated the
impact of the adoption of SFAS No. 150, and has concluded that it did not have an effect on its financial statements for the three months ended June 30, 2003.



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



The Company has identified certain of its significant accounting policies that it considers particularly important to the portrayal of the Companys results of
operations and financial position and which may require the application of a higher level of judgment by the Companys management, and as a result are subject to an inherent level of uncertainty. These are characterized as critical
accounting policies



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and address revenue recognition and accounts receivable, inventories, foreign currency translation and transactions, impairment of long-lived assets and
retirement plan funding, each more fully described under Managements Discussion and Analysis of Results of Operations and Financial Condition in the Companys Annual Report on Form 10-K for the year ended December 31, 2002.
The Companys accounting policy on the recognition of research and development funding, which is also described in the Companys Form 10-K, is no longer considered a critical accounting policy in 2003 as the Companys recognition of
research and development funding from Philips ceased as of November 1, 2002 with the termination of the exclusive agreement with Philips.



During the quarter ended June 30, 2003, the Company identified a new critical accounting policy, Accounting for Debt and Equity Instruments. As discussed in
notes 3 and 4, during the second quarter 2003, the Company completed the renegotiation of the terms of its Convertible Senior Secured Fixed Rate Notes and completed a $1.5 million interim financing through the sale of 15,000 shares of Series E
convertible preferred stock. Both transactions also included the issuance of warrants for the purchase of the Companys common stock. The accounting for these debt and equity related transactions was complex and required the Company to make
certain judgements regarding their accounting treatment. The Companys significant conclusions related to these transactions included: 1) the accounting applicable to the modification of the convertible notes falls primarily under the treatment
prescribed by EITF 96-19, Debtors Accounting for a Modification or Exchange of Debt Instruments, 2) the determination of the respective fair values to use as a basis for recording the carrying values of the convertible notes, Series E
preferred stock and warrants issued in connection with each transaction and 3) the classification of the warrants as equity versus debt based upon an assessment under EITF 00-19 of the Companys contractual obligations for registration of the
related common shares issuable upon exercise of the warrants. The Company engaged an outside valuation firm to assist management in the measurement of the fair value of the modified notes. Management has reviewed and agrees with the assumptions used
in the determination of fair value. The primary element of that measurement was the calculation of the estimated present value of the cash flows associated with the notes, including interest and principal payments from the effective date of
modification of the notes of April 7, 2003 through the maturity date of the notes of August 4, 2005. A discount rate of approximately 25% was used to calculate the present value of the remaining cash flows associated with the notes. The 25% discount
rate represents an estimate of the Companys cost of capital, and was based upon market studies of venture capitalists required return on investment and current trends within the venture capital markets as of the valuation date, with
consideration of the Companys history, status, prospects and risks.



Diametrics Medical, Inc. is an established business with proven technological platforms. However, given the Companys historic losses and recent changes in its exclusive distribution agreement with Philips, perceived equity investor
risk would likely be higher than an alternative equity investment in a larger, profitable business enterprise. Therefore, the most likely investor in the Company would expect venture capital rates of return commensurate with the Companys
business history, status, prospects and risks.



Based upon a review of various
independent studies, including a survey by QED Research of 300 venture capitalists (QED Report on Venture Capital Financial Analysis, 1989); Pratts Guide to Venture Capital Financial Sources; an analysis of investors expected annual
returns of companies at various stages of development by William Rygrave, Professor of Free Enterprise at Babson College in Massachusetts; and an analysis of actual annual returns of companies at those stages by Houlihan Valuation Advisors and
Venture One, a base required rate of return for a company at a development stage similar to the Companys would be 25-40% before consideration of company specific factors and the trends in the venture capital markets as of the valuation date.
Following are company specific factors and market trends considered in arriving at an appropriate discount rate:



The Companys technology platforms are proven and viable, and the marketplace has demonstrated an interest in and demand for the Companys products. Perceived
investor risk would likely relate to recent changes in the Companys distribution channels and methods and managements ability to execute an alternative and successful marketing and distribution plan, rather than on development of the
market. Further, the modified notes are interest bearing and are secured by the assets of the



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Companys U.K. subsidiary. Additionally, deteriorating economic conditions over the past two to three years have led to a large scale-back in venture
capital investments, with the reduced level of investing activity shifting away from start-up stage companies to companies at a stage of development similar to the Companys or a later stage. Along with this, venture capitalists have generally
reduced their expectations of required rates of return on investment. Consideration of these factors led to the conclusion that investors would likely require returns towards the low end of the 25-40% range discussed above. Therefore, for purposes
of determining the fair value of the modified notes, the Company applied a discount rate at the low end of this range of 25% to arrive at the present value of the cash flows associated with the modified notes.



Use of a 25% discount rate resulted in a present value calculation for the remaining interest
and principal cash flows of approximately $4.9 million. The fair value of the notes conversion rights was calculated at approximately $100,000, determined through use of the Black Scholes Option Pricing Model, resulting in a total estimated
fair value of the modified notes of $5 million, as further discussed in note 3. The valuation of the modified notes directly affected the calculation of the amount of the gain recognized on the modification of the notes of $1.5 million. If the
Companys estimate of the appropriate discount rate had been 20% higher or lower, resulting in a discount rate of 30% and 20% at the high and low end of the range, respectively, the present value calculation would have decreased by
approximately $400,000 and increased by approximately $460,000, respectively. The impact of such a change in estimate would have increased and decreased by the same amounts the amount of gain recognized on modification of the notes to approximately
$1.9 million and $1 million, respectively.



No other changes to the
Companys critical accounting policies have been made during the quarter ended June 30, 2003. The Company has, however, made changes to manage its exposure associated with future funding of its Retirement Plan, and has provided information on
the financial impact of applying different assumptions to the valuation of the Retirement Plan under Item 3, Quantitative and Qualitative Disclosure About Market Risk.



The Companys discussion and analysis of results of operations and financial condition include forward-looking statements, which may
include statements regarding the Companys expectations about future financial performance; the continuation of historical trends; the sufficiency of its cash balances and cash generated from operating activities for future liquidity and
capital resource needs; the expected impact of changes in accounting policies on the Companys results of operations, financial condition or cash flows; anticipated problems and its plans for future operations; and the economy in general or the
future of the medical device industry, all of which are subject to various risks and uncertainties. Actual results may differ materially from the Companys expectations depending on a variety of important factors, including, but not limited to
such factors as the successful completion of the sale of the Companys intermittent testing business; the Companys ability to raise an adequate level of capital to fund its operations; market demand and pressures on the pricing for its
products; changing market conditions, competition and growth rates within the medical device industry; changes in accounting policies; risks associated with operations outside of the U.S.; changing economic conditions such as general economic
slowdown, decreased consumer confidence and the impact of war on the economy; and other risks and uncertainties, including those described in Exhibit 99.1 to this Form 10-Q. When used in this Form 10-Q, and in future filings by the Company with the
Securities and Exchange Commission, in the Companys press releases, presentations to securities analysts or investors, in oral statements made by or with the approval of an executive officer of the Company, the words or phrases
believes, may, will, expects, should, continue, anticipates, intends, will likely result, estimates, projects, or
similar expressions and variations thereof are intended to identify such forward-looking statements.



Summary



Diametrics Medical, Inc.
develops and manufactures critical care blood and tissue analysis systems that provide immediate or continuous diagnostic results at the point-of-patient care, rather than in laboratories located away from patients. Since the commencement of the
Companys operations in 1990, it has transitioned from a development stage company to a full-scale development,



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manufacturing, sales and marketing organization located in Roseville, Minnesota and High Wycombe, England. The Companys mission is to be a leading
provider of innovative sensors to guide medical therapy of critically ill patients.



The Companys blood and tissue analysis systems are built from two technology platforms. The first platform includes intermittent blood testing products based upon electrochemical sensor technology (which measures electrical signal
changes as a result of changes in chemical compounds as they interact with chemicals in the blood), consisting primarily of the IRMA® SL Blood Analysis System and the Blood Analysis Portal measurement module, which the Company co-developed with Philips Medical Systems, a division of
Royal Philips Electronics. The second platform consists of continuous monitoring products based upon fiberoptic sensor technology (which measures color changes optically via light transmitted through plastic fibers embedded with fluorescent dye
sensitive to chemicals in blood and tissue), including the TrendCare® Continuous Blood Gas Monitoring Systems and the Neurotrend® Cerebral Tissue Monitoring System.



