##### 



EXHIBIT 13.1

TO OUR SHAREHOLDERS

(PHOTO)

Letter from the CEO

I am happy to report that CHAD Therapeutics continued to gain momentum during
fiscal 2003. Sales of our core oxygen conserver products increased 22% over
the prior year. We tackled the manufacturing and supplier issues that have
affected the success of our TOTAL O2® Delivery System, and believe that these
issues have been corrected and are now behind us. In addition, we entered into
product development and licensing agreements that give CHAD access to
technology to expand our home and hospital respiratory product lines and enter
the sleep disorder market for the first time. We are pleased with our progress
in implementing CHADs strategic growth plan.

Financial Results

Revenue for the fiscal year ended March 31, 2003 increased 3% to $19,541,000
from $19,006,000 for fiscal 2002, as the increase in sales of oxygen conservers
more than offset the anticipated decline in sales of our TOTAL O2 system.

The net loss for fiscal 2003 was $433,000, or $0.04 per diluted share. This
included a non-cash charge of $934,000 for the write-off of an intangible
license fee asset associated with the TOTAL O2 system under FASB Statement No.
144, Accounting for the Impairment of Long-Lived Assets and Long-Lived Assets
to Be Disposed Of, and $165,000 in unanticipated expenses incurred in
connection with a proxy contest waged by a group of dissident shareholders who
attempted unsuccessfully to elect nominees to CHADs Board.

For fiscal 2002, net earnings were $1,157,000, or $0.11 per diluted share,
which included an income tax benefit of $995,000 that resulted from newly
enacted Federal income tax regulations extending the period during which net
operating losses may be carried back.

CHADs financial position is strong as we enter the new fiscal year, with cash
of $1,596,000 and no long-term debt. The Company generated $1,577,000 in
positive cash flow from operating activities in fiscal 2003, which allowed us
to fund our operating growth and investments in new technologies to develop
product opportunities for the future.

Growth Strategy

We are implementing a three-pronged growth strategy. First, we are continuing
to build on the strong position and reputation we have established over the
years in our core oxygen conserver market. CHAD continued to gain share in
this market during fiscal 2003, as the strong performance of our
OXYMATIC®
400 Series electronic conservers was augmented by our new CYPRESS
OXYPneumatic® conserver, which was approved for marketing by the Food and
Drug Administration (FDA) in July 2002. CHADs first-ever pneumatic
conserver, CYPRESS is a state-of the-art product which features a conserving
ratio in excess of 3:1 - the highest in the industry - and can be used with a
single lumen cannula. We are pleased to report that sales of this product
exceeded our expectations.

CHADs advanced conserver products are also being well-received by our
international customers, particularly in Canada, where revenue was
significantly ahead of the prior year. We also are beginning to see
encouraging results from the upgrades to our distributor network we implemented
during the year. We believe that the combination of advanced products and
improved distribution will provide the foundation to further broaden our
international presence in fiscal 2004.

The second element of our growth plan is our continuing effort to promote the
benefits of our TOTAL O2 system. As we reported in last years annual report,
the decline in sales of our TOTAL O2 system was largely the result of the
acquisition, in October of 2001, of a customer that was purchasing significant
numbers of this product by a national chain that discontinued those purchases.
While we were required by FAS 144 to write off the intangible license fee asset
related to the TOTAL O2 system due to modest current sales levels, we continue
to support it and believe that it should ultimately be successful in the home
respiratory marketplace.

1



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##### 



TO OUR SHAREHOLDERS

The TOTAL O2 system provides a safe, reliable and efficient means for patients
to fill their portable oxygen cylinders at home and thereby gain independence
and complete control over their oxygen supplies. At the same time, the system
can help home healthcare providers reduce service and delivery costs and
cylinder inventories, yielding savings which may quickly offset the higher
initial capital cost of the TOTAL O2 system. We believe that these compelling
patient benefits and cost savings ultimately should lead to increased market
penetration for this technology.

The third element of our growth strategy is to expand the Companys product
lines and improve existing products through investment in and development of
new technologies. We made great progress in these areas in fiscal 2003. We
added two experienced pulmonary product engineers to our in-house engineering team, which raised our
total staff in this crucial area to nine people and considerably strengthened
our internal engineering capability. We also entered into product development
and licensing agreements with AirMatrix Technologies, Inc. and ACOBA, LLC of
St. Louis, Missouri. These agreements give us access to proprietary sensor
technologies and control software, which we plan to use to improve and expand
our conserver product lines and to develop innovative new products to enhance
our position in the far larger oxygen concentrator market. These agreements
should also enable us to develop potential applications for the high-growth
sleep disorder market for the first time. The sleep disorder technology is
aimed at products with the potential to add value in both the diagnostic as
well as the therapeutic segments of this rapidly growing market.

Our new relationships with AirMatrix and ACOBA underscore CHADs reputation for
technology leadership in the respiratory industry and our commitment to
developing products that improve the quality of life for patients while at the
same time reducing the cost of treatment. We are excited about the opportunity
to develop technology with the potential to significantly expand and diversify
CHADs product lines and addressable markets. This product development
program, a joint project between CHADs internal product development team and
ACOBA, is expected to take 12 to 24 months before the initial products are
ready for market introduction. We expect to fund the development program from
cash flow from operations.

A Look Ahead

Our goals for fiscal 2004 are to continue to improve CHADs position in the
oxygen conserver market, gradually increase our penetration of the oxygen
concentrator market, and continue to expand our growth opportunities through
new product development. And of course, with the unrelenting pressure on
health care costs and reimbursement, we will continue our efforts to reduce
expenses as we provide the most effective products for our customers. We
currently expect fiscal 2004 to be another year of revenue and earnings growth
for CHAD Therapeutics.

We thank all of our shareholders for their patience and the overwhelming show
of confidence given management and the Board of Directors during the proxy
contest at the annual meeting last September. We will continue to work
diligently on your behalf to uncover and capitalize on opportunities to enhance
shareholder value.

Thomas E. Jones(-s- THOMAS E. JONES)
Chief Executive Officer

2



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##### 



SELECTED FINANCIAL DATA

Selected Financial Data

|                                  |  |                       |            |      |  |      |            |      |  |      |            |   |  |  |            |   |  |  |            |  
|--------------------------------- |  | --------------------- | ---------- | ---- |  | ---- | ---------- | ---- |  | ---- | ---------- | - |  |  | ---------- | - |  |  | ---------- | -
|                                  |  | Years Ended March 31,
|                                  |  |                      
|                                  |  | 2003                  |            | 2002 |  | 2001 |            | 2000 |  | 1999
|                                  |  |                       |            |      |  |      |            |      |  |     
|Net Sales                         |  | $                     | 19,541,000 |      |  |      | 19,006,000 |      |  |      | 12,400,000 |   |  |  | 13,019,000 |   |  |  | 14,242,000 |  
|Interest Income, Net              |  |                       | 20,000     |      |  |      | 50,000     |      |  |      | 87,000     |   |  |  | 43,000     |   |  |  | 41,000     |  
|Net Earnings (loss)               |  |                       | (433,000   | )    |  |      | 1,157,000  |      |  |      | (3,011,000 | ) |  |  | (2,511,000 | ) |  |  | (1,464,000 | )
|Basic Earnings (loss) Per Share   |  |                       | (.04       | )    |  |      | .12        |      |  |      | (.30       | ) |  |  | (.25       | ) |  |  | (.15       | )
|Diluted Earnings (loss) Per Share |  |                       | (.04       | )    |  |      | .11        |      |  |      | (.30       | ) |  |  | (.25       | ) |  |  | (.15       | )
|Net Working Capital               |  |                       | 8,224,000  |      |  |      | 7,497,000  |      |  |      | 5,847,000  |   |  |  | 8,389,000  |   |  |  | 10,164,000 |  
|Total Assets                      |  |                       | 12,105,000 |      |  |      | 12,323,000 |      |  |      | 10,788,000 |   |  |  | 13,583,000 |   |  |  | 15,899,000 |  
|Shareholders Equity              |  |                       | 10,100,000 |      |  |      | 10,373,000 |      |  |      | 9,211,000  |   |  |  | 12,207,000 |   |  |  | 14,693,000 |  

No cash dividends have been declared or paid during the periods presented.

3



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##### 



BALANCE SHEETS

|                                 |                                                                                                                  |                                                |            |           |            |      |            |           |           | 
|-------------------------------- | ---------------------------------------------------------------------------------------------------------------- | ---------------------------------------------- | ---------- | --------- | ---------- | ---- | ---------- | --------- | --------- | 
|                                 |                                                                                                                  |                                                |            | March 31,
|                                 |                                                                                                                  |                                                |            |          
|                                 |                                                                                                                  |                                                |            | 2003      |            | 2002
|                                 |                                                                                                                  |                                                |            |           |            |     
|Assets                           |                                                                                                                  |                                                |            |           |            |      |            |          
|Current assets:                  |                                                                                                                  |                                                |            |           |            |      |            |          
|                                 | Cash                                                                                                             |                                                | $          | 1,596,000 |            |      |            | 520,000   |          
|                                 | Accounts receivable, less allowance for doubtful
accounts of $112,000 and $76,000 in 2003 and 2002, respectively |                                                |            | 2,517,000 |            |      |            | 2,333,000 |          
|                                 | Income taxes refundable                                                                                          |                                                |            | 4,000     |            |      |            | 995,000   |          
|                                 | Inventories (Note 2)                                                                                             |                                                |            | 5,511,000 |            |      |            | 5,284,000 |          
|                                 | Prepaid expenses                                                                                                 |                                                |            | 601,000   |            |      |            | 315,000   |          
|                                 |                                                                                                                  |                                                |            |           |            |      |            |           |          
|                                 |                                                                                                                  | Total current assets                           |            |           | 10,229,000 |      |            |           | 9,447,000 | 
|                                 |                                                                                                                  |                                                |            |           |            |      |            |           |          
|Property and equipment, at cost: |                                                                                                                  |                                                |            |           |            |      |            |          
|                                 | Office equipment and furniture                                                                                   |                                                |            | 1,990,000 |            |      |            | 1,876,000 |          
|                                 | Machinery and equipment                                                                                          |                                                |            | 972,000   |            |      |            | 905,000   |          
|                                 | Tooling                                                                                                          |                                                |            | 1,432,000 |            |      |            | 1,377,000 |          
|                                 | Leasehold improvements                                                                                           |                                                |            | 1,821,000 |            |      |            | 1,814,000 |          
|                                 |                                                                                                                  |                                                |            |           |            |      |            |           |          
|                                 |                                                                                                                  |                                                | 6,215,000  |           |            |      | 5,972,000  |          
|                                 |                                                                                                                  | Less accumulated depreciation and amortization |            |           | 4,979,000  |      |            |           | 4,320,000 | 
|                                 |                                                                                                                  |                                                |            |           |            |      |            |           |          
|                                 |                                                                                                                  | Net property and equipment                     |            |           | 1,236,000  |      |            |           | 1,652,000 | 
|                                 |                                                                                                                  |                                                |            |           |            |      |            |           |          
|Other assets, net (Note 4)       |                                                                                                                  |                                                | 640,000    |           |            |      | 1,224,000  |          
|                                 |                                                                                                                  |                                                |            |           |            |      |            |           |          
|                                 |                                                                                                                  | $                                              | 12,105,000 |           |            |      | 12,323,000 |          
|                                 |                                                                                                                  |                                                |            |           |            |      |            |           |          

