<PAGE>   1

                                                                    EXHIBIT 13.1


                            [PHOTOGRAPH OF CHAIRMAN]
                                Charles R. Adams
                              Chairman of the Board


LETTER FROM THE CHAIRMAN


For the past seven years or more it has been a personal pleasure to write this
opening paragraph. I was able to report phenomenal success and growth in both
sales and earnings and the establishment of many new records each year. That is
not the case for fiscal 1998 as both sales and earnings declined significantly.
While it was a disappointing year in terms of our financial performance, we
remain in solid financial condition and progress is being made towards regaining
our growth pattern. I will let Tom Jones, your new Chief Executive Officer,
review plans and the outlook for the future in his letter to you which follows
and I will attempt to review the events and causes of the difficult year just
concluded.

During much of calendar year 1997 discussions and negotiations were being held
as the federal government tried to achieve a balanced budget. As these
negotiations took place rumors became rampant regarding the size of the proposed
reduction in reimbursement for home oxygen services by Medicare, with some
estimates as high as 40%. This had a significant impact on home oxygen providers
all over the country in two major ways. Providers reduced spending as much as
possible as they scrambled to minimize costs and expenses; and they became
seriously concerned about their ability to survive in business with these
proposed drastic reductions. The final budget bill enacted in the fall included
a 25% cut in home oxygen reimbursement, which went into effect on January 1,
1998, with an additional 5% cut to become effective January 1, 1999. As a result
providers continued their efforts to reduce expenses. In Chad's area of portable
oxygen, many took drastic measures and reverted to the methods of ten or more
years ago, substituting the old large bulky cylinders and carts for more modern
and truly ambulatory systems.

Another impact of the turmoil over reimbursement cuts was the increase in
consolidation activity that resulted in strong independent dealers being
acquired by large national chains. Independents have been, by far, the largest
and most important part of Chad's business. Chad's independent dealers have also
been the most attractive acquisitions for the national chains because of


<PAGE>   2
their growth and profitability, due in large part to Chad's efficient and
desirable systems. The loss of these dependable customers as they complied with
the purchasing policies of their new owners was a substantial loss to Chad.

The Company also faced a form of competition that had heretofore not manifested
itself. There had been competition in the oxygen conserving device market for
several years but it had never been serious. There was no other electronic
conserver that could compete with Chad's OXYMATIC conserver because of its
clearly superior oxygen savings efficiency. We had always argued that the only
logical reason for using an oxygen conserving device was to conserve as much
oxygen as possible. Chad's OXYMATIC conserver provided an average savings ratio
of seven to one compared with competitive devices three to one savings at best.
However, the first half of fiscal 1998 brought several new conserving devices to
the market with all of them competing on the basis of unit cost of the device.
They accomplished something I never would have believed possible. They
successfully got a number of physicians, therapists and providers to think of
oxygen conservers as generic products without regard to efficiency.
Consequently, the market became more unit price sensitive and cheaper electronic
conservers captured some of the loyal market we had built over the years. The
good news is that despite the loss in market share in the past year the OXYMATIC
conserver is still the market leader and recent indications are that unit sales
of this product are on the rise again as providers are learning to cope with the
reimbursement cuts.

During this time the Company was working to complete development of the new
TOTAL 0[subscript]2(TM) Delivery System. It promises to be the right product at
the right time for both the Company and the home oxygen industry. The TOTAL
0[subscript]2 system provides stationary oxygen for the patient at home,
portable oxygen including an oxygen conserving device for ambulation and a safe
efficient mechanism to fill the portable unit from the stationary unit. It can
improve providers' profitability by reducing the cost of servicing patients
while at the same time delivering a higher quality of service to those patients
as they are no longer restricted in the amount of ambulatory oxygen they can
use. Truly the right product at the right TIME. The Company previewed the new
product in early October at the Medtrade show in New Orleans to great
enthusiasm. However, it was not ready to sell as clearance was not received from
the FDA until mid-November and shipping did not begin until January as the
Company and its suppliers refined manufacturing practices for the new system.
Manufacturing processes are still being refined as the Company works to increase
production capability of the TOTAL 0[subscript]2 system. We did ship $535,000 in
TOTAL 0[subscript]2 systems through March 31, 1998, and had a $361,000 backlog
of systems at that date. Tom Jones will review expectations for the new product
in his report, including the product's international potential.

I certainly would have much preferred a different outcome for this, my last year
as Chad's CEO. Even so, I still feel very good and increasingly optimistic about
the Company's future with the opportunities we have and Tom Jones to lead us. I
wouldn't trade my experiences of the past 16 years and my wonderful associations
for anything. That includes not only Chad management and employees but the many
loyal friends who have invested in Chad.

Although I'm no longer a part of management, as Chairman of the Board I would
like to promise you once again that we will all do our very best.

Charles R. Adams

/s/ CHARLES R. ADAMS


Chairman of the Board of Directors



                                                                               5
<PAGE>   3

                               [PHOTOGRAPH OF CEO]
                                Thomas E. Jones
                            Chief Executive Officer



I am pleased to be able to write to you as your new Chief Executive Officer.
While the respiratory care industry faces many challenges today I am excited
about the opportunities the Company currently has before it and look forward to
working with the people at Chad to achieve the Company's potential.