The
Company markets and distributes its products through both direct and indirect distribution channels. With the termination effective November 1, 2002 of the Companys agreement with Philips Medical Systems for exclusive worldwide distribution of
the Companys TrendCare continuous blood gas monitoring systems and intermittent testing blood analysis systems, the Company began reestablishing a direct sales force in the United States, the United Kingdom and Germany, as well as nonexclusive
third-party distributors outside of these countries for sale of these products. As of June 30, 2003, the Company has expanded its direct sales organization to 10 sales personnel and clinical application specialists based in the United States, the
United Kingdom and Germany, with future additions dependent upon the rate and timing of sales growth. Further, the Company has expanded its global distribution network with the appointment of approximately 20 third-party distributors primarily
addressing markets in Europe, the Far East and the Middle East. The Company continues to sell disposable cartridges, sensors and related accessories to Philips for Philips nonexclusive distribution to its customer base through October 31, 2004
(more fully discussed below). The Company also continues to distribute its Neurotrend cerebral tissue monitoring system through Codman, a Johnson & Johnson company, under an exclusive distribution agreement entered into effective October 1,
1998. Additionally, the Company distributes its products to the veterinary market through direct end-user sales and regional distributors. Product pricing extended to the Companys distributors is negotiated at the time of contract. The
Companys contract with Philips requires that the Companys pricing to them be no higher than prices charged to other distributors in a given territory, and the contract with Codman requires a price reduction if the Neurotrend instrument
manufacturing cost is reduced beyond a certain level, which has not occurred. To the extent these requirements become applicable, related price adjustments would be applied prospectively to products purchased after the event occurs and would not
result in retroactive adjustments. No other price incentives or price protection clauses are included in the Companys sales contracts.



The exclusive agreement with Codman expires in October 2004 and is renewable for two years. The agreement provides for annual minimum purchase levels based on a
percentage of the prior years purchases, or payment of 50% of any shortfall from those minimum levels. The Companys revenue from Codman was less than 3% of total revenue for the six months ended June 30, 2003, less than 5% in 2002 and
2001, and less than 10% in 2000.



On April 10, 2003, the Company and Philips
signed an amendment to the exclusive distribution agreement between the parties, clarifying certain rights and obligations of the parties subsequent to the termination of the exclusive agreement effective November 1, 2002. Under the terms of the
amendment, Philips has the nonexclusive right to sell the Companys intermittent testing cartridges, TrendCare sensors and related accessories to Philips existing customer base and support the Companys products in that base through
October 31, 2004, but is no longer subject to minimum purchase requirements. Philips sales and support rights may be transitioned to the Company prior to October 31, 2004 on a territory-by-territory basis under mutual agreement. Under the
amendment, the Company will also continue to manufacture the Portal measurement module for Philips nonexclusive distribution as a component of Philips Blood Analysis Portal System through October 31, 2004. The



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Company also has nonexclusive rights to sell the Blood Analysis Portal System. Additionally, the amendment provides the Company with the option to purchase
from Philips unused inventory of the Companys IRMA and TrendCare hardware products previously sold to Philips at quantities determined by the Company. Available instrument inventory (from completed hardware products in finished goods inventory
or otherwise expected to be available to the Company through purchase from Philips) will reduce the Companys inventory purchases and production requirements in 2003.



The Companys revenue from Philips for the six months ended June 30, 2003 and 2002 comprised 34% and 93%, respectively, of total
revenue, and is expected to continue to decline as a percentage of total revenue until the end of the current contract term on October 31, 2004. From the initiation of the exclusive agreement with Philips in mid 1999 through October 31, 2002,
revenue from Philips included product purchases by Philips to meet sales demand of its end-user customers and to fulfill Philips internal product requirements associated with the sales and service processes and customer financing programs, as
well as contractual purchase commitments and royalties under the distribution agreement. As a result, the level of the Companys sales to Philips during the three-year period ended October 31, 2002 is not indicative of Philips sales to
its end-user customers during that period, which are estimated to be substantially less than the Companys sales to Philips during the three-year period ended October 31, 2002.



On July 18, 2003, the Company announced that it had entered into an asset purchase agreement with International Technidyne Corporation
(ITC), a wholly owned subsidiary of Thoratec Corporation, whereby ITC will acquire substantially all of the assets used in the operation of the Companys intermittent testing business. Pursuant to the terms of the agreement, ITC
will pay the Company approximately $5.2 million in cash, which may be adjusted downward if any purchase price adjustments are required, and assume certain liabilities, including up to $550,000 in trade payables. Of the $5.2 million cash payment,
$780,000 will be placed in escrow by ITC for 180 days after the closing of the transaction to cover any shortfall in collected receivables or any indemnification claims. The asset sale is subject to customary closing conditions, including approval
by the Companys shareholders, and is expected to close in the third quarter of 2003. Proceeds from the sale of the Companys intermittent testing business will be used to fund and grow the Companys continuous monitoring business.



The Company anticipates that the pending sale of its intermittent testing
business and resulting transition of the distribution channels related to that business will result in a reduction in revenues in the last half of 2003 relative to the first half. The Company also expects that the sale of its intermittent testing
business will result in a reduction in its operating loss in the last half of the year, partially offset by restructuring and other charges expected to be incurred to lower the cost structure of the Company going forward.



The following unaudited pro forma financial statements give effect to the sale of the
Companys intermittent testing business.



The unaudited pro forma
consolidated balance sheet and statements of operations filed with this report are presented for illustrative purposes only. The pro forma balance sheet as of June 30, 2003 has been prepared to reflect the sale of the assets and liabilities of the
Companys intermittent testing business to ITC as if such sale had taken place on June 30, 2003, and is not necessarily indicative of the financial position of Diametrics Medical, Inc. had such sale occurred on that date. The pro forma results
of operations for the six months ended June 30, 2003 and the years ended December 31, 2002, 2001 and 2000 have been prepared assuming that the sale of the Companys intermittent testing business occurred as of the beginning of each of these
periods, and are not necessarily indicative of the results of operations for future periods or the results that actually would have been realized had the Company sold its intermittent testing business as of those dates. The pro forma financial
statements, including notes thereto, should be read in conjunction with the historical financial statements of Diametrics Medical, Inc. included in the Companys filings on Form 10-K for the years ended December 31, 2002, 2001 and 2000 and the
unaudited financial statements included in this Form 10-Q for the quarter ended June 30, 2003.



25



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##### Table of Contents

The intermittent testing business is the primary operation of the Companys U.S. entity located in Roseville,
Minnesota, along with the Companys corporate headquarters. The continuous monitoring business is the primary operation of the Companys wholly-owned subsidiary located in the United Kingdom. Due to this separation, most amounts
attributable to the intermittent testing business are readily identifiable. Costs of the U.S. field sales organization were allocated based on the estimated level of effort applied to sell the respective product lines. The payment received in lieu
of product purchases from Philips in 2002 was not specifically attributable to products. Therefore, that amount was allocated based on the relative ratio of products purchased by Philips year-to-date in 2002, prior to making that payment.



Costs and expenses attributed to the intermittent testing business are
specific, direct costs primarily associated with that business. As such, they do not reflect general corporate allocations or other non-direct cost savings that may occur as a result of the Company focusing its efforts exclusively on the continuous
monitoring business going forward. The Company intends to make additional business changes, not reflected in the following pro forma financial statements, with the objective of reducing its cost structure to be more in line with the reduced size of
its ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating leases associated
with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs, which are not reflected in the pro forma financial statements. Given the evolving nature of these
and potentially other business changes, the Company is unable to provide an estimate of the associated charges at this time.



As described in note 4, the Companys Series E convertible preferred stock holders have the option to put back to the Company 50% of their original $1.5 million
investment plus a return of 1% per month in the event of the Companys completion of the sale of the intermittent testing business. The potential impact of this transaction, if it occurred, has not been reflected in the pro forma financial
statements.