|                                     |                                                                                                                   |                           |            |            |            |      |            |            |            | 
|------------------------------------ | ----------------------------------------------------------------------------------------------------------------- | ------------------------- | ---------- | ---------- | ---------- | ---- | ---------- | ---------- | ---------- | 
|                                     |                                                                                                                   |                           |            | 2003       |            | 2002
|                                     |                                                                                                                   |                           |            |            |            |     
|Liabilities and Shareholders Equity |                                                                                                                   |                           |            |            |            |      |            |           
|Current liabilities:                 |                                                                                                                   |                           |            |            |            |      |            |           
|                                     | Accounts payable                                                                                                  |                           | $          | 741,000    |            |      |            | 777,000    |           
|                                     | Accrued expenses (Note 7)                                                                                         |                           |            | 1,263,000  |            |      |            | 1,169,000  |           
|                                     | Income taxes payable (Note 3)                                                                                     |                           |            | 1,000      |            |      |            | 4,000      |           
|                                     |                                                                                                                   |                           |            |            |            |      |            |            |           
|                                     |                                                                                                                   | Total current liabilities |            |            | 2,005,000  |      |            |            | 1,950,000  | 
|                                     |                                                                                                                   |                           |            |            |            |      |            |            |           
|Commitments (Note 8)                 |                                                                                                                   |                           |            |            |            |      |            |           
|Shareholders equity (Note 5):       |                                                                                                                   |                           |            |            |            |      |            |           
|                                     | Common shares, no par value
Authorized 40,000,000 shares;
10,076,000 and 10,059,000 shares issued and outstanding |                           |            | 13,257,000 |            |      |            | 13,097,000 |           
|                                     | Accumulated deficit                                                                                               |                           |            | (3,157,000 | )          |      |            | (2,724,000 | )         
|                                     |                                                                                                                   |                           |            |            |            |      |            |            |           
|                                     |                                                                                                                   | Net shareholders equity  |            |            | 10,100,000 |      |            |            | 10,373,000 | 
|                                     |                                                                                                                   |                           |            |            |            |      |            |            |           
|                                     |                                                                                                                   | $                         | 12,105,000 |            |            |      | 12,323,000 |           
|                                     |                                                                                                                   |                           |            |            |            |      |            |            |           

See accompanying notes to financial statements.

4



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##### 



STATEMENTS OF OPERATIONS

|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |           |            |            | 
|------------------------------------- | ----------------------------------- | ----------------------------------- | ---------- | --------- | --------------------- | ---------- | ---------- | --------- | --------- | ---------- | ---------- | --------- | ---------- | ---------- | 
|                                      |                                     |                                     |            |           | Years Ended March 31,
|                                      |                                     |                                     |            |           |                      
|                                      |                                     |                                     |            |           | 2003                  |            | 2002       |           | 2001     
|                                      |                                     |                                     |            |           |                       |            |            |           |          
|Net sales                             |                                     | $                                   | 19,541,000 |           |                       |            | 19,006,000 |           |           |            | 12,400,000 |          
|Cost of sales                         |                                     |                                     | 11,190,000 |           |                       |            | 11,839,000 |           |           |            | 9,701,000  |          
|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |          
|                                      |                                     | Gross profit                        |            |           | 8,351,000             |            |            |           | 7,167,000 |            |            |           | 2,699,000  |           
|Costs and expenses:                   |                                     |                                     |            |           |                       |            |            |           |           |            |            |          
|                                      | Selling, general and administrative |                                     |            | 7,810,000 |                       |            |            | 6,231,000 |           |            |            | 5,137,000 |           
|                                      | Research and development            |                                     |            | 989,000   |                       |            |            | 819,000   |           |            |            | 658,000   |           
|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |          
|                                      |                                     | Total costs and expenses            |            |           | 8,799,000             |            |            |           | 7,050,000 |            |            |           | 5,795,000  |           
|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |          
|                                      |                                     | Operating income (loss)             |            |           | (448,000              | )          |            |           | 117,000   |            |            |           | (3,096,000 | )         
|Interest income, net                  |                                     |                                     | 20,000     |           |                       |            | 50,000     |           |           |            | 87,000     |          
|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |          
|                                      |                                     | Earnings (loss) before income taxes |            |           | (428,000              | )          |            |           | 167,000   |            |            |           | (3,009,000 | )         
|Income tax (benefit) expense (Note 3) |                                     |                                     | 5,000      |           |                       |            | (990,000   | )         |           |            | 2,000      |          
|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |          
|                                      |                                     | Net earnings (loss)                 |            | $         | (433,000              | )          |            |           | 1,157,000 |            |            |           | (3,011,000 | )         
|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |          
|                                      |                                     | Basic earnings (loss) per share     |            | $         | (.04                  | )          |            |           | .12       |            |            |           | (.30       | )         
|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |          
|                                      |                                     | Diluted earnings (loss) per share   |            | $         | (.04                  | )          |            |           | .11       |            |            |           | (.30       | )         
|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |          
|                                      |                                     | Weighted shares outstanding:        |            |           |                       |            |            |           |           |            |            |           |            |           
|                                      |                                     |                                     | Basic      |           |                       | 10,071,000 |            |           |           | 10,053,000 |            |           |            | 10,044,000 | 
|                                      |                                     |                                     | Diluted    |           |                       | 10,071,000 |            |           |           | 10,386,000 |            |           |            | 10,044,000 | 
|                                      |                                     |                                     |            |           |                       |            |            |           |           |            |            |          

See accompanying notes to financial statements.

5



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##### 



STATEMENTS OF SHAREHOLDERS EQUITY

For the years ended March 31, 2003, 2002, and 2001

|                                                        |  |                        |            |             |  |         |            |  |  |   |            |  
|------------------------------------------------------- |  | ---------------------- | ---------- | ----------- |  | ------- | ---------- |  |  | - | ---------- | -
|                                                        |  | Common Shares (Note 5) |            |             |  |        
|                                                        |  |                        |            | Accumulated
|                                                        |  | Shares                 |            | Amount      |  | Deficit
|                                                        |  |                        |            |             |  |        
|Balance at March 31, 2000                               |  |                        | 10,035,000 |             |  | $       | 13,077,000 |  |  | $ | (870,000   | )
|Common shares issued in lieu of
cash for directors fees |  |                        | 17,000     |             |  |         | 15,000     |  |  |   |           |  
|Net loss                                                |  |                        |           |             |  |         |           |  |  |   | (3,011,000 | )
|                                                        |  |                        |            |             |  |         |            |  |  |   |            |  
|Balance at March 31, 2001                               |  |                        | 10,052,000 |             |  |         | 13,092,000 |  |  |   | (3,881,000 | )
|Exercise of stock options                               |  |                        | 7,000      |             |  |         | 5,000      |  |  |   |           |  
|Net earnings                                            |  |                        |           |             |  |         |           |  |  |   | 1,157,000  |  
|                                                        |  |                        |            |             |  |         |            |  |  |   |            |  
|Balance at March 31, 2002                               |  |                        | 10,059,000 |             |  |         | 13,097,000 |  |  |   | (2,724,000 | )
|Exercise of stock options                               |  |                        | 17,000     |             |  |         | 20,000     |  |  |   |           |  
|Stock options granted as part of
technology acquisition |  |                        |           |             |  |         | 140,000    |  |  |   |           |  
|Net loss                                                |  |                        |           |             |  |         |           |  |  |   | (433,000   | )
|                                                        |  |                        |            |             |  |         |            |  |  |   |            |  
|Balance at March 31, 2003                               |  |                        | 10,076,000 |             |  | $       | 13,257,000 |  |  | $ | (3,157,000 | )
|                                                        |  |                        |            |             |  |         |            |  |  |   |            |  

See accompanying notes to financial statements.