After the shock of experiencing the reality of a 25% across the board Medicare
oxygen revenue reduction (effective January 1, 1998), our home care provider
customers, we believe, are rolling up their sleeves and going about the tasks of
re-engineering their businesses to absorb this revenue reduction as well as the
5% reduction scheduled for January 1, 1999. For the most part, they also
recognize that these revenue cuts will not be the end of the cost reduction
pressure in the health care arena. The Competitive Bidding study mandated by
Congress is only one example of further pricing pressure.

With this atmosphere in mind, I cannot envision a more appropriate time to be
offering a product such as the Total 0[subscript]2"(TM) Delivery System. Not
only is the reimbursement structure forcing home care providers to learn how to
deliver oxygen to home care patients more efficiently, but the growth of the
home oxygen patient base, driven by chronic obstructive pulmonary disease
(COPD), continues at about 8-10% annually by most estimates.

From our perspective the clinical advantages of ambulatory oxygen for the
increasingly mobile patient population continues to align the market
characteristics in favor of innovative lower total cost home oxygen patient
solutions, such as the Total 0[subscript]2 system.

The adoption of the Total 0[subscript]2 system lends itself to those home care
providers who want to and are willing to technologically leapfrog their
competition to achieve lower costs and a higher quality of service for
ambulatory patients. Some home care providers who wish to try to incrementally
squeeze their costs to regain acceptable profitability in the face of Medicare
revenue cuts are very reluctant to adopt a new technology such as the Total
0[subscript]2 system, which requires changes in various operating


<PAGE>   4
approaches such as rationalizing or eliminating truck delivery schedules.

However, for those providers willing to "think outside the box" and restructure
their businesses, we believe the rewards will be great. For several of our
"early adopters" of the Total 0[subscript]2 system, the rewards appear to be
very significant in achieving lower operating costs, increasing market share and
improving patient satisfaction. Several of these "early adopter" accounts are
having excellent success directing media ads at patients through Chad's co-op
advertising program to gain market share.

The U.S. market for home oxygen systems is generally estimated to be in the area
of $250-$300 million with unit volume of oxygen systems at 250-300 thousand for
calendar 1997. With the non-U.S. market adding approximately 25% to those U.S.
numbers, the size of the opportunity for Chad is enormous even when one accounts
for the non-ambulatory patients who have been built into these base estimates.

With so large a market opportunity before us we are currently exploring various
methods of achieving more effective sales efforts including utilizing some form
of field sales organization to provide face-to-face sales representatives to
sell the Total 0[subscript]2 system to home care providers. We would expect to
come to some conclusion and have a plan implemented by the time you receive this
Annual Report.

After the sharp erosion of our market share in the traditional OXYMATIC
conserver product line during fiscal 1998, we believe this profitable line is
beginning to grow again. We believe this is due to both regaining some
historical customers as well as the expanding market discussed earlier combined
with home care providers search for the most cost efficient products to deal
with the recent Medicare reimbursement cuts.

In the International arena, we can tell you that interest in the Total
0[subscript]2 system is high. Converting this interest to sales revenues will
however take time and much effort due to both the necessary regulatory approvals
as well as the various reimbursement structures outside the U.S. which, in some
cases, do not necessarily favor cost reductions for home oxygen delivery. Cost
reduction pressures are however, consistent in virtually every venue, so most
foreign health care systems are examining ways to reduce healthcare costs over
time. We are nevertheless pursuing regulatory approval in numerous foreign
venues. In some countries we, along with our selected distributors, may need to
pursue modifications of drug delivery regulations to allow delivery of 93%
oxygen via compressed gas cylinders. We do however anticipate modest but growing
revenue during fiscal 1999 for the Total 0[subscript]2 system.

With regard to the traditional OXYMATIC conserver and related products, we
anticipate some recovery from fiscal 1998. However, significant growth and
penetration in international markets is not expected until the regulatory
approvals are received for the Total 0[subscript]2 system.

For this coming year, Chad's focus will be on the following objectives:

        -       To achieve smooth and efficient Total 0[subscript]2 system
                manufacturing operations with the ability and plan to expand
                manufacturing volume as necessary

        -       To achieve sales and market penetration in the U.S. consistent
                with the large opportunities that the current market conditions
                offer

        -       To continue preparation for introduction of the Total
                0[subscript]2 system to international markets, and

        -       To pursue and develop the new product opportunities which we
                have before us

These objectives will certainly challenge everyone within the Chad team.
However, I have no doubt that these things can be accomplished with the
outstanding group of fellow employees here at Chad.


Thomas E. Jones


/s/ THOMAS E. JONES

Chief Executive Officer



                                                                               7
<PAGE>   5

                             ISO 9000 CERTIFICATION


                CHAD RECEIVES ISO 9000 CERTIFICATION AND CE MARK

   By: Louie Goryoka, Vice President Quality Assurance and Regulatory Affairs



                [PHOTOGRAPH OF VICE PRESIDENT QUALITY ASSURANCE]

                                 Louie Goryoka
                        Vice President Quality Assurance
                             and Regulatory Affairs



One of the most significant changes in domestic and international business is
the recent movement toward quality awareness. The importance of quality and
reliability is becoming recognized as a critical factor for the sale of many
products and services. This growth in international quality awareness has
resulted in customer and consumer demand for products and services that are
entirely suitable for the purpose intended. Furthermore, there is a growing
expectation that products distributed internationally will continue to be
operational and serviceable for an acceptable period of time.