26



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##### Table of Contents

The following unaudited pro forma statements represent the June 30, 2003 balance sheet adjusted to reflect the sale of
the assets and liabilities of the intermittent testing business to ITC as if such sale had taken place on June 30, 2003:



PRO FORMA CONSOLIDATED BALANCE SHEET

AS OF JUNE 30, 2003

(UNAUDITED)



|                                                 |  | ConsolidatedJune 30, 2003                  |              |   | Pro Forma Adjustments |   |            | Pro Forma June 30, 2003 | 
|------------------------------------------------ |  | ------------------------------------------ | ------------ | - | --------------------- | - | ---------- | ----------------------- | 
|                                                 |  | Net Assets ToBe Sold/ConsiderationReceived |              |   | OtherAdjustments      |   |           
|ASSETS                                           |  |                                            |              |   |                       |   |            |                         | 
|Current assets:                                  |  |                                            |              |   |                       |   |            |                         | 
|Cash and cash equivalents                        |  | $                                          | 1,271,339    |   |                       | $ | 4,420,000  | (a)                     | 
|Accounts receivable                              |  |                                            | 1,160,447    |   |                       |   | (843,911   | ) (b)                   | 
|Amounts due from ITC                             |  |                                            |             |   |                       |   | 780,000    | (d)                     | 
|Inventories                                      |  |                                            | 2,917,965    |   |                       |   | (998,152   | ) (b)                   | 
|Prepaid expenses and other current assets        |  |                                            | 103,970      |   |                       |   | (6,510     | ) (b)                   | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|Total current assets                             |  |                                            | 5,453,721    |   |                       |   | 3,351,427  |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|Property and equipment, net                      |  |                                            | 4,096,548    |   |                       |   | (1,737,942 | ) (b)                   | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|Other assets                                     |  |                                            | 42,588       |   |                       |   |           |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|                                                 |  | $                                          | 9,592,857    |   |                       | $ | 1,613,485  |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|LIABILITIES AND SHAREHOLDERS EQUITY (DEFICIT)   |  |                                            |              |   |                       |   |            |                         | 
|Current liabilities:                             |  |                                            |              |   |                       |   |            |                         | 
|Accounts payable                                 |  | $                                          | 1,288,248    |   |                       | $ | (347,536   | ) (b)                   | 
|Accrued expenses                                 |  |                                            | 1,349,132    |   |                       |   | (30,000    | ) (b)                   | 
|Capital lease obligations and other borrowings   |  |                                            | 195,601      |   |                       |   |           |                         | 
|Deferred gain                                    |  |                                            |             |   |                       |   | 780,000    | (d)                     | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|Total current liabilities                        |  |                                            | 2,832,981    |   |                       |   | 402,464    |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|Long-term liabilities:                           |  |                                            |              |   |                       |   |            |                         | 
|Convertible senior secured fixed rate notes      |  |                                            | 5,193,213    |   |                       |   |           |                         | 
|Long-term liabilities, excluding current portion |  |                                            | 169,064      |   |                       |   |           |                         | 
|Accrued retirement plan benefit                  |  |                                            | 2,563,201    |   |                       |   |           |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|Total liabilities                                |  |                                            | 10,758,459   |   |                       |   | 402,464    |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|Shareholders equity (deficit):                  |  |                                            |              |   |                       |   |            |                         | 
|Capital stock                                    |  |                                            | 272,197      |   |                       |   |           |                         | 
|Additional paid-in capital                       |  |                                            | 151,469,159  |   |                       |   |           |                         | 
|Accumulated deficit                              |  |                                            | (148,494,073 | ) |                       |   | 1,211,021  | (c)                     | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|Deferred compensation                            |  |                                            | (446,718     | ) |                       |   |           |                         | 
|Accumulated other comprehensive loss             |  |                                            | (3,966,167   | ) |                       |   |           |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|Total shareholders equity (deficit)             |  |                                            | (1,165,602   | ) |                       |   | 1,211,021  |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 
|                                                 |  | $                                          | 9,592,857    |   |                       | $ | 1,613,485  |                         | 
|                                                 |  |                                            |              |   |                       |   |            |                         | 

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:

|a) |  | Proceeds to be received at the closing of the sale of the Companys intermittent testing business.
|-- |  | --------------------------------------------------------------------------------------------------

|b) |  | Assets sold to and liabilities assumed by ITC under the asset purchase agreement.
|-- |  | ---------------------------------------------------------------------------------



27



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##### Table of Contents

|c) |  | The net consideration to be received at closing of $4,420,000 (see adjustment a above) less the net assets sold of $3,208,979 (see adjustment b above)
represents the pro forma gain at closing, assuming the transaction occurred on June 30, 2003.
|-- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|d) |  | Fifteen percent of the total transaction consideration ($780,000) placed in escrow by ITC for 180 days after closing to fund indemnification obligations, if any, that arise. At the
time amounts in escrow are released, the Company will recognize additional gain on the transaction.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|e) |  | Includes payment at the closing date of $416,728, representing accrued salaries ($65,966), accrued vacation ($237,632) and accrued retention bonus ($113,130) earned by employees of
the Companys intermittent testing business that are either transferring to ITC or leaving Diametrics. The cash reduction also includes payment of severance totaling $99,571 for personnel reductions in the Companys intermittent testing
business which will occur as a result of the transaction.
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|f) |  | Accrual of estimated legal and accounting fees associated with the transaction, based upon billings to date and estimated remaining charges for these services.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------

|g) |  | Reflects adjustments to record the impact on equity and deferred compensation of transferring the employees of the Companys intermittent testing business to ITC who are
participants in the Companys retention agreement.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



The Companys retention agreement, which became effective August 1, 2002, included the grant of restricted stock to certain key employees who remain employed by the Company for at least one year from the agreements effective
date. The stock grants consisted of the issuance of an aggregate of 329,885 shares of restricted stock, of which 85,692 shares were issued to four employees of the intermittent testing business. The restricted stock vests over a 24-month period,
with 50% vesting after 12 months and pro rata vesting of shares over the remaining 12 months to achieve 100% vesting after 24 months. As described in note 11, the aggregate fair value of the restricted common stock on the date of grant, August 1,
2002, was $824,711, which was recognized as restricted stock with a corresponding charge to deferred compensation, a contra equity account. Of this amount, $214,230 corresponds to the fair value of the 85,692 shares issued to employees of the
intermittent testing business. The deferred compensation for the restricted stock grants is being recognized as expense ratably over the 24-month vesting period. Under the terms of the retention agreement, in the event of involuntary termination of
employment from the Company (such as the transfer of employees to ITC), 50% of restricted shares vest if termination occurs prior to August 1, 2003 and a pro rata portion of shares vest if termination occurs on or after August 1, 2003. The retention
agreement requires cancellation of remaining unvested shares. Assuming the transaction occurred on June 30, 2003, restricted shares held by employees of the intermittent testing business that are transferring to ITC would be eligible for one month
of accelerated vesting to achieve the minimum 50% vesting under the retention agreement, and the remaining 50% of unvested shares held by these employees would be cancelled. The noted adjustments to capital stock and additional paid-in-capital
totaling $107,115 reflect the cancellation of 50% of the original $214,230 fair value of the restricted stock held by employees of the intermittent testing business, and the $116,041 adjustment to deferred compensation reflects the acceleration of
one month of vesting of the fair value of such restricted stock ($8,926) and write-off of the remaining 50% of fair value associated with the cancelled restricted stock ($107,115).



Note: As described in note 4, the Companys Series E convertible preferred stock holders have the option to put back to the Company 50%
of their original $1.5 million investment plus a return of 1% per month in the event of the Companys completion of the sale of the intermittent testing business. The potential impact of this transaction, if it occurred, has not been reflected
in the pro forma financial statements.



28



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##### Table of Contents

The following pro forma and unaudited statement of operations for the six months ended June 30, 2003, represents the
results of operations as if the sale to ITC occurred on December 31, 2002:



PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE SIX MONTHS ENDED JUNE 30, 2003

(UNAUDITED)



|                                                         |  | Six Months Ended June 30, 2003 |           
|-------------------------------------------------------- |  | ------------------------------ | ----------
|                                                         |  | As Reported                    |           
|Net revenue                                              |  | $                              | 5,003,918 
|                                                         |  |                                |           
|Cost of revenue                                          |  |                                | 3,955,635 
|                                                         |  |                                |           
|Gross profit                                             |  |                                | 1,048,283 
|                                                         |  |                                |           
|Operating expenses:                                      |  |                                |           
|                                                         |  |                                |           
|Research and development                                 |  |                                | 2,156,746 
|Selling, general and administrative                      |  |                                | 4,024,882 
|                                                         |  |                                |           
|Total operating expenses                                 |  |                                | 6,181,628 
|                                                         |  |                                |           
|Operating loss                                           |  |                                | (5,133,345
|                                                         |  |                                |           
|Interest income                                          |  |                                | 10,685    
|Interest expense                                         |  |                                | (479,238  
|Other income, net                                        |  |                                | 1,485,273 
|                                                         |  |                                |           
|Net loss                                                 |  |                                | (4,116,625
|                                                         |  |                                |           
|Beneficial conversion feature  preferred stock Dividend |  |                                | (958,962  
|                                                         |  |                                |           
|Net loss available to common shareholders                |  | $                              | (5,075,587
|                                                         |  |                                |           
|Basic and diluted net loss per common share              |  | $                              | (0.19     
|                                                         |  |                                |           
|Weighted average number of common shares outstanding     |  |                                | 26,844,197
|                                                         |  |                                |           

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:

|a) |  | Elimination of operating results of the intermittent testing business.
|-- |  | ----------------------------------------------------------------------

|b) |  | The Company intends to make additional business changes, not reflected in the adjusted amounts above, with the objective of reducing its cost structure to be more in line with the
reduced size of its ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating
leases associated with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs, which are not reflected in the pro forma financial statements. Given the
evolving nature of these and potentially other business changes, the Company is unable to provide an estimate of the associated charges at this time.
|-- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



29



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##### Table of Contents

The following pro forma and unaudited statement of operations for the year ended December 31, 2002 represents the results
of operations as if the sale to ITC occurred on December 31, 2001.



PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002

(UNAUDITED)



|                                                     |  | Year ended December 31, 2002 |           
|---------------------------------------------------- |  | ---------------------------- | ----------
|                                                     |  | As Reported                  |           
|Revenue                                              |  |                              |           
|Product revenue                                      |  | $                            | 15,962,187
|Other revenue                                        |  |                              | 2,736,000 
|                                                     |  |                              |           
|                                                     |  |                              | 18,698,187
|                                                     |  |                              |           
|Cost of revenue                                      |  |                              | 14,714,856
|                                                     |  |                              |           
|Gross profit                                         |  |                              | 3,983,331 
|                                                     |  |                              |           
|Operating expenses:                                  |  |                              |           
|Research and development                             |  |                              | 4,772,775 
|Selling, general and administrative                  |  |                              | 5,379,967 
|Restructuring and other charges                      |  |                              | 886,744   
|                                                     |  |                              |           
|Total operating expenses                             |  |                              | 11,039,486
|                                                     |  |                              |           
|Operating loss                                       |  |                              | (7,056,155
|                                                     |  |                              |           
|Interest income                                      |  |                              | 86,441    
|Interest expense                                     |  |                              | (545,976  
|Other expense, net                                   |  |                              | (15,326   
|                                                     |  |                              |           
|Net loss                                             |  | $                            | (7,531,016
|                                                     |  |                              |           
|Basic and diluted net loss per common share          |  | $                            | (0.28     
|                                                     |  |                              |           
|Weighted average number of common shares outstanding |  |                              | 26,804,451
|                                                     |  |                              |           

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:

|a) |  | Elimination of operating results of the intermittent testing business.
|-- |  | ----------------------------------------------------------------------

|b) |  | The Company intends to make additional business changes, not reflected in the amounts above, with the objective of reducing its cost structure to be more in line with the reduced
size of its ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating leases
associated with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs, which are not reflected in the pro forma financial statements. Given the evolving
nature of these and potentially other business changes, the Company is unable to provide an estimate of the associated charges at this time.
|-- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



30



---

##### Table of Contents

The following pro forma and unaudited statement of operations for the year ended December 31, 2001 represents the results
of operations as if the sale to ITC occurred on December 31, 2000.



PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001

(UNAUDITED)



|                                                     |  | Year ended December 31, 2001 |           
|---------------------------------------------------- |  | ---------------------------- | ----------
|                                                     |  | As Reported                  |           
|Revenue                                              |  |                              |           
|Product revenue                                      |  | $                            | 23,888,928
|Other revenue                                        |  |                              | 600,000   
|                                                     |  |                              |           
|                                                     |  |                              | 24,488,928
|                                                     |  |                              |           
|Cost of revenue                                      |  |                              | 17,984,341
|                                                     |  |                              |           
|Gross profit                                         |  |                              | 6,504,587 
|                                                     |  |                              |           
|Operating expenses:                                  |  |                              |           
|Research and development                             |  |                              | 5,137,974 
|Selling, general and administrative                  |  |                              | 4,944,599 
|                                                     |  |                              |           
|Total operating expenses                             |  |                              | 10,082,573
|                                                     |  |                              |           
|Operating loss                                       |  |                              | (3,577,986
|                                                     |  |                              |           
|Interest income                                      |  |                              | 323,490   
|Interest expense                                     |  |                              | (572,618  
|Other expense, net                                   |  |                              | (48,785   
|                                                     |  |                              |           
|Net loss                                             |  | $                            | (3,875,899
|                                                     |  |                              |           
|Basic and diluted net loss per common share          |  | $                            | (0.14     
|                                                     |  |                              |           
|Weighted average number of common shares outstanding |  |                              | 26,762,684
|                                                     |  |                              |           

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:

|a) |  | Elimination of operating results of the intermittent testing business.
|-- |  | ----------------------------------------------------------------------

|b) |  | We intend to make additional business changes, not reflected in the adjusted amounts above, with the objective of reducing our cost structure to be more in line with the reduced
size of our ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating leases
associated with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs, which are not reflected in the pro forma financial statements. Given the evolving
nature of these and potentially other business changes, the Company is unable to provide an estimate of the associated charges at this time.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



31



---

##### Table of Contents

The following pro forma and unaudited statement of operations for the year ended December 31, 2000 represents the results
of operations as if the sale to ITC occurred on December 31, 1999.



PRO FORMA CONSOLIDATED STATEMENT OF OPERATIONS

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2000

(UNAUDITED)



|                                                     |  | Year ended December 31, 2000 |           
|---------------------------------------------------- |  | ---------------------------- | ----------
|                                                     |  | As Reported                  |           
|Revenue                                              |  |                              |           
|Product revenue                                      |  | $                            | 22,998,407
|Other revenue                                        |  |                              | 2,260,000 
|                                                     |  |                              |           
|                                                     |  |                              | 25,258,407
|                                                     |  |                              |           
|Cost of revenue                                      |  |                              | 17,738,103
|                                                     |  |                              |           
|Gross profit                                         |  |                              | 7,520,304 
|                                                     |  |                              |           
|Operating expenses:                                  |  |                              |           
|Research and development                             |  |                              | 4,962,348 
|Selling, general and administrative                  |  |                              | 5,300,918 
|                                                     |  |                              |           
|Total operating expenses                             |  |                              | 10,263,266
|                                                     |  |                              |           
|Operating loss                                       |  |                              | (2,742,962
|                                                     |  |                              |           
|Interest income                                      |  |                              | 787,396   
|Interest expense                                     |  |                              | (586,616  
|Other expense, net                                   |  |                              | (105,435  
|                                                     |  |                              |           
|Net loss                                             |  | $                            | (2,647,617
|                                                     |  |                              |           
|Basic and diluted net loss per common share          |  | $                            | (0.10     
|                                                     |  |                              |           
|Weighted average number of common shares outstanding |  |                              | 26,490,826
|                                                     |  |                              |           

---

Pro forma adjustments to reflect the sale of the
intermittent testing business to ITC include:

|a) |  | Elimination of operating results of the intermittent testing business.
|-- |  | ----------------------------------------------------------------------

|b) |  | We intend to make additional business changes, not reflected in the adjusted amounts above, with the objective of reducing our cost structure to be more in line with the reduced
size of our ongoing business. These changes are expected to involve the termination of certain employees in the Companys corporate headquarters and continuous monitoring business, as well as the potential termination of operating leases
associated with certain Company facilities. As such, the Company expects to incur charges after the closing of the transaction for severance and other exit costs, which are not reflected in the pro forma financial statements. Given the evolving
nature of these and potentially other business changes, the Company is unable to provide an estimate of the associated charges at this time.
|-- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



32



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##### Table of Contents

RESULTS OF OPERATIONS



Revenue. The Companys total revenue was $2,827,251 and $5,003,918 for the three and six months ended June 30,
2003, compared to $5,275,931 and $10,738,805 for the same periods in the prior year, a decrease of 46% and 53% for the three and six month periods, respectively. The decline in revenue was primarily due to the termination of the exclusive
distribution agreement with Philips and the Companys resulting transition to its new distribution and direct sales force channel model. The transition had a negative impact primarily on the volume of instrument sales during the three and six
months ended June 30, 2003, but positively impacted average selling prices for instruments and disposable cartridges and sensors as a higher concentration of sales were made to direct end-user customers and distributors at pricing higher than that
extended to Philips. Instrument revenues declined 65% and 75% for the three and six months ended June 30, 2003, respectively, with related unit sales decreasing 89% and 84% during the same periods. Disposable cartridge and sensor revenue declined
11% and 8% for the three and six months ended June 30, 2003, respectively, and related unit sales decreased 4% and 1% for the same periods. The smaller decrease in disposable unit sales during the 2003 periods relative to the revenue decline
occurred primarily due to a higher concentration of intermittent testing cartridge sales, which carry a lower average selling price than continuous monitoring sensors. Higher average selling prices for disposable cartridges and sensors partially
offset the impact of the increased concentration of cartridge sales. The larger decrease in instrument unit sales relative to the revenue decline primarily reflects a shift in the mix of intermittent testing instrument sales from the lower priced
Portal measurement module to the higher priced IRMA SL analyzer, and also an increase in average instrument selling prices. The described shift in the mix of intermittent testing instrument sales was impacted by the introduction of the Portal
measurement module in the first quarter 2002, which generated significant purchases of that product by Philips during 2002, while Philips reduced its purchases of IRMA analyzers during the same period given Philips available inventory of this
product. Intermittent testing products represented 76% and 72% of total revenue for the three and six months ended June 30, 2003, compared to 62% and 61% for the comparable periods in 2002. Continuous monitoring products comprised the remaining
revenue in each period. Products sold internationally comprised 59% and 57% of total revenue for the three and six months ended June 30, 2003, respectively, with remaining revenue in each period generated in the United States. (As sales in 2002 were
primarily to Philips, comparable information on the geographic distribution of sales for 2002 is not available).