6



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##### 



STATEMENTS OF CASH FLOWS

|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |         |           |  
|------------------------------------------------- | ---------------------------------------------------------------------------------------------------- | -------------------------------------------------------------- | --------------------------------------------------- | -------- | --------------------- | --------- | --------- | --------- | ------- | ---------- | --------- | ---------- | ------- | --------- | -
|                                                  |                                                                                                      |                                                                |                                                     |          | Years Ended March 31,
|                                                  |                                                                                                      |                                                                |                                                     |          |                      
|                                                  |                                                                                                      |                                                                |                                                     |          | 2003                  |           | 2002      |           | 2001   
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |        
|Cash flows from operating activities:             |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |           
|                                                  | Net earnings (loss)                                                                                  |                                                                | $                                                   | (433,000 | )                     |           |           | 1,157,000 |         |            |           | (3,011,000 | )      
|                                                  | Adjustments to reconcile net earnings (loss) to net cash provided by (used in) operating activities: |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|                                                  |                                                                                                      | Depreciation and amortization                                  |                                                     |          | 768,000               |           |           |           | 902,000 |            |           |            | 909,000 |          
|                                                  |                                                                                                      | Loss on write down of intangible asset                         |                                                     |          | 934,000               |           |           |           |        |            |           |            |        |          
|                                                  |                                                                                                      | Compensation expense related to option grants and stock issued |                                                     |          |                      |           |           |           |        |            |           |            | 15,000  |          
|                                                  |                                                                                                      | Changes in assets and liabilities:                             |                                                     |          |                       |           |           |           |         |            |           |            |         |          
|                                                  |                                                                                                      |                                                                | Decrease (increase) in accounts receivable          |          |                       | (184,000  | )         |           |         | 19,000     |           |            |         | (349,000  | )
|                                                  |                                                                                                      |                                                                | Decrease (increase) in inventories                  |          |                       | (227,000  | )         |           |         | (1,869,000 | )         |            |         | 1,882,000 |  
|                                                  |                                                                                                      |                                                                | Decrease (increase) in income taxes refundable      |          |                       | 991,000   |           |           |         | (995,000   | )         |            |         | 175,000   |  
|                                                  |                                                                                                      |                                                                | Decrease (increase) in prepaid expenses             |          |                       | (286,000  | )         |           |         | 283,000    |           |            |         | (80,000   | )
|                                                  |                                                                                                      |                                                                | Decrease (increase) in other assets                 |          |                       | (41,000   | )         |           |         | (17,000    | )         |            |         | (50,000   | )
|                                                  |                                                                                                      |                                                                | Increase (decrease) in accounts payable             |          |                       | (36,000   | )         |           |         | 312,000    |           |            |         | 151,000   |  
|                                                  |                                                                                                      |                                                                | Increase (decrease) in accrued expenses             |          |                       | 94,000    |           |           |         | 60,000     |           |            |         | 47,000    |  
|                                                  |                                                                                                      |                                                                | Increase (decrease) in income taxes payable         |          |                       | (3,000    | )         |           |         | 1,000      |           |            |         | 3,000     |  
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|                                                  |                                                                                                      |                                                                | Net cash provided by (used in) operating activities |          |                       | 1,577,000 |           |           |         | (147,000   | )         |            |         | (308,000  | )
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|Cash flows from investing activities:             |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |           
|                                                  | Additions to other assets                                                                            |                                                                |                                                     | (278,000 | )                     |           |           |          |         |            |           | (150,000   | )      
|                                                  | Capital expenditures                                                                                 |                                                                |                                                     | (243,000 | )                     |           |           | (398,000  | )       |            |           | (266,000   | )      
|                                                  | Proceeds from sale of property and equipment                                                         |                                                                |                                                     |         |                       |           |           | 1,000     |         |            |           | 11,000     |        
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|                                                  |                                                                                                      |                                                                | Net cash used in investing activities               |          |                       | (521,000  | )         |           |         | (397,000   | )         |            |         | (405,000  | )
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|Cash flows from financing activities:             |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |           
|                                                  | Exercise of stock options                                                                            |                                                                |                                                     | 20,000   |                       |           |           | 5,000     |         |            |           |           |        
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|                                                  |                                                                                                      |                                                                | Net cash provided by financing activities           |          |                       | 20,000    |           |           |         | 5,000      |           |            |         |          |  
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|Net increase (decrease) in cash                   |                                                                                                      |                                                                | 1,076,000                                           |          |                       |           | (539,000  | )         |         |            | (713,000  | )         
|Cash beginning of year                            |                                                                                                      |                                                                | 520,000                                             |          |                       |           | 1,059,000 |           |         |            | 1,772,000 |           
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|Cash end of year                                  |                                                                                                      | $                                                              | 1,596,000                                           |          |                       |           | 520,000   |           |         |            | 1,059,000 |           
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|Supplemental disclosure of cash flow information: |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |           
|                                                  | Cash paid during the year for:                                                                       |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        
|                                                  |                                                                                                      | Income taxes                                                   |                                                     | $        | 15,000                |           |           |           | 4,000   |            |           |            |        |          
|                                                  |                                                                                                      |                                                                |                                                     |          |                       |           |           |           |         |            |           |            |        

See accompanying notes to financial statements.

7



---



##### 



NOTES TO FINANCIAL STATEMENTS

(1) Summary of Significant Accounting Policies

The Company

CHAD Therapeutics, Inc. (the Company) is in the business of developing,
producing and marketing respiratory care devices designed to improve the
efficiency of oxygen delivery systems for home health care and hospital
treatment of patients suffering from pulmonary diseases.

Fair Value of Financial Instruments

The carrying amounts of financial instruments approximate fair value as of
March 31, 2003 and 2002. The carrying amounts related to cash, accounts
receivable, other current assets, and accounts payable approximate fair value
due to the relatively short maturity of such instruments.

Inventories

Inventories are valued at lower of cost or market. Cost is determined based on
standard cost which approximates the first-in, first-out method.

Property and Equipment

Property and equipment are stated at cost. Depreciation of property and
equipment is provided using the straight-line method based on the estimated
useful lives of the related assets as follows:

|                               |  |           
|------------------------------ |  | ----------
|Office Equipment and Furniture |  | 5-10 Years
|Machinery and Equipment        |  | 5-10 Years
|Tooling                        |  | 4 Years   

Amortization of leasehold improvements is over the life of the related lease or
asset, whichever is shorter.

Use of Estimates

Management of the Company has made a number of estimates and assumptions
relating to the reporting of assets and liabilities and the disclosure of
contingent assets and liabilities at the balance sheet date and the reporting
of revenues and expenses during the periods to prepare these financial
statements in conformity with accounting principles generally accepted in the
United States of America. Actual results could differ from those estimates.

Significant estimates include the allowance for doubtful accounts, inventory
valuation, deferred income tax asset valuation allowances, and the estimated
future operating cash flows from the Companys long-lived assets, including its
intangible assets. Considerable management judgement is necessary to estimate
future operating cash flows as future cash flows are impacted by competitive
and other factors that are generally out of managements control. Accordingly,
actual results could vary significantly from managements estimates.

Impairment of Long-Lived Assets

The Company reviews its long-lived assets for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to undiscounted future net cash
flows expected to be generated by the asset. If such assets are considered to
be impaired, the impairment to be recognized is measured by the amount by which
the carrying amount of the assets exceeds the fair value of the assets.

Revenue Recognition

Revenue from product sales is recognized upon shipment of merchandise. Products
are shipped FOB shipping point and title to the products transfers to the
purchaser upon shipment. Shipping charges billed to customers are included in
net sales. Allowances for customer returns have not been established as
historical experience has been minor.

Comprehensive Income (Loss)

The Company did not have components of other comprehensive income during the
periods ended March 31, 2003, 2002 and 2001. As a result, comprehensive income
(loss) is the same as net earnings (loss) for the periods ended March 31, 2003,
2002 and 2001.

Royalty Expense

The Company charges royalties incurred on product licenses to selling, general
and administrative expenses.

Earnings (Loss) Per Common Share

Following is a calculation of basic and diluted earnings (loss) per common
share for the years ended March 31, 2003, 2002 and 2001, respectively:

|                                                 |                                    |   |            |            |      |  |            |            |  |  |            |            | 
|------------------------------------------------ | ---------------------------------- | - | ---------- | ---------- | ---- |  | ---------- | ---------- |  |  | ---------- | ---------- | 
|                                                 |                                    |   | 2003       |            | 2002 |  | 2001      
|                                                 |                                    |   |            |            |      |  |           
|Basic earnings per share                         |                                    |   |            |            |      |  |            |            |  |  |            |           
|Numerator - net earnings (loss)                  |                                    | $ | (433,000   | )          |      |  | 1,157,000  |            |  |  | (3,011,000 | )         
|Denominator - weighted common
shares outstanding |                                    |   | 10,071,000 |            |      |  | 10,053,000 |            |  |  | 10,044,000 |           
|                                                 |                                    |   |            |            |      |  |            |            |  |  |            |           
|Basic earnings (loss) per share                  |                                    | $ | (.04       | )          |      |  | .12        |            |  |  | (.30       | )         
|                                                 |                                    |   |            |            |      |  |            |            |  |  |            |           
|Diluted earnings (loss) per share                |                                    |   |            |            |      |  |            |            |  |  |            |           
|Numerator - net earnings (loss)                  |                                    | $ | (433,000   | )          |      |  | 1,157,000  |            |  |  | (3,011,000 | )         
|Denominator -                                    |                                    |   |            |            |      |  |            |            |  |  |            |           
|                                                 | Weighted common shares outstanding |   |            | 10,071,000 |      |  |            | 10,053,000 |  |  |            | 10,044,000 | 
|                                                 | Common stock equivalents           |   |            |           |      |  |            | 333,000    |  |  |            |           | 
|                                                 |                                    |   |            |            |      |  |            |            |  |  |            |           
|                                                 |                                    |   | 10,071,000 |            |      |  | 10,386,000 |            |  |  | 10,044,000 |           
|                                                 |                                    |   |            |            |      |  |            |            |  |  |            |           
|Diluted earnings (loss) per share                |                                    | $ | (.04       | )          |      |  | .11        |            |  |  | (.30       | )         
|                                                 |                                    |   |            |            |      |  |            |            |  |  |            |           

Options to purchase 1,089,000, 439,000, and 1,010,000 shares of common stock at
prices ranging from $.50 to $12.54, $3.75 to

8



---



##### 



NOTES TO FINANCIAL STATEMENTS

$12,54, and from $.50 to $12.54
per share were not included in the computation of diluted earnings per share in
2003, 2002, and 2001, respectively, because their inclusion would be
anti-dilutive.

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax basis and net
operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.

Major Customer

No one customer exceeded 10% of net sales during 2001. One national chain
customer accounted for 26% and 20% of net sales during 2003 and 2002,
respectively. Another national chain customer accounted for 13% of net sales
during 2003. The Companys customers are affected by Medicare reimbursement
policy as approximately 80% of home oxygen patients are covered by Medicare and
other government programs.

Stock Option Plan

The Company accounts for its stock option plan in accordance with the
provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock
Issued to Employees, and related interpretations. The Company has also adopted
the pro forma disclosure provisions of Statement of Financial Accounting
Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, which
permits entities to provide pro forma net income and pro forma net earnings per
share disclosures as if the fair-value-based method defined in SFAS No. 123 had
been applied.