The international standards for meeting these quality goals are ISO 9000
certification and CE marking of products and Chad Therapeutics has recently been
approved for both of these standards. In pursuit of an increasingly successful
role in the global economy Chad has been constantly improving its quality system
to meet or exceed these standards. Thus, as Chad's quality system moves through
improvement phases, so does the Company's opportunity for success in the
competitive global marketplace.

With the ISO 9000 certification Chad is improving efficiency, reducing costs and
most importantly increasing customer satisfaction. The CE Marking is the
manufacturer's self-declaration, showing compliance with all applicable EC
directives. For most products sold in the European Union (EU), the use of the CE
Marking and the Declaration of Conformity are mandatory as of June 1998. With
this mark of conformity, Chad's products can be marketed freely throughout the
member countries.

In today's marketplace there are many benefits resulting from ISO 9000
certification and CE Marking of products. Chad Therapeutics is committed to
maintaining the highest possible quality standards so that our products are in
the best possible competitive position.





8
<PAGE>   6
                              FINANCIAL HIGHLIGHTS




SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                                YEARS ENDED MARCH 31,
                                 -----------------------------------------------------------------------------------
                                     1998               1997              1996             1995              1994
                                 -----------        ----------        ----------        ----------         ---------
<S>                              <C>                <C>               <C>               <C>                <C>      
Net Sales                        $16,593,000        26,161,000        20,359,000        14,518,000         9,470,000
Interest Income                      164,000           113,000            97,000            50,000            28,000
Net Earnings                         797,000         5,035,000         4,310,000         2,606,000         2,053,000
Basic Earnings Per Share                 .08               .51               .44               .26               .20
Diluted Earnings Per Share               .08               .49               .42               .26               .20
Net Working Capital               10,704,000        10,985,000         9,219,000         5,172,000         4,176,000
Total Assets                      17,436,000        15,861,000        10,778,000         6,371,000         5,075,000
Shareholders' Equity              16,074,000        15,110,000         9,775,000         5,574,000         4,507,000
</TABLE>


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




                                                                               9
<PAGE>   7
                                 BALANCE SHEETS


<TABLE>
<CAPTION>
                                                                          MARCH 31,
                                                             --------------------------------
                                                                 1998                1997
                                                             ------------          ----------
<S>                                                          <C>                    <C>      
ASSETS

Current assets:
    Cash                                                     $  1,579,000           2,289,000
    Accounts receivable, less allowance for doubtful
      accounts of $105,000 and $107,000 in 1998 and 1997        2,469,000           2,329,000
    Inventories (Note 2)                                        7,133,000           6,063,000
    Income taxes refundable (Note 3)                              572,000             527,000
    Prepaid expenses                                              249,000             172,000
    Deferred income taxes (Note 3)                                 64,000             356,000
                                                             ------------          ----------
      Total current assets                                     12,066,000          11,736,000
                                                             ------------          ----------
Property and equipment, at cost:
    Office equipment and furniture                              1,639,000           1,265,000
    Machinery and equipment                                       804,000             634,000
    Tooling                                                     1,084,000             305,000
    Leasehold improvements                                      1,748,000           1,640,000
                                                             ------------          ----------
                                                                5,275,000           3,844,000
      Less accumulated depreciation and amortization            1,310,000             717,000
                                                             ------------          ----------
      Net property and equipment                                3,965,000           3,127,000
                                                             ------------          ----------
Note receivable from related party (Note 4)                       126,000                  --
Other assets, net (Note 5)                                      1,279,000             998,000
                                                             ------------          ----------
                                                             $ 17,436,000          15,861,000
                                                             ============          ==========
</TABLE>

<TABLE>
<CAPTION>
                                                                  1998                1997
                                                             ------------           ---------
<S>                                                          <C>                      <C>    
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
    Accounts payable                                         $    730,000             344,000
    Accrued expenses (Note 8)                                     632,000             407,000
                                                             ------------           ---------
      Total current liabilities                                 1,362,000             751,000
                                                             ------------           ---------
Commitments (Note 9)
Shareholders' equity (Note 6):
    Common shares
      Authorized 40,000,000 shares;
       10,008,000 and 9,951,000 shares issued                  13,100,000          12,834,000
    Retained earnings                                           3,105,000           2,308,000
                                                             ------------          ----------
                                                               16,205,000          15,142,000
    Less treasury shares at cost, 19,000 and 3,000
        shares in 1998 and 1997                                  (131,000)            (32,000)
                                                             ------------          ----------
      Net shareholders' equity                                 16,074,000          15,110,000
                                                             ------------          ----------
                                                             $ 17,436,000          15,861,000
                                                             ============          ==========
</TABLE>

See accompanying notes to financial statements.



<PAGE>   8
                             STATEMENTS OF EARNINGS


<TABLE>
<CAPTION>
                                                            YEARS ENDED MARCH 31,
                                              -----------------------------------------------
                                                  1998              1997               1996
                                              -----------        ----------        ----------
<S>                                           <C>                <C>               <C>
Net sales                                     $16,593,000        26,161,000        20,359,000
Cost of sales                                   8,670,000        11,356,000         8,480,000
                                              -----------        ----------        ----------
       Gross profit                             7,923,000        14,805,000        11,879,000
Costs and expenses:
    Selling, general and administrative         6,042,000         5,595,000         4,791,000
    Research and development                      713,000           910,000           113,000
                                              -----------        ----------        ----------
       Total costs and expenses                 6,755,000         6,505,000         4,904,000
                                              -----------        ----------        ----------
       Operating income                         1,168,000         8,300,000         6,975,000
Interest income                                   164,000           113,000            97,000
                                              -----------        ----------        ----------
       Earnings before income taxes             1,332,000         8,413,000         7,072,000
Income taxes (Note 3)                             535,000         3,378,000         2,762,000
                                              -----------        ----------        ----------
       Net earnings                           $   797,000         5,035,000         4,310,000
                                              ===========        ==========        ==========
       Basic earnings per share               $       .08               .51               .44
                                              ===========        ==========        ==========
       Diluted earnings per share             $       .08               .49               .42
                                              ===========        ==========        ==========
</TABLE>


                                 See accompanying notes to financial statements.