The Companys sales to Philips comprised approximately 26% and 34% of total revenue for the three and six months ended June 30, 2003, compared to 95% and 93% for the
comparable periods in 2002, and are expected to continue to reflect a declining share of total revenue until the end of the current contract term on October 31, 2004. Due to the significant purchases of the Companys products by Philips for its
internal use in the sales process and to meet minimum purchase commitments, Philips sales to its end-user customers are estimated to be approximately 50% of the Companys product sales related to Philips over the approximate three-year
period ended October 31, 2002.



For the three and six months ended June 30,
2003, intermittent testing products revenue was comprised of 56% and 63% disposable cartridge revenue, respectively, with remaining product revenues in each period generated by instrument-related sales. Continuous monitoring products revenue for the
three and six months ended June 30, 2003 was comprised of 60% and 62% disposable sensor revenue, respectively, with remaining product revenues consisting of instrument-related sales. The Companys revenues are affected principally by the number
of instruments, consisting of continuous monitoring instruments, IRMA SL analyzers and Portal measurement modules and accessories, sold to distributors and direct customers, the extent to which the distributors sell the Companys instruments to
end-user customers, and the rate at which disposable sensors and cartridges are used in connection with these products. As of June 30, 2003, the Company has sold approximately 13,700 instruments, primarily to distributors. As the Company grows, it
is expected that the Companys growing end-user customer base will increase the usage and rate of usage of disposable products, with the result that overall disposable product sales will exceed that of instrument sales.



33



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##### Table of Contents

Cost of Revenue. Cost of revenue totaled $2,197,889 and $3,955,635, or 78% and 79% of revenue for the three
and six months ended June 30, 2003, compared to $3,953,497 and $7,958,776, or 75% and 74% of revenue for the same periods in the prior year. The increase in cost of revenue as a percentage of total revenue was primarily impacted by a significant
reduction in the mix of instrument sales to total sales, as instrument sales generally carry higher margins than sales of disposable cartridges and sensors. Partially offsetting the impact of lower instrument revenue was an increase in average
selling prices for the Companys products, due to the Companys expansion of its distribution channels, and a resulting lower concentration of sales to Philips. Also partially offsetting the negative impact of a reduction in instrument
sales volumes was a reduction in overhead costs, stemming largely from manufacturing work force reductions in the second and third quarters of 2002 and further cost containment measures initiated in the second half of 2002. Savings from the work
force reductions approximated $220,000 and $440,000 in the three and six months ended June 30, 2003, respectively.



Operating Expenses. Research and development expenditures totaled $1,025,240 and $2,156,746 for the three and six months ended June 30, 2003,
compared to $1,298,895 and $2,520,532 for the same periods in 2002, reductions of 21% and 14%, respectively. The decline in expense was primarily impacted by work force reductions in the second and third quarters of 2002 and other spending
reductions stemming from completion and postponement of projects and other cost containment measures initiated in the last half of 2002. Realized cost savings during the three and six months ended June 30, 2003 related to research and development
work force reductions approximated $220,000 and $440,000, respectively, and were in line with managements expectations. The cost savings related to work force reductions and other spending reductions were partially mitigated by the impact of
the recognition in last years second quarter and year-to-date period of research and development funding from Philips of $500,000 and $1,000,000, respectively, and no funding recognition during the same periods this year. The Companys
recognition of research and development funding from Philips ceased as of November 1, 2002 with the termination of the exclusive agreement with Philips.



Selling, general and administrative expenses totaled $1,976,389 and $4,024,882 for the three and six months ended June 30, 2003, compared to $1,345,102 and $2,529,048 for
the same periods in 2002. The 47% and 59% respective increase in expense between periods was primarily impacted by the establishment during the fourth quarter 2002 of a direct sales force and increased marketing activities stemming from the
termination of the exclusive agreement with Philips.. The Companys establishment of a direct sales force and associated marketing activities resulted in an increase in the average number of sales and marketing personnel of approximately 13,
and a related increase in travel and promotional costs, causing total sales and marketing expenses for the three and six months ended June 30, 2003 to rise by approximately $631,000 and $1.3 million, respectively. The remaining increase in total
selling, general and administrative expenses during the six months ended June 30, 2003, was due to an increase in general and administrative expenses of $224,000, stemming primarily from increased costs for executive compensation and insurance.



Operating results for the second quarter of 2002 included restructuring and
other charges totaling $688,188. This amount included approximately $504,000 of other charges for severance and related costs resulting from the resignation of the Companys Chief Executive Officer and President effective June 1,
2002. The remaining $184,000 represents restructuring charges consisting of severance and related costs associated with a work force reduction impacting 22 employees in the Companys U.K. and U.S. operations, including 14 in manufacturing, two
in research and development and one in general and administration. The Company implemented another work force reduction in the third quarter of 2002, impacting an additional 23 employees in manufacturing and research and development. Severance and
related costs accrued in connection with third quarter 2002 restructuring activities totaled approximately $199,000, bringing total 2002 restructuring and other charges to approximately $887,000. The Company paid the full $383,000 of restructuring
costs and $342,000 of the other charges during 2002, and paid the remaining $162,000 of other charges during the first half of 2003.



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Other Income (Expense). Net other income totaled $1,146,263 and $1,016,720 for the three and six months ended June
30, 2003, compared to net other expense of $120,837 and $231,840 for the same periods in 2002.



The significant increase in net other income in the 2003 periods occurred as a result of the accounting treatment for the modification of the Companys convertible senior secured fixed rate notes, which resulted
in the recognition as other income in the second quarter of a $1.5 million gain. The modified notes and associated warrants were recorded at their individual estimated fair values of $5 million and $800,000, respectively. The $7.3 million carrying
value of the original notes was retired, and the residual amount of $1.5 million was reflected as a gain on the transaction. The Company will accrete the initial $5 million carrying value of the modified notes to their redemption value of $7.3
million using the effective interest method over the remaining term of the modified notes, which will result in the recording of $2.3 million of additional interest expense over this period. Accordingly, the accretion of the note balance resulted in
an additional charge to interest expense of $193,213 in the second quarter 2003, partially offsetting the gain.



The Company realized interest income of $3,199 and $10,685 for the three and six months ended June 30, 2003, compared to $21,733 and $53,970 for the same periods in 2002.
The period-to-period decrease in interest income reflects the impact of lower average cash and investment balances and lower average interest rates.



Interest expense totaled $340,711 and $479,238 for the three and six months ended June 30, 2003, compared to $135,282 and $271,021 for the same periods in 2002. The
period-to-period increase in interest expense primarily reflects the recognition in the second quarter of additional interest expense of $193,213 related to the modification of the convertible notes as discussed above, and the impact of higher
average interest rates on capital lease obligations entered into in late 2002 and early 2003.



Net Loss. The net loss for the three and six months ended June 30, 2003 was $1,226,004 and $4,116,625, compared to $2,130,588 and $3,189,579 for the same periods in 2002, including restructuring
and other charges. Excluding the impact of the 2002 restructuring and other charges, net loss for the three and six months ended June 30, 2002 was $1,442,400 and $2,501,391. The primary contributors to the net loss amounts realized for the three and
six months ended June 30, 2003 were a reduction in instrument revenue and an increase in selling, general and administrative expenses, both stemming from the termination of the exclusive agreement with Philips and the Companys transition to
its new distribution and direct sales force channel model. Partially offsetting the impact of these changes for the six month period and creating the improvement in the net loss before restructuring and other charges for the second quarter 2003 was
the $1.3 million net favorable impact on other income resulting from the accounting for the modification of the convertible notes.