The Company applies Accounting Principles Board Opinion No. 25 in accounting
for the Plan and no compensation expense has been recognized for its stock
options in the accompanying financial statements. The following table
illustrates the effect on net earings (loss) and earnings (loss) per share if
the Company had applied the fair value recognition provison of FASB
Statement
No. 123, Accounting for Stock-Based Compensation, to stock-based employee
compensation:

|                                                                                                                                            |                       |   |                      |      |      |   |           |     |  |   |            |      |  
|------------------------------------------------------------------------------------------------------------------------------------------- | --------------------- | - | -------------------- | ---- | ---- | - | --------- | --- |  | - | ---------- | ---- | -
|                                                                                                                                            |                       |   | Year Ended March 31,
|                                                                                                                                            |                       |   | 2003                 |      | 2002 |   | 2001     
|                                                                                                                                            |                       |   |                      |      |      |   |          
|Net earnings (loss), as reported                                                                                                            |                       | $ | (433,000             | )    |      | $ | 1,157,000 |     |  | $ | (3,011,000 | )   
|Deduct: Total stock-based
employee compensation expense
determined under fair value-based method for all awards,
net of related tax effects |                       |   | (147,000             | )    |      |   | (169,000  | )   |  |   | (172,000   | )   
|Pro forma net income (loss)                                                                                                                 |                       |   | (580,000             | )    |      |   | 988,000   |     |  |   | (3,183,000 | )   
|Earnings (loss) per share:                                                                                                                  |                       |   |                      |      |      |   |           |     |  |   |            |     
|                                                                                                                                            | Basic - as reported   |   |                      | (.04 | )    |   |           | .12 |  |   |            | (.30 | )
|                                                                                                                                            | Basic - pro forma     |   |                      | (.05 | )    |   |           | .10 |  |   |            | (.32 | )
|                                                                                                                                            | Diluted - as reported |   |                      | (.04 | )    |   |           | .11 |  |   |            | (.30 | )
|                                                                                                                                            | Diluted - pro forma   |   |                      | (.05 | )    |   |           | .09 |  |   |            | (.32 | )

The weighted average fair value of options granted during 2003, 2002 and 2001
is estimated at $1.74, $2.04, and $.51, respectively. The disclosure of
compensation cost under this pronouncement may not be representative of the
effects on net earnings (loss) for future years. The fair value of options
granted during each period was estimated using the Black-Scholes option pricing
model with the following assumptions:

|                        |  |      |     |      |  |      |     |   |  |  |     |  
|----------------------- |  | ---- | --- | ---- |  | ---- | --- | - |  |  | --- | -
|                        |  | 2003 |     | 2002 |  | 2001
|                        |  |      |     |      |  |     
|Risk-free interest rate |  |      | 5.9 | %    |  |      | 5.9 | % |  |  | 5.9 | %
|Forfeiture rate         |  |      | 2.0 | %    |  |      | 2.0 | % |  |  | 2.0 | %
|Dividend yield          |  |      | .0  |      |  |      | .0  |   |  |  | .0  |  
|Volatility              |  |      | 86  | %    |  |      | 89  | % |  |  | 90  | %
|Expected life (years)   |  |      | 5.0 |      |  |      | 5.0 |   |  |  | 5.0 |  

Segment Information

The Company operates in one segment, the respiratory care market.

Reclassifications

Certain reclassifications have been made to the prior years balances to
conform to the 2003 presentation.

(2)  Inventories

At March 31, 2003 and 2002, inventories consisted of the following:

|                           |  |      |           |      |  |  |           | 
|-------------------------- |  | ---- | --------- | ---- |  |  | --------- | 
|                           |  | 2003 |           | 2002
|                           |  |      |           |     
|Finished goods             |  | $    | 1,245,000 |      |  |  | 935,000   | 
|Work in process            |  |      | 1,382,000 |      |  |  | 987,000   | 
|Raw materials
and supplies |  |      | 2,884,000 |      |  |  | 3,362,000 | 
|                           |  |      |           |      |  |  |           | 
|                           |  | $    | 5,511,000 |      |  |  | 5,284,000 | 
|                           |  |      |           |      |  |  |           | 

During the year ended March 31, 2001, the Company recorded inventory
write-downs totaling $112,000.

(3)  Income Taxes

The provision (benefit) for income taxes for fiscal 2003, 2002, and 2001
consisted of the following:

|          |         |  |       |       |      |  |          |          |   |  |       |       | 
|--------- | ------- |  | ----- | ----- | ---- |  | -------- | -------- | - |  | ----- | ----- | 
|          |         |  | 2003  |       | 2002 |  | 2001    
|          |         |  |       |       |      |  |         
|Current:  |         |  |       |       |      |  |          |          |   |  |       |      
|          | Federal |  | $     | 3,000 |      |  |          | (995,000 | ) |  |       |      | 
|          | State   |  |       | 2,000 |      |  |          | 5,000    |   |  |       | 2,000 | 
|          |         |  |       |       |      |  |          |          |   |  |       |       | 
|          |         |  | 5,000 |       |      |  | (990,000 | )        |   |  | 2,000 |      
|Deferred: |         |  |       |       |      |  |          |          |   |  |       |      
|          | Federal |  |       |      |      |  |          | (6,000   | ) |  |       |      | 
|          | State   |  |       |      |      |  |          | 6,000    |   |  |       |      | 
|          |         |  |       |       |      |  |          |          |   |  |       |       | 
|          |         |  |      |       |      |  |         |          |   |  |      |      
|          |         |  |       |       |      |  |          |          |   |  |       |       | 
|          | Total   |  | $     | 5,000 |      |  |          | (990,000 | ) |  |       | 2,000 | 
|          |         |  |       |       |      |  |          |          |   |  |       |       | 

A reconciliation of the difference between the Companys provision (benefit)
for income taxes and the statutory income tax for the years ended March 31,
2003, 2002 and 2001, respectively, is as follows:

9



---



##### 



NOTES TO FINANCIAL STATEMENTS

|                                |  |      |          |      |  |      |            |   |  |  |            |  
|------------------------------- |  | ---- | -------- | ---- |  | ---- | ---------- | - |  |  | ---------- | -
|                                |  | 2003 |          | 2002 |  | 2001
|                                |  |      |          |      |  |     
|Statutory tax
expense (benefit) |  | $    | (145,000 | )    |  |      | 57,000     |   |  |  | (1,023,000 | )
|State income tax, net           |  |      | (22,000  | )    |  |      | 6,000      |   |  |  | (84,000    | )
|Valuation allowance             |  |      | 157,000  |      |  |      | (1,030,000 | ) |  |  | 1,109,000  |  
|Warranty and other              |  |      | 15,000   |      |  |      | (23,000    | ) |  |  |           |  
|                                |  |      |          |      |  |      |            |   |  |  |            |  
|                                |  | $    | 5,000    |      |  |      | (990,000   | ) |  |  | 2,000      |  
|                                |  |      |          |      |  |      |            |   |  |  |            |  

The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets at March 31, 2003 and 2002 are presented as follows:

|                          |                           |   |         |            |      |  |         |            |  
|------------------------- | ------------------------- | - | ------- | ---------- | ---- |  | ------- | ---------- | -
|                          |                           |   | 2003    |            | 2002
|                          |                           |   |         |            |     
|Bad debt reserves         |                           | $ | 47,000  |            |      |  | 32,000  |           
|Accrued expenses          |                           |   | 269,000 |            |      |  | 284,000 |           
|Inventories               |                           |   | 71,000  |            |      |  | 106,000 |           
|Depreciation              |                           |   | 369,000 |            |      |  | 256,000 |           
|Amortization              |                           |   | 10,000  |            |      |  | 21,000  |           
|Intangible assets         |                           |   | 393,000 |            |      |  |        |           
|Net Operating Loss        |                           |   | 343,000 |            |      |  | 599,000 |           
|Tax Credits               |                           |   | 53,000  |            |      |  | 97,000  |           
|                          |                           |   |         |            |      |  |         |           
|                          | Total deferred tax assets |   |         | 1,555,000  |      |  |         | 1,395,000  |  
|Deferred tax liabilities: |                           |   |         |            |      |  |         |           
|                          | State Taxes               |   |         | (168,000   | )    |  |         | (165,000   | )
|                          |                           |   |         |            |      |  |         |           
|                          | Subtotal                  |   |         | 1,387,000  |      |  |         | 1,230,000  |  
|                          | Valuation Allowance       |   |         | (1,387,000 | )    |  |         | (1,230,000 | )
|                          |                           |   |         |            |      |  |         |           
|Net deferred tax assets   |                           | $ |        |            |      |  |        |           
|                          |                           |   |         |            |      |  |         |           

In assessing the realizability of deferred tax assets, management considers
whether it is more likely than not that some portion or all of the deferred tax
assets will be realized. At March 31, 2003, the Companys net deferred tax
assets are fully offset by a valuation allowance. The Company will continue to
assess the valuation allowance and to the extent it is determined that such
allowance is no longer required, the tax benefit of the remaining net deferred tax
assets will be recognized in the future. The
Company has Federal and California net operating loss carry forwards of
$346,000 and $2,785,000, respectively. The State of California has suspended
the utilization of net operating loss carryforwards during tax years starting
in 2002 and 2003. As a result, the Company will be unable to use its
California net operating loss carryforwards until the tax year beginning April
1, 2004. The Federal and California net operating losses expire in 2021 and
2006, respectively. In addition, the Company has manufacturing tax credit
carryforwards of $46,000 available to offset future California taxable income.

(4) Other Assets

Other assets include amounts paid for licenses on new and existing products.
License fees are being amortized using the straight-line method over the life
of the related patents. Accumulated amortization on the license fees amounted
to $15,000 and $422,000 at March 31, 2003 and 2002, respectively. Annual
amortization on intangible assets currently in service will be $2,000 for each
of the next five years. There is a total of $590,000 in intangible assets that
relates to items for which the development has not yet been completed and the
related amortizaton periods have not been determined. During 2003, the company
wrote off a license fee asset that had a net book value of $934,000 in
accordance with the provisions of FASB Statement No. 144, Accounting for the
Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed Of. Net
intangible assets were $562,000 and $1,196,000 at March 31, 2003 and 2002,
respectively.