<PAGE>   9
                       STATEMENTS OF SHAREHOLDERS' EQUITY



FOR THE YEARS ENDED MARCH 31,1998,1997 AND 1996

<TABLE>
<CAPTION>
                                                                                               RETAINED
                                                            COMMON SHARES (NOTE 6)             EARNINGS
                                                      -------------------------------         (ACCUMULATED          TREASURY
                                                          SHARES             AMOUNT             DEFICIT)             SHARES
                                                      ------------       ------------         ------------       -------------
<S>                                                     <C>              <C>                   <C>               <C>
Balance at March 31, 1995                               9,620,000        $  6,832,000          (1,258,000)       $         --
Common Shares Repurchased and Retired                     (71,000)           (392,000)                 --                  --
Common Shares Repurchased At Cost                              --            (228,000)                 --                  --
Common Shares Issued For Purchases
  Under Employee Benefit Plan                                  --                  --                  --             160,000
Exercise of Stock Options                                  74,000             187,000                  --                  --
Tax Benefit From Exercise of
  Non-Qualified Stock Options                                  --             164,000                  --                  --
Net Earnings                                                   --                  --           4,310,000                  --
                                                       ----------        ------------        ------------        ------------ 

Balance at March 31, 1996                               9,623,000           6,791,000           3,052,000             (68,000)
Common Shares Repurchased At Cost                              --                  --                  --            (183,000)
Common Shares Issued For Purchases
  Under Employee Benefit Plan                                  --               5,000                  --             219,000
3% Stock Dividend                                         289,000           5,779,000          (5,779,000)                 --
Exercise of Stock Options                                  41,000             216,000                  --                  --
Common Shares Tendered and Retired
  For Stock Option Exercise                                (2,000)            (32,000)                 --                  --
Tax Benefit From Exercise of
  Non-Qualified Stock Options                                  --              75,000                  --                  --
Net Earnings                                                   --                  --           5,035,000                  --
                                                       ----------        ------------        ------------        ------------ 

Balance at March 31, 1997                               9,951,000          12,834,000           2,308,000             (32,000)
Common Shares Repurchased At Cost                              --                  --                  --            (285,000)
Common Shares Issued For Purchases
  Under Employee Benefit Plan                                  --                  --                  --             186,000
Exercise of Stock Options                                  57,000             156,000                  --                  --
Tax Benefit From Exercise of
  Non-Qualified Stock Options                                  --             103,000                  --                  --
Stock Option Grants                                            --               7,000                  --                  --
Net Earnings                                                   --                  --             797,000                  --
                                                       ----------        ------------        ------------        ------------ 

Balance at March 31, 1998                              10,008,000        $ 13,100,000        $  3,105,000        $   (131,000)
                                                       ==========        ============        ============        ============ 
</TABLE>



See accompanying notes to financial statements.


12
<PAGE>   10
                            STATEMENTS OF CASH FLOWS





<TABLE>
<CAPTION>
                                                                               INCREASE (DECREASE) IN CASH
                                                                                    YEARS ENDED March 31,
                                                                    -------------------------------------------------
                                                                       1998                1997                1996
                                                                    -----------          ---------          ---------
<S>                                                                 <C>                  <C>                <C>
 Cash flows from operating activities:
    Net earnings                                                    $   797,000          5,035,000          4,310,000
    Adjustments to reconcile net earnings
       to net cash provided by operating activities:
         Depreciation and amortization                                  617,000            280,000            114,000
         Compensation expense related
          to option grants                                                7,000                 --                 --
         Changes in assets and liabilities:
           Decrease (increase) in accounts receivable                  (140,000)           543,000           (746,000)
           Decrease (increase) in inventories                        (1,070,000)        (2,052,000)        (2,166,000)
           Decrease (increase) in income taxes refundable               (45,000)          (527,000)            84,000
           Decrease (increase) in prepaid expenses                      (77,000)           (27,000)           (20,000)
           Decrease (increase) in deferred income taxes                 292,000                 --           (202,000)
           Decrease (increase) in note receivable
              from related party                                       (126,000)                --                 --
           Decrease (increase) in other assets                         (305,000)          (942,000)                --
           Increase (decrease) in accounts payable                      386,000            (55,000)          (115,000)
           Increase (decrease) in accrued expenses                      225,000            (17,000)          (141,000)
           Increase (decrease) in income taxes payable                       --           (180,000)           180,000
                                                                    -----------          ---------          ---------
           Net cash provided by operating activities                    561,000          2,058,000          1,580,000
                                                                    -----------          ---------          ---------

Cash flows from investing activities:
    Decrease (increase) in marketable securities                             --          1,029,000           (613,000)
    Capital expenditures                                             (1,431,000)        (2,912,000)          (268,000)
    Dispositions of property and equipment                                   --              5,000                 --
                                                                    -----------          ---------          ---------
           Net cash (used in) investing activities                   (1,431,000)        (1,878,000)          (881,000)
                                                                    -----------          ---------          ---------