The Company anticipates that the pending sale of its intermittent testing business and resulting transition of the distribution channels related to that business will
result in a reduction in revenues in the last half of 2003 relative to the first half. The Company also expects that the sale of its intermittent testing business will result in a reduction in its operating loss in the last half of the year,
partially offset by restructuring and other charges expected to be incurred to lower the cost structure of the Company going forward.



LIQUIDITY AND CAPITAL RESOURCES



The accompanying financial statements have been prepared on a going-concern basis, which contemplates the realization of assets and satisfaction of liabilities and other
commitments in the normal course of business. The report of the Companys independent auditors pertaining to the Companys consolidated financial statements for the year ended December 31, 2002 contained an explanatory paragraph expressing
substantial doubt about the Companys ability to continue as a going concern as a result of negative working capital at December 31, 2002, recurring losses and negative cash flows. The financial statements do not include any adjustments
relating to the recoverability and



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classification of recorded asset amounts or the amounts and classification of liabilities that may be necessary if the Company is unable to continue as a
going concern.



On July 18, 2003, the Company announced that it had entered
into an asset purchase agreement with International Technidyne Corporation (ITC), a wholly owned subsidiary of Thoratec Corporation, whereby ITC will acquire substantially all of the assets used in the operation of the Companys
intermittent testing business. Pursuant to the terms of the agreement, ITC will pay the Company approximately $5.2 million in cash, which may be adjusted downward if any purchase price adjustments are required, and assume certain liabilities,
including up to $550,000 in trade payables. Of the $5.2 million cash payment, $780,000 will be placed in escrow by ITC for 180 days after the closing of the transaction to cover any shortfall in collected receivables or any indemnification claims.
The asset sale is subject to customary closing conditions, including approval by the Companys shareholders, and is expected to close in the third quarter of 2003. Proceeds from the sale of the Companys intermittent testing business will
be used to fund and grow the Companys continuous monitoring business.



At
June 30, 2003, the Company had working capital of $2,620,740, an increase of $3,625,956 from the working capital reported at December 31, 2002. The increase is impacted primarily by the reclassification as of March 31, 2003 of $7.3 million of
Convertible Senior Secured Fixed Rate Notes from current to long-term liabilities, as a result of the extension effective April 7, 2003 of the due date of the notes from August 4, 2003 to August 4, 2005, and net proceeds of approximately $1.2
million from the Companys Series E convertible preferred stock interim financing. A net loss before non-cash items of approximately $4.4 million and capital expenditures of $331,298 partially offset the impact of the increase in working
capital.



The Company incurred net losses of $4,116,625 and $3,189,579 for the
six months ended June 30, 2003 and 2002, respectively, incurred a net loss of $7,531,016 for the year ended December 31, 2002, and has incurred net losses since inception. The 2003 year-to-date net loss is net of a $1.5 million gain recognized as a
result of the modification of the Companys Convertible Senior Secured Fixed Rate Notes, further described in note 3. Financial results for the year ending December 31, 2003 are expected to show an increase in net loss relative to 2002 due to
lower expected revenue and increased sales and marketing expenses, primarily impacted by the Companys transition to its new distribution and direct sales force channel model. The unfavorable financial impact of this transition on 2003 results,
however, will be partially offset by the gain realized in the second quarter from the refinancing of the Companys convertible notes and an expected reduction in the operating loss of the Companys intermittent testing business and net
gain stemming from the pending sale of that business.



Cash and marketable
securities decreased by approximately $2.7 million during the six months ended June 30, 2003 to approximately $1.3 million. The Company is monitoring its cash position carefully and is evaluating its future operating cash requirements in the context
of its strategy, business objectives and expected business performance. As part of this, the Company has elected to delay project spending and capital expenditures, and is implementing other cost-cutting measures across all areas of the
Companys operations, including personnel, facilities and discretionary spending. A significant amount of instrument inventory available to the Company will allow a reduction of inventory purchases and production requirements during 2003.
Further, the Company is positioning its business for future sales and earnings growth with the pursuit of strategic partners for its business as well as the expansion of its global distribution channels, including a direct sales force in the United
States, the United Kingdom and Germany, and third-party distributors outside of these countries. Proceeds from the expected sale in the third quarter 2003 of the Companys intermittent testing business will increase the Companys cash
reserves, and the sale of this business will reduce the Companys cash usage rate. The Company is also pursuing interim financing options to bridge it to completion of the sale of the intermittent testing business, if necessary. While the
Company believes it will be successful in securing interim financing, there can be no assurance that adequate funds will be available or on acceptable terms. Once the transaction for the sale of the intermittent testing business closes, the Company
expects proceeds from the sale to meet the Companys funding requirements for support of its operations for approximately the next twelve months. This period could be shortened if the holders



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of the Companys Series E convertible preferred stock elect to exercise their put option to sell up to 7,500 shares of the outstanding Series E
convertible preferred stock back to the Company after completion of the sale of the intermittent testing business. The Company will be required to raise additional capital during this twelve month period in order to sustain and fund its operations
over the long term. Such funding could include the issuance of additional equity or debt securities to the extent funding raised from other strategic business alternatives is not sufficient to meet the Companys funding requirements. In May
2003, the Company received shareholder approval to increase its number of authorized shares of common stock by 15 million shares, enhancing the Companys ability to pursue additional financing. As of June 30, 2003, the primary funding for the
operations of the Company has been approximately $150 million raised through public and private sales of its equity securities and issuance of convertible promissory notes.



On July 1, 2003, the Company received a notice from the Nasdaq Stock Market indicating that, following a review of the appeal the Company
presented on June 5, 2003, the Nasdaq Listing Qualifications Panel determined to delist the Companys common stock from the Nasdaq SmallCap Market effective with the open of business on Wednesday, July 2, 2003. The Companys common stock
became immediately eligible to trade on the Over-the-Counter Bulletin Board effective with the open of business on July 2, 2003 under the symbol DMED. Trading of the Companys common stock through the Over-the-Counter Bulletin Board
may be more difficult because of lower trading volumes, transaction delays and reduced security analyst and news media coverage of the Company. These factors could contribute to lower prices and larger spreads in the bid and ask prices for the
Companys common stock. Trading of its common stock in an over-the-counter market may also attract a different type of investor in the Companys common stock, which may limit the Companys future equity funding options.



The Companys long-term capital requirements will depend upon numerous factors,
including the impact of changes in distribution relationships and methods on revenue, the rate of market acceptance of the Companys products, the level of resources devoted to expanding the Companys business and manufacturing
capabilities, and the level of research and development activities. While there can be no assurance that adequate funds will be available when needed or on acceptable terms, management believes that the Company will be able to raise adequate funding
to meet its operational requirements. If the Company is unable to raise an adequate level of additional capital or generate sufficient cash flows from operations, the Companys ability to execute its business plan and remain a going concern
will be significantly impaired.



Net cash used in operating activities totaled
$3,440,795 for the six months ended June 30, 2003, compared to $4,376,433 for the same period in 2002. This was the result of net losses of $4,116,625 and $3,189,579 for these same periods in 2003 and 2002, respectively, adjusted by non-cash items
and changes in operating assets and liabilities, including accounts receivable, inventories, prepaid expenses, accounts payable, accrued expenses and deferred credits and revenue, discussed below.



Net accounts receivable increased $69,967 for the six months ended June 30, 2003, compared to
a $111,326 increase for the same period in 2002. The increase during 2003 was primarily impacted by increased sales in the second quarter 2003 relative to the fourth quarter 2002, partially offset by an improvement in days sales outstanding in 2003,
primarily impacted by second quarter pre-payments from a distributor for sales in the quarter and an increased mix of direct versus indirect sales for the Companys U.K. subsidiary, resulting in improved collection timing. The increase for the
same period in 2002 occurred in spite of a reduction in sales from the fourth quarter 2001 due to the timing of sales and related accounts receivable collections.