(5) Shareholders Equity

The Company has an incentive stock option plan (the Plan) for key employees as
defined under Section 422(A) of the Internal Revenue Code. The Plan as amended,
provides that 1,509,000 common shares be reserved for issuance under the Plan,
which expires on September 10, 2004. In addition, the Plan provides that
non-qualified options can be granted to directors and independent contractors
of the Company. Transactions involving the stock option plan are summarized as
follows:

|                             |  |        |          |        |  |           |            |   |  |          |      | 
|---------------------------- |  | ------ | -------- | ------ |  | --------- | ---------- | - |  | -------- | ---- | 
|                             |  |        |          |        |  |           |            |   |  | Weighted
|                             |  |        |          |        |  |           |            |   |  | Average 
|                             |  | Option |          | Option |  | Price    
|                             |  | Shares |          | Amount |  | Per Share
|                             |  |        |          |        |  |          
|Incentive Options:           |  |        |          |        |  |           |            |   |  |          |      | 
|Outstanding 
March 31, 2000 |  |        | 823,000  |        |  | $         | 3,592,000  |   |  |          | 4.36 | 
|Cancelled                    |  |        | (228,000 | )      |  |           | (1,121,000 | ) |  |          | 4.92 | 
|Granted                      |  |        | 244,000  |        |  |           | 227,000    |   |  |          | 0.93 | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 
|Outstanding 
March 31, 2001 |  |        | 839,000  |        |  |           | 2,698,000  |   |  |          | 3.22 | 
|Cancelled                    |  |        | (25,000  | )      |  |           | (80,000    | ) |  |          | 3.20 | 
|Granted                      |  |        | 75,000   |        |  |           | 253,000    |   |  |          | 3.37 | 
|Exercised                    |  |        | (7,000   | )      |  |           | (5,000     | ) |  |          | .71  | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 
|Outstanding 
March 31, 2002 |  |        | 882,000  |        |  |           | 2,866,000  |   |  |          | 3.25 | 
|Cancelled                    |  |        | (120,000 | )      |  |           | (1,118,000 | ) |  |          | 9.32 | 
|Granted                      |  |        | 77,000   |        |  |           | 200,000    |   |  |          | 2.49 | 
|Exercised                    |  |        | (17,000  | )      |  |           | (20,000    | ) |  |          | 1.18 | 
|Expired                      |  |        | (33,000  | )      |  |           | (61,000    | ) |  |          | 1.85 | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 
|Outstanding 
March 31, 2003 |  |        | 789,000  |        |  | $         | 1,867,000  |   |  |          | 2.37 | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 
|Exercisable 
March 31, 2003 |  |        | 558,000  |        |  | $         | 1,370,000  |   |  |          | 2.46 | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 
|Non-qualified Options:       |  |        |          |        |  |           |            |   |  |          |      | 
|Outstanding 
March 31, 2000 |  |        | 156,000  |        |  | $         | 1,429,000  |   |  |          | 9.16 | 
|Cancelled                    |  |        | (16,000  | )      |  |           | (64,000    | ) |  |          | 4.00 | 
|Granted                      |  |        | 31,000   |        |  |           | 43,000     |   |  |          | 1.39 | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 
|Outstanding 
March 31, 2001 |  |        | 171,000  |        |  |           | 1,408,000  |   |  |          | 8.23 | 
|Granted                      |  |        | 19,000   |        |  |           | 19,000     |   |  |          | 1.00 | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 
|Outstanding 
March 31, 2002 |  |        | 190,000  |        |  |           | 1,427,000  |   |  |          | 7.50 | 
|Cancelled                    |  |        | (10,000  | )      |  |           | (89,000    | ) |  |          | 8.90 | 
|Granted                      |  |        | 120,000  |        |  |           | 272,000    |   |  |          | 2.27 | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 
|Outstanding 
March 31, 2003 |  |        | 300,000  |        |  | $         | 1,610,000  |   |  |          | 5.37 | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 
|Exercisable 
March 31, 2003 |  |        | 171,000  |        |  | $         | 1,333,000  |   |  |          | 7.80 | 
|                             |  |        |          |        |  |           |            |   |  |          |      | 

10



---



##### 



NOTES TO FINANCIAL STATEMENTS

At March 31, 2003, information regarding outstanding options is summarized as
follows:

|                                       |  |                          |          |  |  |  |            | 
|-------------------------------------- |  | ------------------------ | -------- |  |  |  | ---------- | 
|                                       |  | Range of Exercise Prices
|                                       |  | $                        | .50-6.69 |  |  |  | 7.63-12.54 | 
|                                       |  |                          |          |  |  |  |            | 
|Number outstanding                     |  |                          | 981,000  |  |  |  | 108,000    | 
|Weighted average
remaining life (yrs.) |  |                          | 7.6      |  |  |  | 2.2        | 
|Weighted average
exercise price        |  | $                        | 2.31     |  |  |  | 11.22      | 
|Number exercisable                     |  |                          | 621,000  |  |  |  | 108,000    | 
|Weighted average
exercise price        |  | $                        | 2.40     |  |  |  | 11.22      | 

Incentive and non-qualified options were granted at prices not less than 100%
of market value at dates of grant. Options under the Plan become exercisable on
the anniversary of the grant date on a prorata basis over a defined period and
expire 10 years after the date of grant. To the extent the Company derives a
tax benefit from options exercised by employees, such benefit is credited to
Common Shares when realized on the Companys income tax returns.

(6) Employee Benefit Plan

In December, 1992, the Company adopted a defined contribution profit sharing
plan, including features under Section 401(k) of the Internal Revenue Code. The
purpose of the plan is to provide an incentive for employees to make regular
savings for their retirement. Company contributions to the profit sharing plan
are discretionary and are determined by the Board of Directors. There were no
contributions in 2003, 2002 and 2001.

(7) Accrued Expenses

Accrued expenses consist of the following:

|                                         |  |      |           |      |  |  |           | 
|---------------------------------------- |  | ---- | --------- | ---- |  |  | --------- | 
|                                         |  | 2003 |           | 2002
|                                         |  |      |           |     
|Accrued royalties                        |  | $    | 488,000   |      |  |  | 460,000   | 
|Product and business
liability insurance |  |      | 94,000    |      |  |  | 77,000    | 
|Deferred rent                            |  |      | 4,000     |      |  |  | 22,000    | 
|Accrued vacation                         |  |      | 147,000   |      |  |  | 133,000   | 
|Warranty expense                         |  |      | 140,000   |      |  |  | 161,000   | 
|Retirement liability                     |  |      |          |      |  |  | 73,000    | 
|Payroll and incentive
compensation       |  |      | 167,000   |      |  |  | 54,000    | 
|Other                                    |  |      | 223,000   |      |  |  | 189,000   | 
|                                         |  |      |           |      |  |  |           | 
|                                         |  | $    | 1,263,000 |      |  |  | 1,169,000 | 
|                                         |  |      |           |      |  |  |           | 

The Company provides for estimated product warranty expenses based on the best
available information, primarily historical claims experience, but actual
claims costs may differ from amounts provided. An analysis of changes in the
liability for product warranties follows:

|                          |  |   |         |  
|------------------------- |  | - | ------- | -
|Balance at April 1, 2002  |  | $ | 161,000 |  
|Current year provisions   |  |   | 12,000  |  
|Expenditures              |  |   | (33,000 | )
|                          |  |   |         |  
|Balance at March 31, 2003 |  | $ | 140,000 |  
|                          |  |   |         |  

(8) Commitments

The Company is currently leasing its administrative and plant facilities and
certain office equipment under noncancelable operating leases which expire
through June, 2008.

The Companys minimum annual rental commitments under these leases are as
follows:

|           |  |   |           | 
|---------- |  | - | --------- | 
|2004       |  | $ | 397,000   | 
|2005       |  |   | 403,000   | 
|2006       |  |   | 419,000   | 
|2007       |  |   | 433,000   | 
|2008       |  |   | 487,000   | 
|Thereafter |  |   | 113,000   | 
|           |  |   |           | 
|TOTAL:     |  | $ | 2,252,000 | 
|           |  |   |           | 

Rent expense amounted to $469,000, $470,000, and $431,000 for the years ended
March 31, 2003, 2002 and 2001, respectively.

The Company has minimum annual royalty requirements pursuant to the terms of
license agreements related to certain products in the amount of $515,000.
Annual royalty expense on all products amounted to $1,102,000, $1,136,000 and
$838,000 for the years ended March 31, 2003, 2002 and 2001, respectively.

The Company is involved in certain legal actions resulting from the ordinary
course of business. The Company believes the ultimate outcome of the legal
actions will not have a material adverse impact on the Companys financial
statements as a whole.

(9) Geographic Information

The Company has one reportable operating segment as defined in Note 1.
Geographic information regarding the Companys net sales is as follows:

|                    |  |      |            |      |  |      |            |  |  |  |            | 
|------------------- |  | ---- | ---------- | ---- |  | ---- | ---------- |  |  |  | ---------- | 
|                    |  | 2003 |            | 2002 |  | 2001
|                    |  |      |            |      |  |     
|United States       |  | $    | 18,639,000 |      |  |      | 17,904,000 |  |  |  | 10,368,000 | 
|Canada              |  | $    | 307,000    |      |  |      | 265,000    |  |  |  | 192,000    | 
|Japan               |  |      | 207,000    |      |  |      | 240,000    |  |  |  | 639,000    | 
|Germany             |  |      | 46,000     |      |  |      | 289,000    |  |  |  | 751,000    | 
|All other countries |  |      | 342,000    |      |  |      | 308,000    |  |  |  | 450,000    | 
|                    |  |      |            |      |  |      |            |  |  |  |            | 
|                    |  | $    | 19,541,000 |      |  |      | 19,006,000 |  |  |  | 12,400,000 | 
|                    |  |      |            |      |  |      |            |  |  |  |            | 

All long-lived assets are located in the United States.

Sales of OXYMATIC® and
CYPRESS® conservers accounted for 74%, 60%, and 42%
of the Companys net sales for the years ended March 31, 2003, 2002 and 2001,
respectively.

(10) Valuation and Qualifying Accounts and Reserves

The following is the Companys schedule of activity in the valuation and
qualifying accounts and reserves for the years ended March 31, 2003, 2002 and
2001:

|                                 |      |  |            |        |            |  |            |        |         |  |         |         |  |  |  |         | 
|-------------------------------- | ---- |  | ---------- | ------ | ---------- |  | ---------- | ------ | ------- |  | ------- | ------- |  |  |  | ------- | 
|                                 |      |  | Balance at |        | Charged to |  |            |        |         |  | Balance
|                                 |      |  | Beginning  |        | Costs and  |  |            |        |         |  | at End 
|                                 |      |  | of Year    |        | Expenses   |  | Deductions |        | of Year
|                                 |      |  |            |        |            |  |            |        |        
|Allowance for
doubtful accounts: |      |  |            |        |            |  |            |        |         |  |         |         |  |  |  |        
|                                 | 2001 |  |            | 95,000 |            |  |            | 70,000 |         |  |         | 132,000 |  |  |  | 33,000  | 
|                                 | 2002 |  |            | 33,000 |            |  |            | 64,000 |         |  |         | 21,000  |  |  |  | 76,000  | 
|                                 | 2003 |  |            | 76,000 |            |  |            | 97,000 |         |  |         | 61,000  |  |  |  | 112,000 | 

11



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##### 



NOTES TO FINANCIAL STATEMENTS

(11) Quarterly Financial Data (Unaudited)