Cash flows from financing activities:
    Tax benefit from exercise of non-qualified stock options            103,000             75,000            164,000
    Exercise of stock options                                           156,000            216,000            187,000
    Common shares purchased                                            (285,000)          (183,000)          (620,000)
    Common shares issued                                                186,000            224,000            160,000
    Common shares tendered and retired                                       --            (32,000)                --
                                                                    -----------          ---------          ---------
          Net cash provided by (used in) financing activities           160,000            300,000           (109,000)
                                                                    -----------          ---------          ---------

Net increase (decrease) in cash                                        (710,000)           480,000            590,000

Cash beginning of year                                                2,289,000          1,809,000          1,219,000
                                                                    -----------          ---------          ---------
Cash end of year                                                    $ 1,579,000          2,289,000          1,809,000
                                                                    ===========          =========          =========
Supplemental disclosure of cash flow information:
          Cash paid during the year for:
       Income taxes                                                 $   185,000          4,010,000          2,535,000
                                                                    ===========          =========          =========
Supplemental schedule of noncash investing
      and financing activities:
   Common stock issued as payment of dividend                       $        --          5,779,000                 --
                                                                    ===========          =========          =========
</TABLE>

                                 See accompanying notes to financial statements.



                                                                              13

<PAGE>   11
                         NOTES TO FINANCIAL STATEMENTS

MARCH 31, 1998

(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, 1998. The carrying amounts related to cash, accounts receivable, other
current assets, accounts payable and accrued expenses approximate fair value due
to the relatively short maturity of such instruments. It is not practicable to
estimate the fair value of the note receivable from related party due to the
nature of the instrument.

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.

DEPRECIATION

Depreciation of property and equipment is provided using straight-line methods
based on the estimated useful lives of the related assets as follows:

<TABLE>
<S>                                                                   <C>       
Office Equipment and Furniture                                         5-7 Years
Machinery and Equipment                                               5-10 Years
Tooling                                                                  3 Years
</TABLE>

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 generally accepted accounting principles. Actual results
could differ from those estimates.

REVENUE RECOGNITION

Revenue from product sales is recognized upon shipment of merchandise.

NET EARNINGS PER COMMON SHARE

The Financial Accounting Standards Board issued Statement No. 128, "Earnings Per
Share ("FAS 128"), in February 1997. FAS 128 is effective for both interim and
annual periods ending after December 1997. FAS 128 requires the presentation of
"Basic" earnings per share which represents income available to common
shareholders divided by the weighted average number of common shares outstanding
for the period. A dual presentation of "Diluted" earnings per share is also
required. The adoption of FAS 128 did not have a material impact on the
Company's financial position or results of operations.

Following is a reconciliation of the numerators and denominators used in the
calculation of basic and diluted net earnings per common share for the years
ended March 31, 1998, 1997 and 1996, respectively:

<TABLE>
<CAPTION>
                                           1998           1997           1996
                                       -----------    -----------    -----------
<S>                                    <C>              <C>            <C>      
Basic net earnings per share
Numerator - net earnings               $   797,000      5,035,000      4,310,000
Denominator - common
  shares outstanding                     9,958,000      9,931,000      9,853,000
                                       -----------    -----------    -----------
Basic net earnings per share           $       .08    $       .51    $       .44
                                       ===========    ===========    ===========
Diluted net earnings per share
Numerator - net earnings               $   797,000       5,035,00      4,310,000
Denominator -
  Common shares outstanding              9,958,000      9,931,000      9,853,000
  Common stock options                     256,000        442,000        367,000
                                       -----------    -----------    -----------
                                        10,214,000     10,373,000     10,220,000
                                       -----------    -----------    -----------
Diluted net earnings per share         $       .08    $       .49    $       .42
                                       ===========    ===========    ===========
</TABLE>

Options to purchase 407,000 shares of common stock at prices ranging from $9.75
to $13.471 per share were not included in the computation of diluted earnings
per share in 1998 because the option price was greater than the average market
price of the common shares.

All of the share, per share and weighted average number of shares have been
retroactively adjusted for a three-for-two stock split distributed on October
16, 1995, to all shareholders of record on October 2, 1995. In addition, the
weighted average number of shares has been adjusted for a 3% stock dividend paid
on October 15, 1996, to shareholders of record on October 1, 1996, which
resulted in the issuance of 289,000 new shares.

RESEARCH AND DEVELOPMENT COSTS

The Company charges all research and development costs to expense when incurred.

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 bases. 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


14

<PAGE>   12


effect on deferred tax assets and liabilities of a change in tax rates is
recognized in income in the period that includes the enacted date.

MAJOR CUSTOMER

The Company had sales to one major customer which accounted for approximately
11% and 18% of net sales during the years ended March 31, 1998 and 1997,
respectively. No one customer exceeded 10% of net sales during 1996.

RECLASSIFICATIONS

Certain reclassifications have been made to the prior year's balances to conform
to the 1998 presentation.