Inventories decreased $652,550 for the six months ended June 30, 2003, compared to an increase of $389,018 for the same period in 2002. The
decrease in 2003 was primarily due to a reduction in required disposable sensor raw material and instrument purchases, due to inventory availability, and increased sales of IRMA instruments during the second quarter 2003, impacted by significant
sales to an Asia Pacific distributor to help support SARS related testing in China. The increase in 2002 was primarily due to a ramp up of intermittent testing raw material inventories to facilitate third quarter



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production requirements for Portal measurement modules and IRMA analyzers. This was partially offset by a decline in continuous monitoring instrument
inventory resulting from sales of these products during the period. During the last half of 2002, the Company underwent an extensive evaluation of its inventory levels and related vendor commitments and recoverability of the same in light of the
expected decline in product sales upon termination of the exclusive distribution agreement with Philips effective November 1, 2002. This review resulted in the write-off during the last half of 2002 of $1.2 million of excess IRMA, Portal and
TrendCare instrument components on hand or in process at vendors. Manufacturing of the impacted products was discontinued due to the expected decrease in demand, the level of finished goods inventory on hand and inventory available to the Company
from other sources. The written off inventory components were not disposed of to accommodate any potential growth in demand for these products beyond expectations, but will be scrapped at the time the Company believes there is not any potential for
their use. Since that time, the Company has continued to monitor the level and recoverability of its inventories in view of the timing of potential new product introductions, and actual and expected unit sales and demonstrated and expected market
prices of its existing products. Based on review of these factors, the Company has determined that its inventory balances are recoverable as of June 30, 2003. No sales have occurred during 2003 of inventory items previously written off in 2002.



Prepaid expenses decreased $255,581 and increased $195,558 during the six
months ended June 30, 2003 and 2002, respectively. The decrease in 2003 is due primarily to the timing of the annual renewal of the Companys insurance policies and payment of related premiums, while the increase in 2002 was primarily due to a
prepayment for a technology feasibility study conducted during 2002.



Accounts
payable and accrued expenses increased $150,757 and decreased $443,229 on a combined basis for the six months ended June 30, 2003 and 2002, respectively. The increase in 2003 is primarily impacted by an increase in accrued interest expense due to
the deferral of 2003 interest payments on the Companys Convertible Senior Secured Fixed Rate Notes until September 30, 2003. Partially offsetting this increase were payments during the period for product purchase commitments and severance
costs accrued at December 31, 2002. The reduction in 2002 primarily reflects the payment of employee incentive bonuses earned in the prior year and a reduction in trade payables due to lower inventory purchases, partially offset by the accrual in
the second quarter 2002 of severance and related costs associated with the resignation of the Companys Chief Executive Officer and President and work force reductions in that quarter.



Deferred credits and revenue decreased $1,083,333 for the six months ended June 30, 2002,
primarily representing the recognition of funding from Philips for research and development costs. No related activity occurred during the six months ended June 30, 2003, as the Companys recognition of funding from Philips ceased as of
November 1, 2002, with the termination of the exclusive agreement with Philips.



Net cash used in investing activities totaled $331,298 for the six months ended June 30, 2003, compared to $463,230 provided by investing activities for the six months ended June 30, 2002. Changes in cash flows from investing activities are
typically affected primarily by the amounts and timing of equity or other funding and operating cash flow requirements, which affect the amount of cash available for the purchase and subsequent maturity of marketable securities. For 2003, the
Companys cash and investment balance consisted entirely of cash equivalents, and as a result, no proceeds from maturities of marketable securities occurred during the current year-to-date period. Purchases of property and equipment totaled
$331,298 in 2003 and $287,911 in 2002. In 2003, the Company expects capital expenditures and new lease commitments to be below $800,000 for the year, primarily reflecting investments to support production, internal product requirements for the
direct sales process and new product development.



Net cash provided by
financing activities totaled $1,086,107 and net cash used in financing activities totaled $60,943 for the six months ended June 30, 2003 and 2002, respectively. Financing activities in the current period were primarily impacted by the Companys
receipt in May 2003 of net proceeds of approximately $1.2 million in connection with the completion of a convertible preferred stock interim



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financing. This was partially offset by principal payments on borrowings and capital leases and payment of debt extension
costs related to the modification of the Companys convertible notes. The net use of cash during the same period in 2002 primarily reflects payments on borrowings and capital leases, partially offset by proceeds from employee stock plans.



At June 30, 2003, the Company had U.S. tax net operating loss and research and
development tax credit carryforwards for income tax purposes of approximately $129 million and $1.5 million, respectively. Pursuant to the Tax Reform Act of 1986, use of a portion of the Companys net operating loss carryforwards are limited
due to a change in ownership. If not used, these net operating loss carryforwards begin to expire in 2005 ($500,000) and at increasing amounts between 2006 and 2022 ($31.6 million between 2006 and 2009, and $94.5 million thereafter). The
Companys foreign subsidiary also has a net operating loss carryforward of approximately $54 million, which can be carried forward indefinitely, subject to review by the governmental taxing authority.



Item 3. Quantitative and Qualitative Disclosure About Market Risk



The Company is exposed to market risk from foreign exchange rate fluctuations of the British pound sterling to the U.S. dollar as the financial position and operating results of the Companys U.K. subsidiary,
DML, are translated into U.S. dollars for consolidation. The Companys exposure to foreign exchange rate fluctuations also arises from transferring funds to its U.K. subsidiary in British pounds sterling. From November 1999 through October
2002, most of the Companys sales were made to the Companys two global distribution partners, Philips and Codman, with sales denominated in U.S. dollars, thereby significantly mitigating the risk of exchange rate fluctuations on trade
receivables. With the termination of the exclusive agreement with Philips, the Company established a direct sales force in the United States, the United Kingdom and Germany, as well as nonexclusive third-party distributors outside of these countries
for sale of the Companys TrendCare continuous blood gas monitoring systems and IRMA SL intermittent testing blood analysis system. All sales made from the Companys U.S. operations are denominated in U.S. dollars and, with the exception
of sales to end-user customers in Germany (which are denominated in euros), all sales made from DML are denominated in British pounds sterling. The Company is currently reassessing its risk of exchange rate fluctuations on trade receivables due to
changing distribution relationships and methods precipitated by the termination of the Companys exclusive agreement with Philips. The Company plans to minimize exposure to currency risk due to fluctuations between the exchange rates for the
British pound sterling and the euro by offsetting euro denominated payment obligations with euro denominated receipts to the full extent possible. The Company anticipates that any remaining exposure due to euro denominated sales will not be
material, as related sales are not expected to comprise a significant portion of the Companys total sales.



The effect of foreign exchange rate fluctuations on the Companys financial results for the periods presented was not material. The Company does not currently use
derivative financial instruments to hedge against exchange rate risk or interest rate risk. Over 99% of the Companys debt balance as of June 30, 2003 bears interest at fixed rates, and is therefore not subject to exposure from fluctuating
interest rates.



The Company is exposed to both market and interest rate risk
in the actuarial valuation of its subsidiarys defined benefit Retirement Plan. The Retirement Plans projected benefit obligation exceeded the fair value of plan assets by approximately $3 million at the plans valuation date of
December 31, 2002, reflecting a $1.6 million increase in the plans underfunded status relative to the prior year. As a result, the Companys balance sheet at December 31, 2002 reflected significant increases in the accrued retirement plan
benefit liability and minimum pension liability (included as a charge to accumulated other comprehensive loss in shareholders equity) relative to the prior year. This occurred due to an environment of weaker investment performance
in the global markets over the past two to three years (which negatively affected the value of Retirement Plan assets), and to a lesser extent, lower prevailing interest rates (which drove the use of a lower discount rate to calculate the projected
benefit obligation, thereby increasing the amount of this obligation at December 31, 2002). While the underfunded status of the Companys Retirement Plan is expected to improve relative to



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current levels over time as a result of actuarial assumed improvements in future average market (and trust fund) performance, the inability of the trust fund
investments to perform at or near these average projected rates of return over the employees remaining service lives could result in a significant future funding obligation of the Company. To help manage this exposure, the Company has modified
the Retirement Plan effective August 31, 2003 to close the plan to future accrual of benefits. The Retirement Plan will continue to exist; however, the liabilities of the Retirement Plan will be frozen effective August 31, 2003. The Company will
continue to make monthly contributions into the Retirement Plan, but these contributions will be fully allocated to reduce the Retirement Plans liabilities for participant benefits earned through August 31, 2003. This change will help secure
Plan participants benefits earned through that date, and reduce the Companys exposure to a potential future significant funding obligation. The Company is currently evaluating SFAS No. 88, Employers Accounting for Settlements
and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, to determine the proper accounting treatment for the closing of the Retirement Plan to future accrual of benefits effective August 31, 2003.



Significant assumptions applied to the valuation of the Companys Retirement Plan as of
December 31, 2002 included the discount rate used for calculating the Retirement Plans projected benefit obligation at year-end, and the estimated long-term rate of return on assets, which affected the actuarial computation of net periodic
pension cost for 2002. The rates utilized in the actuarial valuation of the Retirement Plan at December 31, 2002 were a discount rate of 5.6% per annum, and an expected long-term rate of return on plan assets of 8% per annum.