The following table presents summarized unaudited quarterly financial data for
2003 and 2002:

|               |  |         |            |        |  |        |           |           |  |        |           |          |  |         |       |  
|-------------- |  | ------- | ---------- | ------ |  | ------ | --------- | --------- |  | ------ | --------- | -------- |  | ------- | ----- | -
|               |  |         |            |        |  |        |           |           |  |        |           |          |  | Basic &
|               |  |         |            |        |  |        |           |           |  |        |           |          |  | Diluted
|               |  |         |            |        |  |        |           |           |  | Net    |           | Earnings
|               |  |         |            |        |  | Gross  |           | Earnings  |  | (Loss)
|               |  | Revenue |            | Profit |  | (Loss) |           | Per Share
|               |  |         |            |        |  |        |           |          
|2003           |  |         |            |        |  |        |           |           |  |        |           |          |  |         |       |  
|First Quarter  |  | $       | 5,022,000  |        |  | $      | 2,140,000 |           |  | $      | 178,000   |          |  | $       | 0.02  |  
|Second Quarter |  |         | 4,840,000  |        |  |        | 2,043,000 |           |  |        | 2,000     |          |  |         | 0.00  |  
|Third Quarter  |  |         | 4,980,000  |        |  |        | 2,132,000 |           |  |        | 228,000   |          |  |         | 0.02  |  
|Fourth Quarter |  |         | 4,699,000  |        |  |        | 2,036,000 |           |  |        | (841,000  | )        |  | $       | (0.08 | )
|               |  |         |            |        |  |        |           |           |  |        |           |          |  |         |       |  
|Year           |  | $       | 19,541,000 |        |  | $      | 8,351,000 |           |  | $      | (433,000  | )        |  | $       | (0.04 | )
|               |  |         |            |        |  |        |           |           |  |        |           |          |  |         |       |  
|2002           |  |         |            |        |  |        |           |           |  |        |           |          |  |         |       |  
|First Quarter  |  | $       | 4,914,000  |        |  | $      | 1,718,000 |           |  | $      | 13,000    |          |  | $       | 0.00  |  
|Second Quarter |  |         | 5,192,000  |        |  |        | 1,862,000 |           |  |        | 67,000    |          |  |         | 0.01  |  
|Third Quarter  |  |         | 4,724,000  |        |  |        | 1,846,000 |           |  |        | 81,000    |          |  |         | 0.01  |  
|Fourth Quarter |  |         | 4,176,000  |        |  |        | 1,741,000 |           |  |        | 996,000   |          |  | $       | 0.10  |  
|               |  |         |            |        |  |        |           |           |  |        |           |          |  |         |       |  
|Year           |  | $       | 19,006,000 |        |  | $      | 7,167,000 |           |  | $      | 1,157,000 |          |  | $       | 0.12  |  
|               |  |         |            |        |  |        |           |           |  |        |           |          |  |         |       |  

In the fourth quarter of 2002, the Company recorded an income tax benefit of
$995,000 that resulted from recently enacted federal income tax regulations
extending the carryback periods for operating losses incurred in 2002 and 2001.
In the fourth quarter of 2003, the Company recorded a complete write down of
an intangible license fee asset in the amount of $934,000.

(12) New Accounting Pronouncements.

In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement
Obligations (SFAS No. 143), SFAS No. 143 requires the Company to record the
fair value of an asset retirement obligation as a liability in the period in
which it incurs a legal obligation associated with the retirement of tangible
long-lived assets that result from the acquisition, construction, development
and/or normal use of the assets. The Company is required to adopt SFAS No. 143
on April 1, 2003. The Company does not currently have any assets affected by
SFAS No. 143.

In August, 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets (SFAS No. 144). This Statement requires that
long-lived assets be reviewed for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net cash flows expected
to be generated by the asset. If the carrying amount of an asset exceeds its
estimated future cash flows, an impairment charge is recognized by the amount
by which the carrying amount of the asset exceeds the fair value of the asset.
SFAS No. 144 requires companies to separately report discontinued operations
and extends that reporting to a component of an entity that either has been
disposed of (by sale, abandonment, or in a distribution to owners) or is
classified as held for sale. Assets to be disposed of are reported at the
lower of the carrying amount or fair value less costs to sell. The Company
adopted SFAS No. 144 on April 1, 2002, and it did not have an impact on the
Companys financial statements.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No.
4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections
which requires that the extinguishment of debt not be considered an
extraordinary item under APB Opinion No. 30, Reporting the Results of
Operations - Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions,
unless the debt extinguishment meets the unusual in nature and infrequency of
occurrence criteria in APB 30. SFAS No. 145 is effective for fiscal years
beginning after May 15, 2002. The adoption of SFAS No. 145 is not expected to
have a material impact on the Companys financial condition or results of
operations.

In July 2002, the FASB issued Statement No. 146, Accounting for Costs
Associated with Exit or Disposal Activities. This standard requires companies
to recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of the commitment to an exit or disposal plan.
This statement is effective prospectively to exit or disposal activities
initiated after December 31, 2002. The Company adopted SFAS 146, effective
August 1, 2002, and the adoption of this standard did not have an impact on the
Companys financial statements.

In November 2002, the FASB issued Interpretation Number 45, Guarantors
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others (FIN 45). This interpretation elaborates
on the disclosures to be made by a guarantor in its interim and annual
financial statements about its obligations under certain guarantees that it has
issued. It also clarifies that a guarantor is required to recognize, at the
inception of a guarantee, a liability for the fair value of the obligation
undertaken in issuing the guarantee. The disclosure requirements of FIN 45 are
effective for interim and annual periods after December 15, 2002. The Company
adopted FIN 45 effective January 1, 2003 and the adoption of FIN 45 did not
have a material impact on the Companys financial statements.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation - Transition and Disclose - an amendment of FASB Statement No.
123.
SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to
provide alternative methods of transition for a voluntary change to the fair
value based method of accounting for stock-based employee compensation. In
addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to
require prominent disclosures in both annual and interim financial statements
about the method of accounting for stock-based employee compensation and the
effect of the method used on reported results. The disclosure requirements
apply to all companies for fiscal years ending after December 15, 2002. The
interim disclosure provisions are effective for financial reports containing
financial statements for interim periods beginning after December 15, 2002.
The adoption of SFAS No. 148 did not have a material impact on the Companys
financial statements.

12



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##### 



INDEPENDENT AUDITORS REPORT

The Board of Directors and Shareholders

CHAD Therapeutics, Inc.



| |  |  | We have audited the accompanying balance sheets of CHAD Therapeutics, Inc. as
of March 31, 2003 and 2002 and the related statements of operations,
shareholders equity and cash flows for each of the years in the three-year
period ended March 31, 2003. These financial statements are the responsibility
of the Companys management. Our responsibility is to express an opinion on
these financial statements based on our audits.                                                                                                                                                                                                                                
| |  |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|
| |  |  | We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
|
| |  |  | In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of CHAD Therapeutics, Inc. as of
March 31, 2003 and 2002 and the results of its operations and its cash flows
for each of the years in the three-year period ended March 31, 2003, in
conformity with accounting principles generally accepted in the United States
of America.                                                                                                                                                                                                                                                              
|
| |  |  | (KPMG LLP LOGO)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|
| |  |  | Los Angeles, California                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| |  |  | May 2, 2003                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

13



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##### 



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

Overview

The Company develops, assembles and markets medical devices that furnish
supplementary oxygen to home health care patients. The Company was a pioneer
in developing oxygen conserving devices that enhance the quality of life for
patients by increasing their mobility and, at the same time, lower operating
costs by achieving significant savings in the amount of oxygen actually
required to properly oxygenate patients. The market for oxygen conserving
devices has been and continues to be significantly affected by increased
competition, consolidation among home oxygen dealers and revisions (and
proposed revisions) in governmental reimbursement policies. All of these
factors, as described more fully below, have contributed to a more competitive
market for the Companys products, as devices that were less expensive but
which provided lower oxygen savings (or, in some cases, did not truly provide
ambulatory oxygen) have achieved some level of success.

The current procedures for reimbursement by Medicare for home oxygen services
provide a prospective flat fee monthly payment based solely on the patients
prescribed oxygen requirement. Under this system, inexpensive concentrators
have grown in popularity because of low cost and less frequent servicing
requirements. At the same time, oxygen conserving devices, such as the
Companys products, have also grown in popularity due to their ability to
extend the life of oxygen supplies and reduce service calls by dealers, thereby
providing improved mobility for the patient and cost savings for dealers.

In addition, other changes in the health care delivery system, including the
increase in the acceptance and utilization of managed care, have stimulated a
significant consolidation among home oxygen dealers. Major national and
regional home medical equipment chains have continued to expand their
distribution networks through the acquisition of independent dealers in
strategic areas. Margins on sales to national chains are generally lower due to
quantity pricing. Four major national chains accounted for approximately 52%,
39% and 19% of the Companys net sales for the years ended March 31, 2003, 2002
and 2001, respectively. One chain accounted for 26% and 20% of sales in the
years ended March 31, 2003 and 2002, respectively, and one other chain
accounted for 13% of sales for the year ended March 31, 2003.

The Company believes that price competition, continuing industry consolidation
and competitive products with features not found in the Companys products
prior to the introduction of the OXYMATIC 400 Series conservers discussed below
adversely affected sales during the three years ending March 31, 2001. To
combat the erosion in sales of the oxygen conserver product line, the Company
developed and introduced several new products in this area. The first of
these, the OXYMATIC 401 conserver, received 501(k) clearance from the Food and
Drug Administration in June 2000, and shipments of the new product began in
July 2000. The second, the OXYMATIC 411 conserver was cleared in December 2000
and shipments began in January 2001. The third, the OXYMATIC 401A and 411A
conservers, received clearance in March 2001
with shipments beginning that month. The SEQUOIA OXYMATIC conservers began
shipping in December 2001 and the Company began shipment of the CYPRESS
OXYPneumatic conserver in July 2002. Management believes the features and
improvements in these products have enabled the Company to regain some of the
market share lost in the conserver market prior to 2001 and reestablish the
Company as a leader in the conserver market. No estimate can currently be made
regarding the level of success the Company may achieve with these new lines of
conservers. For information that may affect the forward- looking statements
made in this paragraph about new conservers, see Outlook: Issues
and Risks  New Products.

In 1998 the Company introduced the TOTAL O2 system, which provides stationary
oxygen for patients at home, portable oxygen, including an oxygen conserving
device for ambulatory use, and a safe and efficient mechanism for filling
portable oxygen cylinders in the home. This provides home care dealers with a
means to reduce their monthly cost of servicing patients while at the same time
providing a higher quality of service by maximizing ambulatory capability. The
Company received clearance in November 1997, to sell this product from the Food
and Drug Administration. Initial sales of the TOTAL O2 system were adversely
affected by several factors, including the overall home oxygen market climate
as well as start-up manufacturing and related supplier quality issues. The
Company has taken a number of steps to resolve the manufacturing and supplier
issues and now believes the success of this product will be dependent on the
healthcare communitys acceptance of this technology and willingness to
substitute a higher capital acquisition cost for lower operating costs. While
the Company will continue its efforts to promote this product, based on current
sales levels, the Company has determined it is required to completely write off
the unamortized license fees related to the TOTAL O2 system. For information
that may affect the outcome of forward-looking statements made in this
paragraph about the TOTAL O2 systems, see Outlook:
Issues and Risks  New
Products.