STOCK OPTION PLAN

Prior to April 1, 1996, the Company accounted for its stock option plan in
accordance with the provisions of Accounting Principles Board ("APB") Opinion
No. 25, Accounting for Stock Issued to Employees, and related interpretations.
As such, compensation expense would be recorded on the date of the grant only if
the current market price of the underlying stock exceeded the exercise price. On
April 1, 1996, the Company adopted Statement of Financial Accounting Standards
(SFAS) No. 123, Accounting for Stock-Based Compensation, which permits entities
to recognize as expense over the vesting period the fair value of all
stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows
entities to continue to apply the provisions of APB Opinion No. 25 and provide
pro forma net income and pro forma earnings per share disclosures for employee
stock option grants made in 1995 and future years as if the fair-value-based
method defined in SFAS No. 123 had been applied. The Company has elected to
continue to apply the provisions of APB Opinion No. 25 and provide the pro forma
disclosure provisions of SFAS No. 123.

NEWLY ISSUED ACCOUNTING STANDARDS

The Financial Accounting Standards Board issued Statement No. 130, "Reporting
Comprehensive Income" ("FAS 130"), in June 1997. FAS 130 establishes standards
for reporting and display of comprehensive income and its components in
financial statements. FAS 130 is effective for both interim and annual periods
beginning after December 15, 1997. The Company will adopt FAS 130 in the first
quarter of the fiscal year ending March 31, 1999. Management believes that the
adoption of FAS 130 will not have a material impact on the Company's financial
position or results of operations.

The Financial Accounting Standards Board issued Statement No. 131, "Disclosures
about Segments of an Enterprise and Related Information" ("FAS 131"), in June
1997. FAS 131 establishes standards for the way public business enterprises are
to report information about operating segments in annual financial statements
and requires enterprises to report selected information about operating segments
in interim financial reports issued to shareholders. It also establishes
standards for related disclosures about products and services, geographic areas
and major customers. It replaces the "industry segment" concept of FAS No. 14,
"Financial Reporting for Segments of a Business Enterprise", with a "management
approach" concept as to basis for identifying reportable segments. FAS 131 is
effective for financial statements for periods beginning after December 15,
1997. The Company will adopt FAS 131 in the annual financial statements of the
fiscal year ending March 31, 1999. Management believes the adoption of FAS 131
will not have a material impact on the Company's financial position or results
of operations.

(2) INVENTORIES

At March 31, 1998 and 1997, inventories consisted of the following:

<TABLE>
<CAPTION>
                                                1998            1997
                                             ----------       ---------
      <S>                                    <C>              <C>      
      Finished goods                         $1,154,000       1,228,000
      Work in process                         1,117,000       1,454,000
      Raw materials
        and supplies                          4,862,000       3,381,000
                                             ----------       ---------
                                             $7,133,000       6,063,000
                                             ==========       =========
</TABLE>

(3) INCOME TAXES

The provision for income taxes for fiscal 1998, 1997 and 1996 consists of the
following:

<TABLE>
<CAPTION>
                                 1998          1997           1996
                              ----------    ----------     ----------
      <S>                     <C>            <C>            <C>
      Current:
        Federal               $  137,000     2,609,000      2,288,000
        State                    106,000       769,000        676,000
                              ----------    ----------     ----------
                                 243,000     3,378,000      2,964,000
      Deferred:
        Federal                  274,000       (10,000)      (181,000)
        State                     18,000        10,000        (21,000)
                              ----------    ----------     ----------
                                 292,000            --       (202,000)
                              ----------    ----------     ----------
            Total             $  535,000     3,378,000      2,762,000
                              ==========    ==========     ==========
</TABLE>

A reconciliation of the difference between the Company's provision for income
taxes and the statutory income tax for the years ended March 31, 1998, 1997 and
1996, respectively, is as follows:

<TABLE>
<CAPTION>
                                        1998          1997          1996
                                     ----------    ----------    ----------
      <S>                            <C>            <C>           <C>      
      Statutory tax expense          $  453,000     2,860,000     2,404,000
      State income tax                   82,000       514,000       432,000
      Warranty and other                     --         4,000       (74,000)
                                     ----------    ----------    ----------
                                     $  535,000     3,378,000     2,762,000
                                     ==========    ==========    ==========
</TABLE>

                                                                              15
<PAGE>   13


The tax effects of temporary differences a give rise to significant portions of
the deferred tax assets at March 31, 1998 and 1997 are presented as follows:

<TABLE>
<CAPTION>
                                                     1998           1997
                                                   --------       -------
      <S>                                          <C>            <C>
      State taxes                                  $ 29,000       265,000
      Bad debt reserves                              36,000        46,000
      Accrued expenses                               57,000        36,000
      Inventories                                    23,000        21,000
                                                   --------       -------
        Total deferred tax assets                  $145,000       368,000
      Deferred tax liability - depreciation         (81,000)      (12,000)
                                                   --------       -------
      Net deferred tax assets                      $ 64,000       356,000
                                                   ========       =======
</TABLE>

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. Based upon the levels of historical taxable income,
management believes that it is more likely than not, that the Company will
realize the deferred tax assets. As such, no valuation allowance has been
recorded.

(4) NOTE RECEIVABLE FROM RELATED PARTY

The note receivable from related party is due from an officer and is payable in
monthly installments of $1,200 with interest at 7.25%, is secured by a second
trust deed and is due in April, 2112.

(5) OTHER ASSETS

Other assets includes $1,250,000 paid in 1997 and 1998 for a license on a new
product. The license fee is being amortized beginning in 1998 using the
straight-line method over the life of the related patents, 14 years.