Yields on AA rated U.K. corporate bonds with terms commensurate with the average remaining
service lives of Retirement Plan participants (15+ years) as of December 31, 2002 supported the use of discount rates ranging from approximately 5.23% to 6%. Had the Company utilized a discount rate at the low-end of this range of 5.25% (versus the
5.6% rate used) at December 31, 2002, the Retirement Plans projected benefit obligation, underfunded status, accrued benefit liability and minimum pension liability would have increased relative to reported amounts by amounts ranging from
$615,000 to $670,000. Alternatively, had the Company utilized a higher discount rate within the range of 5.75% at December 31, 2002, these same amounts would have declined by nearly $250,000 relative to reported amounts at December 31, 2002. Had the
Company reduced the expected long-term rate of return on assets assumption from 8% to 6%, the Retirement Plans net periodic pension cost would have increased by approximately $106,000, with an offsetting reduction in the amount of the minimum
pension liability charged to equity. The December 31, 2002 computation of the Retirement Plans projected benefit obligation and funded status would not have changed from reported amounts as a result of a change in the expected long-term rate
of return on assets as of December 31, 2002.



There have been no other material
changes in market risk faced by the Company from what has been previously reported in the Companys Annual Report on Form 10-K for the year ended December 31, 2002.



Item 4. Controls and Procedures



(a) Evaluation of
disclosure controls and procedures.



Under the supervision and with the
participation of management, including the Companys Chief Executive Officer and Chief Financial Officer, the Company evaluated the effectiveness of the design and operation of its disclosure controls and procedures (as defined in Rule
13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act)). Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered by this report, the
Companys disclosure controls and procedures were effective in timely alerting them to the material information relating to the Company (or its consolidated subsidiary) required to be included in the reports the Company files or submits under
the Exchange Act.



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(b) Changes in internal controls over financial reporting.



During the quarter ended June 30, 2003, there has been no change in the Companys internal control over financial reporting (as defined
in Rule 13a-15(f) under the Exchange Act) that has materially affected, or is reasonably likely to materially affect, its internal control over financial reporting.



PART II - OTHER INFORMATION



Item 1. Legal Proceedings



None



Item 2. Changes in Securities



On May 12, 2003,
the Company completed the sale in a private placement of 15,000 shares of Series E convertible preferred stock, par value $.01 per share, at a price of $100 per share. The preferred stock is convertible at any time into the Companys common
stock at 88% of the volume weighted average trading price of the common stock for the five consecutive trading days before the conversion date, subject to a maximum and minimum conversion price of $.75 per share and $.35 per share, respectively. The
purchasers of the preferred stock also received five-year warrants to purchase 735,000 shares of common stock at $.35 per share, exercisable after conversion of the preferred stock.



Item 3. Defaults Upon Senior Securities



None



Item 4. Submission of Matters to a Vote of Security Holders



The Annual Meeting of the Companys shareholders was held on May 22, 2003. At the meeting, shareholders voted on the reelection to the Board of one director, Carl S. Goldfischer, M.D., and the approval of the
appointment to the Board of David B. Kaysen. Dr. Goldfischer was reelected by a vote as follows: 20,817,041 votes For and 1,056,957 votes were Withheld. Mr. Kaysens appointment to the Board was approved by a vote as
follows: 20,816,215 votes For and 1,057,783 votes were Withheld. The terms for Mr. Kaysen and Dr. Goldfischer expire at the Companys annual meetings in 2005 and 2006, respectively.



The Companys shareholders also voted to approve an amendment to the Companys
Amended and Restated Articles of Incorporation to increase the number of shares of all classes of stock from 50,000,000 to 65,000,000, and to increase the number of authorized shares of Common Stock, par value $.01 per share, from 45,000,000 to
60,000,000. This amendment was approved as follows: 20,633,485 votes For, 1,214,076 votes Against and 26,437 votes Abstained.



Additionally, the Companys shareholders voted to approve an amendment to the Companys 1990 Stock Option Plan to allow
nonemployee directors to participate in the plan and become eligible to receive awards or options under the plan that do not qualify as incentive stock options. This amendment was approved as follows: 19,850,748 votes For, 1,979,459
votes Against, and 43,791 votes Abstained.



Item 5. Other Information



None



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Item 6. Exhibits and Reports on Form 8-K



| | a. |  | Exhibits
| | -- |  | --------



|Exhibit No. |  |                                                                                                                                                                              |  | Method of Filing
|----------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------
|            |  |                                                                                                                                                                             
|3.1         |  | Articles of Amendment to Amended and Restated Articles of Incorporation of the Company                                                                                       |  | (1)             
|            |  |                                                                                                                                                                             
|4.1         |  | Certificate of Designations of Series E Convertible Preferred Stock of the Company, dated May 12, 2003                                                                       |  | (1)             
|            |  |                                                                                                                                                                             
|10.1        |  | 1990 Stock Option Plan, as amended and restated                                                                                                                              |  | (1)             
|            |  |                                                                                                                                                                             
|10.2        |  | First Amendment to Note Purchase Agreement, dated April 7, 2003, between the Company and the Purchasers named therein                                                        |  | (1)             
|            |  |                                                                                                                                                                             
|10.3        |  | Form of First Amended and Restated Convertible Senior Secured Fixed Rate Note due August 4, 2005                                                                             |  | (1)             
|            |  |                                                                                                                                                                             
|10.4        |  | Form of Stock Purchase Warrant, dated April 7, 2003                                                                                                                          |  | (1)             
|            |  |                                                                                                                                                                             
|10.5*       |  | Amendment to Manufacturing and Distribution Agreement, dated April 10, 2003, between the Company and Philips Medical Systems                                                 |  | Filed herewith  
|            |  |                                                                                                                                                                             
|10.6 *      |  | Portal Manufacturing Agreement, dated April 10, 2003, between the Company and Philips Medical Systems                                                                        |  | (1)             
|            |  |                                                                                                                                                                             
|10.7        |  | Subscription Agreement for shares of Series E Convertible Preferred Stock and Common Stock Warrant, dated May 12, 2003, between the Company and the Purchasers named
therein |  | (1)             
|            |  |                                                                                                                                                                             
|10.8        |  | Form of Stock Purchase Warrant, dated May 12, 2003                                                                                                                           |  | (1)             
|            |  |                                                                                                                                                                             
|31.1        |  | Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                       |  | Filed herewith  
|            |  |                                                                                                                                                                             
|31.2        |  | Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                                                       |  | Filed herewith  
|            |  |                                                                                                                                                                             
|32.1        |  | Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                       |  | Filed herewith  
|            |  |                                                                                                                                                                             
|32.2        |  | Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                       |  | Filed herewith  
|            |  |                                                                                                                                                                             
|99.1        |  | Cautionary Statements Under the Private Securities Litigation Reform Act                                                                                                     |  | (1)             

---

|* |  | Pursuant to Rule 24b-2 of the Securities Exchange Act of 1934, as amended, confidential portions of Exhibits 10.5 and 10.6 have been deleted and filed separately with the Securities
and Exchange Commission pursuant to a request for confidential treatment.
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|(1) |  | Incorporated by reference to the Companys Quarterly Report on Form 10-Q for the Quarter ended June 30, 2003, filed with the SEC on August 14, 2003.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------



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| | b. |  | Reports on Form 8-K.
| | -- |  | --------------------



On April 8, 2003, the Company filed a Current Report on Form 8-K under Item 5 relating to the Companys announcement that it had renegotiated the terms and extended the principal payment date of its $7.3 million,
7% Convertible Senior Secured Fixed Rate Notes due August 4, 2003, to extend repayment of the notes to August 4, 2005.



On May 2, 2003, the Company filed a Current Report on Form 8-K under Item 5 relating to the Companys announcement that it received a notice from the Nasdaq Stock
Market, indicating that the Companys common stock was subject to delisting from The Nasdaq SmallCap Market based on the Companys failure to comply with the minimum common stock market value requirement.



On May 14, 2003, the Company filed a Current Report on Form 8-K under Item 9 relating to the
Companys announcement of earnings results for the quarter ended March 31, 2003, as presented in a press release dated May 14, 2003.



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DIAMETRICS MEDICAL, INC.



SIGNATURE



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



|    | 
|--- | 
|    | 
|    | 
|By: | 
|    | 



|Dated: |  | October 24, 2003
|------ |  | ----------------



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