As discussed above, during the past two years, the Company has recovered
substantial market share in the conserver market and is using that platform to
spearhead its growth strategy for the future, which includes the following:



| |  | Development of additional oxygen conserver models, such as the CYPRESS
OXYPneumatic conserver introduced in July, 2002, that diversify the product
line in order to offer customers a range of oxygen conservation choices;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

14



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##### 



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



| |  | A continued promotional and educational campaign with respect to the benefits
of the TOTAL O2 system, coupled with an ongoing emphasis on improving the
performance of component suppliers; and                                                                                                                                                                                                                        
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| 
| |  | An effort to expand the Companys product lines and improve existing products
through the investment in and development of new technologies, such as the
proprietary sensor technology and control software licensed in January of 2003.
These new technologies will provide the Company with an opportunity to expand
its oxygen conserver products lines and potentially enter the high-growth sleep
disorder market.

While the turnaround measures of the past two years have had a positive impact
and management believes the current growth strategy should continue to enhance
the Companys competitive position and future operating performance, no
assurances can be given that these objectives will be achieved. Management of
the Company will continually monitor the success of these efforts and will
attempt to remain flexible in order to adjust to possible future changes in the
market for respiratory care devices.

Results of Operations

Fiscal year 2003 compared to 2002

Sales for the year ended March 31, 2003, increased by $535,000 (2.8%) compared
to the prior year. The Company has experienced a significant increase in sales
of its conservers, primarily as a result of the introduction of the OXYMATIC
400 Series conservers and the CYPRESS OXYPneumatic conserver. Domestic unit
sales of conservers for the year ended March 31, 2003, increased 32% over the
prior year, while the increase in revenues from conserver sales was 22%. This
resulted from price reductions, the impact of national chain contract pricing
(see above) and the generally lower pricing for pneumatic conservers in the
marketplace. The continuing increase in conserver sales was offset by lower
sales of the TOTAL O2 system, due in large part to the loss of a significant
customer. In October of 2001, a customer that was purchasing significant
numbers of TOTAL O2 systems was acquired by a national chain that has
discontinued those purchases, which has been a significant factor in the
decline in sales of this product in fiscal 2003 as compared to the prior year.

On July 31, 2002, a national chain accounting for less than 10% of sales in
2003 filed a Plan of Reorganization under Chapter 11 of the United States
Bankruptcy Code (the Plan). While the initial Plan proposes that the
unsecured creditors be paid in full over a three year term with interest, no
assurance can be given that the Plan as filed will be approved or that the
payments will be made as proposed under the Plan. This chain is currently
indebted to the Company for approximately $245,000. In addition, it is too
early to determine what impact, if any, this reorganization proceeding will
have on future sales by the Company to this chain.

Sales to foreign distributors represented 5% of total sales for the year ended
March 31, 2003. Currently, management expects an increase in sales to foreign
distributors during the upcoming twelve months, however, quarter-to-quarter
sales may fluctuate depending on the timing of shipments. All foreign sales
are denominated in US dollars, except Canada.

Cost of sales as a percent of net sales decreased from 62.3% to 57.3% for the
year ended March 31, 2003 as compared to the prior year. This was the result
of increased sales volume and the change in the product mix, as the TOTAL O2
system has a lower gross profit margin than conservers.

Selling, general and administrative expenditures were $7,810,000 (40% of sales)
in fiscal 2003, an increase from $6,231,000 (33% of sales) in fiscal 2002.
The increase was the result of variable selling expenses that fluctuate
directly with sales volume, $165,000 in proxy contest expenses incurred in the
current year and a $934,000 write down of the unamortized license fees related
to the TOTAL O2 system. The license is subject to the review discussed in
Significant Accounting Policies  Intangible and Long-Lived Assets. At March
31, 2003, the carrying value of the license fee asset was determined to be
impaired, and the asset was completely written off.

The Companys cost reduction efforts over the past two years have helped align
staffing and operating expenses more closely with current sales expectations,
but were offset to some extent by commissions paid to the Companys field sales
force of manufacturers representatives. Research and development expenses
increased by $170,000 for the year ended March 31, 2003, as compared to the
prior year. Currently, management expects research and development
expenditures to total approximately $1,430,000 in the fiscal year ending March
31, 2004, on projects to enhance and expand the Companys product line.
Interest income decreased $30,000 for the year ended March 31, 2003 as compared
to the prior year due to the decline in interest rates in the current year.

At March 31, 2003, the Company had fully utilized its net operating loss
carrybacks and had approximately $346,000 and $2,785,000 in Federal and
California net operating loss carryforwards, respectively. As a result of
valuation allowances placed on the net operating loss carryforwards and
deferred tax assets, these net operating loss carryforwards and deferred tax
assets will be available to offset future income tax expense when and if the
Company generates additional taxable income. In September of 2002, the state
of California enacted legislation that suspends the utilization of net
operating loss carryforwards during tax years starting 2002 and 2003 effective
retroactively back to January

15



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##### 



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

1, 2002. As a result, the Company will be unable
to use its California net operating loss carryforwards until the tax year
beginning April 1, 2004. The Company has manufacturing tax credit
carryforwards of $46,000 available to offset future California taxable income.

Fiscal year 2002 compared to 2001

Sales for the year ended March 31, 2002, increased by $6,606,000 (53.3%)
compared to the prior year. The Company experienced a significant increase in
sales of its conservers, primarily as a result of the introduction of the
OXYMATIC 400 series conservers. Domestic unit sales of conservers for the year
ended March 31, 2002, increased 155% over the prior year; while the increase in
revenues from conserver sales was 126% due to price reductions and the impact
of national chain contract pricing.

Sales to foreign distributors represented 6% of total sales for the year ended
March 31, 2002.

Cost of sales as a percent of net sales decreased from 77.6% to 62.3% for the
year ended March 31, 2002 as compared to the prior year. This was the result
of increased sales volume and the resulting improvement in overhead absorption.

Selling, general and administrative expenditures increased from $5,137,000 (42%
of sales) to $6,231,000 (33% of sales) for the year ended March 31, 2002, as
compared to the prior year. The increase was the result of variable selling
expenses that fluctuate directly with sales volume. Research and development
expenses increased by $161,000 for the year ended March 31, 2002, as compared
to the prior year. Interest income decreased $37,000 for the year ended March
31, 2002 as compared to the prior year due to lower cash balances than in the
prior year.

In the fourth quarter of 2002, the Company recorded an income tax benefit of
$995,000 that resulted from newly enacted federal income tax regulations
extending the carryback periods for operating losses incurred in 2002 and 2001.

Financial Condition

At March 31, 2003, the Company had cash totaling $1,596,000 or 13% of total
assets, as compared to $520,000 (4% of total assets) at March 31, 2002. Net
working capital increased from $7,497,000 at March 31, 2002, to $8,224,000 at
March 31, 2003. Cash provided by and used in operations amounted to $1,577,000
and $147,000 for the years ended March 31, 2003 and 2002, respectively. In the
year ended March 31, 2003, the Company incurred a net loss of $433,000 that
included a non-cash write off of an intangible asset. The Company currently
has $590,000 in remaining unamortized intangible assets, which amounts it
currently believes are fully recoverable. In the year ended March 31, 2002,
the Company had net earnings of $1,157,000 and recovered $995,000 related to
income tax refunds. The income tax refund is not expected to recur in future
periods. Accounts receivable increased $184,000 during the year ended March
31, 2003, due to the increase in sales. For information regarding the
reorganization proceedings of one of our customers please see the discussion in
Results of Operations. Future increases or decreases in accounts receivable
will generally coincide with sales volume fluctuations and the timing of
shipments to foreign customers. During the same period, inventories increased
$227,000. The Company attempts to maintain sufficient inventories to meet its
customer needs as orders are received. Thus, future inventory and related
accounts payable levels will be impacted by the ability of the Company to
maintain its safety stock levels. If safety stock levels drop below target
amounts, then inventories in subsequent periods will increase more rapidly as
inventory balances are replenished. Currently, inventory balances are
generally near safety stock levels.

Management believes cash balances and funds derived from operations should be
adequate to meet the Companys cash requirements for the next twelve months
given the recent recovery of market share for oxygen conservers. Cash derived
from operations will depend on the ability of the Company to maintain
profitable operations and the timing of increases in receivables and
inventories. If profitable operations do not continue, the Company may need to
seek other
sources of working capital but currently has no such arrangements in place and
no assurances can be given that if and when needed other sources of working
capital would be available. The Company expects capital expenditures during
the next twelve months to be approximately $600,000.

The Company has not adopted any programs that provide for post employment
retirement benefits, however, it has on occasion provided such benefits to
individual employees. The Company does not have any off balance sheet
arrangements with any special purpose entities or any other parties, does not
enter into any transactions in derivatives and has no material transactions
with any related parties.

Significant Accounting Policies

The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities and disclosures of contingent assets and liabilities
at the date of the financial statements and the reported amounts of revenues
and expenses during the reporting period. Actual results could differ
significantly from those estimates under different assumptions and conditions.
Management believes that the following discussion addresses the accounting
policies and estimates that are

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

most important in the portrayal of the
Companys financial condition and results.

Allowance for doubtful accounts  the Company provides a reserve against
receivables for estimated losses that may result from our customers inability
to pay. The amount of the reserve is based on an analysis of known
uncollectible accounts, aged receivables, historical losses and
credit-worthiness. Amounts later determined and specifically identified to be
uncollectable are charged or written off against this reserve. The likelihood
of material losses is dependent on general economic conditions and numerous
factors that affect individual accounts.

Inventories  the Company provides a reserve against inventories for excess and
slow moving items. The amount of the reserve is based on an analysis of
inventory turnover for individual items in inventory. The likelihood of
material write-downs is dependent on customer demand and competitor product
offerings.

Intangible and long-lived assets  the Company assesses whether or not there
has been an impairment of intangible and long-lived assets in evaluating the
carrying value of these assets. Assets are considered impaired if the carrying
value is not recoverable over the useful life of the asset. If an asset is
considered impaired, the amount by which the carrying value exceeds the fair
value of the asset is written off. The likelihood of a material change in the
Companys reported results is dependent on each assets ability to continue to
generate income, loss of legal ownership or title to an asset and the impact of
significant negative industry or economic trends.