(6) SHAREHOLDERS' EQUITY

In 1998,1997 and 1996 the Company purchased its own stock for purposes of
funding contributions to the Company's 401(k) plan. Periodically as common
shares are sold to the plan, the difference between the cost and fair market
value at the date of transfer is credited to shareholders' equity ($5,000 in
1997).

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:

<TABLE>
<CAPTION>
                                                                       WEIGHTED
                                                                        AVERAGE
                                     OPTION            OPTION            PRICE
                                     SHARES            AMOUNT          PER SHARE
                                    --------         -----------       ---------
<S>                                 <C>              <C>               <C> 
Incentive Options:
Outstanding -
  March 31, 1995                     512,000         $ 2,536,000          4.95
Granted                              134,000           1,520,000         11.34
Exercised                            (38,000)            (89,000)         2.34
                                    --------         -----------         -----
Outstanding -
  March 31, 1996                     608,000           3,967,000          6.53
Cancelled                            (15,000)           (117,000)         7.80
Granted                                   --                  --            --
Exercised                            (27,000)           (152,000)         5.67
                                    --------         -----------         -----
Outstanding -
  March 31, 1997                     566,000           3,698,000          6.53
Cancelled                            (30,000)           (372,000)        12.40
Granted                              254,000           2,492,000          9.81
Exercised                             (2,000)            (10,000)         5.98
                                    --------         -----------         -----
Outstanding -
  March 31, 1998                     788,000         $ 5,808,000          7.37
                                    ========         ===========         =====
Exercisable -
  March 31, 1998                     372,000         $ 2,107,000          5.66
                                    ========         ===========         =====
Non-qualified Options:
Outstanding -
  March 31, 1995                     160,000         $   526,000          3.29
Granted                               62,000             775,000         12.50
Exercised                            (39,000)            (98,000)         2.51
                                    --------         -----------         -----
Outstanding -
  March 31, 1996                     183,000           1,203,000          6.57
Cancelled                             (3,000)            (11,000)         3.93
Granted                               16,000             139,000          9.25
Exercised                            (14,000)            (64,000)         4.57
                                    --------         -----------         -----
Outstanding -
  March 31, 1997                     182,000           1,267,000          6.96
Granted                               26,000             267,000         10.27
Exercised                            (55,000)           (146,000)         2.66
                                    --------         -----------         -----
Outstanding -
  March 31, 1998                     153,000         $ 1,388,000          9.07
                                    ========         ===========         =====
Exercisable -
  March 31, 1998                     123,000         $ 1,111,000          9.03
                                    ========         ===========         =====
</TABLE>

At March 31, 1998, information regarding outstanding options is summarized as
follows:

<TABLE>
<S>                                              <C>             <C>        
   Range of exercise prices                      $1.68-6.69       8.75-13.47
   Number outstanding                               519,000          422,000
   Weighted average
    remaining life (yrs.)                               6.7              8.9
   Weighted average
    exercise price                               $     5.13      $     10.77
   Number exercisable                               390,000          105,000
   Weighted average
    exercise price                               $     4.56      $     12.26
</TABLE>

16
<PAGE>   14

Incentive and non-qualified options were granted at prices not less than 100% of
fair 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 derived a
tax benefit from options exercised by employees, such benefit is credited to
Common Stock when realized on the Company's income tax returns.

The Company applies Accounting Principles Board Opinion No. 25 in accounting for
its plan. Accordingly, no compensation expense has been recognized for its stock
options in the accompanying financial statements. Had compensation cost for
awards under the Company's stock option plan been determined based upon the fair
value at the grant date prescribed under Statement of Financial Accounting
Standards No. 123, the Company's net earnings in 1998, 1997 and 1996 would have
been reduced by approximately $247,000, $214,000 and $100,000, respectively, and
net earnings per share would have been reduced by $.02, $.02 and $.01 per share
in 1998, 1997 and 1996, respectively. The weighted average fair value of options
granted during 1998, 1997 and 1996 is estimated at $5.41, $2.83 and $5.69,
respectively. The fair value of options granted during each period was estimated
using the Black-Scholes option pricing model with the following assumptions.

<TABLE>
<CAPTION>
                                                 1998         1997         1996
                                                 ----         ----         ----
<S>                                              <C>          <C>          <C> 
Risk-free interest rate                           5.9%         5.9%         6.2%
Forfeiture rate                                   2.0%         2.0%         2.0%
Dividend yield                                     .0           .0           .0
Volatility                                         57%          45%          45%
Expected life (years)                             5.0          5.0          5.0
</TABLE>

(7) 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. The Company has
accrued and paid $59,000, $96,000, and $71,000 of the plan contributions during
1998, 1997 and 1996, respectively.

(8) ACCRUED EXPENSES

Accrued expenses consist of the following:

<TABLE>
<CAPTION>
                                                1998        1997
                                              --------    --------
      <S>                                     <C>         <C>    
      Accrued royalties                       $144,000     116,000
      Deferred revenue                          98,000          --
      Product and business
        liability insurance                     41,000      67,000
      Deferred rent                             92,000      97,000
      Accrued vacation                          76,000      72,000
      Other                                    181,000      55,000
                                              --------    --------
                                              $632,000     407,000
                                              ========    ========
</TABLE>

(9) COMMITMENTS

The Company is currently leasing its administrative and plant facilities and
certain office equipment under noncancellable operating leases which expire
through June, 2003.