Deferred income taxes  the Company provides a valuation allowance to reduce
deferred tax assets to the amount expected to be realized. The likelihood of a
material change in the expected realization of these assets depends on the
Companys ability to generate future taxable income.

Outlook: Issues & Risks

This report contains forward-looking statements, which reflect the Companys
current views with respect to future events and financial performance. These
forward-looking statements are subject to certain risks and uncertainties,
which may cause actual operating results to differ materially from currently,
anticipated results. Among the factors that could cause actual results to
differ materially are the following:

Dependence Upon a Single Product Line

Although the Company currently markets a number of products, these products
comprise a single product line for patients requiring supplementary oxygen.
The Companys future performance is thus dependent upon developments affecting
this segment of the health care market and the Companys ability to remain
competitive within this market sector.

New Products

The Companys future growth in the near term will depend in significant part
upon its ability to successfully introduce new products. In recent years, the
Company has introduced the OXYMATIC 400 Series, the SEQUOIA OXYMATIC and
CYPRESS OXYPneumatic conservers, and the TOTAL O2 Delivery System; the Company
is currently developing additional new products. The success of these products
will depend upon the health care communitys perception of such products
capabilities, clinical efficacy and benefit to patients as well as obtaining
timely regulatory approval. In addition, prospective sales will be impacted by
the degree of acceptance achieved among
home oxygen dealers and patients requiring supplementary oxygen. As with any
product, the Companys ability to successfully promote the OXYMATIC 400 Series,
SEQUOIA OXYMATIC and CYPRESS OXYPneumatic series conservers, the TOTAL O2
Delivery System and other new products cannot be determined at this time.

Consolidation of Home Care Industry

The home health care industry is undergoing significant consolidation. As a
result, the market for the Companys products is increasingly influenced by
major national chains. Four major national chains accounted for 52% of the
Companys net sales during the year ended March 31, 2003. For information
regarding the reorganization proceedings of one of our customers please see the
discussion in Results of Operations. Future sales may
be increasingly dependent on a limited number of customers, which may have an
impact on margins due to quantity pricing.

Competition

Chads success in the early 1990s has drawn new competition to vie for a share
of the home oxygen market. These new competitors include both small and very
large companies. While the Company believes the quality of its products and
its established reputation will continue to be a competitive advantage, some
competitors have successfully introduced lower priced products that do not
provide oxygen conserving capabilities comparable to the Companys products.
Most of these competitors have greater capital resources than the Company. No
assurance can be given that increased competition in the home oxygen market
will not have an adverse affect on the Companys operations.

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

Rapid Technological Change

The health care industry is characterized by rapid technological change. The
Companys products may become obsolete as a result of new developments. The
Companys ability to remain competitive will depend to a large extent upon its
ability to anticipate and stay abreast of new technological developments
related to oxygen therapy. The Company has limited internal research and
development capabilities. Historically, the Company has contracted with
outside parties to develop new products. Some of the Companys competitors
have substantially greater funds and facilities to pursue research and
development of new products and technologies for oxygen therapy.

Potential Changes in Administration of Health Care

A number of bills proposing to regulate, control or alter the method of
financing health care costs have been discussed and certain of such bills have
been introduced in Congress, including various proposals for competitive
bidding, and various state legislatures. Because of the uncertain state of
health care proposals, it is not meaningful at this time to predict the effect
on the Company if any of these proposals is enacted.

Approximately 80% of home oxygen patients are covered by Medicare and other
government programs. Federal law has altered the payment rates available to
providers of Medicare services in various ways during the last several years.
Congress has passed legislation, which has reduced Medicare spending. It
cannot yet be predicted how future changes in reimbursement levels will affect
the home oxygen industry and there can be no assurance that such changes will
not have an adverse effect on the Companys business.

Protection of Intellectual Property Rights

The Company pursues a policy of protecting its intellectual property rights
through a combination of patents, trademarks, trade secret laws and
confidentiality agreements. The Company considers the protection of its
proprietary rights and the patentability of its products to be significant to
the success of the Company. To the extent that the products to be marketed by
the Company do not receive patent protection, competitors may be able to
manufacture and market substantially similar products. Such competition or
claims that the Companys products infringe the patent rights of others could
have an adverse impact upon the Companys business.

Product Liability

The nature of the Companys business subjects it to potential legal actions
asserting that the Company is liable for damages for product liability claims.
Although the Company maintains product liability insurance in an amount which
it believes to be customary in the industry, there is no assurance that this
insurance will be sufficient to cover the costs of defense or judgments which
might be entered against the Company. The type and frequency of these claims
could have an adverse impact on the Companys results of operations and
financial position.

Availability and Reliability of Third Party Component Products

The Company tests and packages its products in its own facility. Some of its
other manufacturing processes are conducted by other firms; the Company expects
to continue using outside firms for certain manufacturing processes for the
foreseeable future and is thus dependent on the reliability and quality of
parts supplied by these firms. From time to time, the Company has experienced
problems with the reliability of components produced by third party suppliers.
The Companys agreements with its suppliers are terminable at will or by
notice. The Company believes that other suppliers would be available in the
event of termination of these arrangements. No assurance can be given,
however, that the Company will not suffer a material disruption in the supply
of parts required for its products.

Accounting Standards

Accounting standards promulgated by the Financial Accounting Standards Board
change periodically. Changes in such standards may have an impact on the
Companys future financial position.

In October 2001, the Financial Accounting Standards Board issued FASB Statement
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which
addresses financial accounting and reporting for the impairment or disposal of
long-lived assets. While Statement No. 144 supersedes FASB Statement No. 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
Be Disposed Of, it retains many of the fundamental provisions of that
Statement. The Company adopted the provisions of Statement 144 effective April
1, 2002. During 2003, the Company wrote-off the remaining unamortized balance
of an intangible license fee asset in the amount of $934,000 in accordance with
Statement No. 144.

In July 2002, the FASB issued Statement No. 146, Accounting for Costs
Associated with Exit or Disposal Activities. This standard requires companies
to recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of the commitment to an exit or disposal plan.
This statement is effective prospectively to
exit or disposal activities initiated after December 31, 2002.

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

We adopted SFAS
146 effective August 1, 2002, and the adoption of this standard did not have an
impact on our financial statements.

In November 2002, the FASB issued
Interpretation Number 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others(FIN 45). This interpretation elaborates
on the disclosures to be made by a guarantor in its interim and annual
financial statements about its obligations under certain guarantees that it has
issued. It also clarifies that a guarantor is required to recognize, at the
inception of a guarantee, a liability for the fair value of the obligation
undertaken in issuing the guarantee. The disclosure requirements of FIN 45 are
effective for interim and annual periods after December 15, 2002. We adopted
FIN 45 effective January 1, 2003 and the adoption of FIN 45 did not have a
material impact on the Companys financial statements.

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation - Transition and Disclosure - an amendment of FASB Statement No.
123. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based
Compensation, to provide alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. In addition, SFAS No. 148 amends the disclosure requirements of
SFAS No. 123 to require prominent disclosures in both annual and interim
financial statements about the method of accounting for stock-based employee
compensation and the effect of the method used on reported results. The
disclosure requirements apply to all companies for fiscal years ending after
December 15, 2002. The interim disclosure provisions are effective for
financial reports containing financial statements for interim periods beginning
after December 15, 2002. The adoption of SFAS No. 148 did not have a material
impact on the Companys financial statements.

Additional Risk Factors

Additional factors, which might affect the Companys performance, may be listed
from time to time in the reports filed by the Company with the Securities and
Exchange Commission.

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CORPORATE DATA

Officers

THOMAS E. JONES
Chairman and Chief Executive OfficerEARL L. YAGER
President, Chief Financial Officer,
and SecretaryOSCAR J. SANCHEZ
Vice President, Business DevelopmentALFONSO DEL TORO
Vice President, ManufacturingKEVIN McCULLOH
Vice President, EngineeringERIKA LASKEY
Vice President, Sales and Marketing

Directors

THOMAS E. JONES
Chief Executive Officer
CHAD Therapeutics, Inc.EARL L. YAGER
President
CHAD Therapeutics, Inc.DAVID L. CUTTER
Retired Chairman Of The Board
Cutter Laboratories, Inc.NORMAN COOPER
Retired Chairman
Kallir, Philips, Ross, Inc.JOHN C. BOYD
RetiredPHILIP T. WOLFSTEIN
Managing Director
P.M. Global Foods, LLCJAMES M. BROPHY
Senior Vice President
Truman Medical Centers

Corporate Data

CORPORATE HEADQUARTERS
21622 Plummer Street
Chatsworth, CA 91311
(818) 882-0883LEGAL COUNSEL
Square, Sanders & Dempsey LLPAUDITORS
KPMG LLP
Los Angeles, CaliforniaTRANSFER AGENT AND REGISTRAR
American Stock Transfer Company
40 Wall Street
New York, NY 10005

Common Stock Price Range

Beginning August 3, 1993, the Companys common shares were traded on the
American Stock Exchange Emerging Company Marketplace and on June 6, 1994, the
Companys shares moved to the primary list of the American Stock Exchange with
the symbol CTU. The following table sets forth, for the periods indicated, the
high and low closing prices as furnished by the American Stock Exchange.

|                   |  |      |      |     |  |  |      | 
|------------------ |  | ---- | ---- | --- |  |  | ---- | 
|Quarter Ended      |  | High |      | Low
|                   |  |      |      |    
|June 30, 2001      |  |      | 2.83 |     |  |  | .75  | 
|September 30, 2001 |  |      | 3.50 |     |  |  | 1.94 | 
|December 31, 2001  |  |      | 3.25 |     |  |  | 2.76 | 
|March 31, 2002     |  |      | 4.17 |     |  |  | 2.70 | 
|June 30, 2002      |  |      | 3.61 |     |  |  | 2.26 | 
|September 30, 2002 |  |      | 3.24 |     |  |  | 2.10 | 
|December 31, 2002  |  |      | 3.10 |     |  |  | 1.85 | 
|March 31, 2003     |  |      | 2.30 |     |  |  | 1.25 | 

As of June 12, 2003, there were approximately 474 shareholders of record and
approximately 3,000 beneficial owners of the Companys common stock. No cash
dividends have been paid on the common stock.

SEC Form 10-K

A copy of the Companys annual report to the Securities and Exchange Commission
on Form 10-K is available without charge upon written request to:

Chief Financial Officer
CHAD Therapeutics, Inc.
21622 Plummer Street
Chatsworth, CA 91311

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