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

<TABLE>
           <S>                                        <C>       
           1999                                       $  368,000
           2000                                          356,000
           2001                                          344,000
           2002                                          354,000
           2003                                          368,000
           Thereafter                                     93,000
                                                      ----------
           TOTAL:                                     $1,883,000
                                                      ==========
</TABLE>

Rent expense amounted to $440,000, $417,000, and $239,000 for the years ended
March 31, 1998, 1997 and 1996, respectively.

(10) QUARTERLY FINANCIAL DATA (UNAUDITED)

The following table presents summarized unaudited quarterly financial data for
1998 and 1997:

<TABLE>
<CAPTION>
                                                             NET             BASIC
                                           GROSS           EARNINGS      EARNINGS(LOSS)
                          REVENUE          PROFIT           (LOSS)         PER SHARE
                        -----------      -----------      -----------    --------------
    <S>                 <C>              <C>              <C>            <C>  
    1998
    ----
    First Quarter       $ 5,428,000      $ 2,985,000      $   804,000        $0.08
    Second Quarter        4,390,000        2,214,000          289,000         0.03
    Third Quarter         3,234,000        1,324,000         (286,000)       (0.03)
    Fourth Quarter        3,541,000        1,400,000          (10,000)        0.00
                        -----------      -----------      -----------        -----
    Year                $16,593,000      $ 7,923,000      $   797,000        $0.08
                        ===========      ===========      ===========        =====
    1997
    ----
    First Quarter       $ 7,772,000      $ 4,593,000      $ 1,624,000        $0.17
    Second Quarter        7,357,000        4,257,000        1,610,000         0.16
    Third Quarter         5,955,000        3,161,000        1,099,000         0.11
    Fourth Quarter        5,077,000        2,794,000          702,000         0.07
                        -----------      -----------      -----------        -----
    Year                $26,161,000      $14,805,000      $ 5,035,000        $0.51
                        ===========      ===========      ===========        =====
</TABLE>

(11) SUBSEQUENT EVENT

On May 7, 1998, the Company entered into an agreement with it's bank to provide
a line of credit for one year of $2,000,000 for working capital to expand the
new TOTAL 0[subscript]2 Delivery System product line. Amounts borrowed under the
line of credit will bear interest at the bank's prime rate and is payable
monthly.

                                                                              17
<PAGE>   15
                          INDEPENDENT AUDITOR'S 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, 1998 and 1997 and the related statements of earnings, shareholders'
equity and cash flows for the three years ended March 31, 1998. 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 generally accepted auditing
standards. 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, 1998 and 1997 and the results of its operations and its cash flows for the
three years ended March 31, 1998, in conformity with generally accepted
accounting principles.

KPMG Peat Marwick LLP

Los Angeles, California
May 1, 1998, except as to Note 11 
which is as of May 7, 1998



18
<PAGE>   16
                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                 FINANCIAL CONDITION AND RESULTS OF OPERATIONS



RESULTS OF OPERATIONS

Sales for the years ended March 31, 1998 and 1997, decreased $9,568,000 (36.6%)
and increased $5,802,000 (28.5%), respectively, from the prior year's periods.
There were no price changes during 1997 and 1996. While there have been limited
price reductions in 1998, the decrease in sales relates primarily to decreases
in domestic unit sales in 1998 of OXYMATIC conservers and OXYLITE complete
portable oxygen systems which are being affected by the current marketing
environment for home oxygen therapy discussed below.

Sales to foreign distributors represented 10% of total sales for the years'
ended March 31, 1998 and 1997. Currently, management expects a small increase in
sales to foreign distributors during the upcoming fiscal year and quarter to
quarter sales will fluctuate depending on the timing of shipments. In addition,
all foreign sales are transacted in dollars, thus annual unit sales could be
affected by foreign currency fluctuations.

The current procedure for reimbursement by Medicare for home oxygen services
provides 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, interest heightened in oxygen conserving devices
which can extend the life of oxygen supplies and reduce service calls by
dealers. Management believes these reimbursement procedures have heightened
interest in the cost savings and improved mobility afforded by oxygen conserving
devices such as the Company's products.

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. As major national and
regional home medical equipment chains attempt to secure managed care contracts
and improve their market position, they have expanded their distribution
networks through the acquisition of independent dealers in strategic areas.
Three major national chains accounted for approximately 24% and 31% of the
Company's domestic sales for the years ended March 31, 1998 and 1997,
respectively. Margins on these sales may be somewhat lower due to quantity
pricing. In some instances this has resulted in reduced purchases as the former
independent provider complies with the chain's purchasing policies. The
Company's products, which allow homecare dealers to provide cost efficient home
oxygen therapy, are ideally suited for use in a managed care environment and as
a tool for dealers to increase revenues and profits. To ensure continued
awareness of the benefits of the Company's products by chain headquarters
personnel, a proactive marketing and communication program is in effect with all
of the major national chains.

The Company believes that its revenues at the end of fiscal 1997 and during the
year ended March 31, 1998, were affected by several factors. During the year
ended March 31, 1998, management believes sales to national chain accounts
decreased as programs to convert patients to more acceptable ambulatory systems
in the previous year did not recur. In addition, sales to national chain
accounts as well as independent dealers have also been impacted by increased
competitive factors and uncertainties regarding the size of potential cuts in
Medicare home oxygen reimbursement which were being discussed as part of the
Federal budget process. This process has now been finalized and a 25% cut in
home oxygen reimbursement went into effect January, 1998. The effects of managed
care and concerns over the severity of reimbursement cuts has, in many cases,
resulted in the provision of systems to patients that do not provide truly
ambulatory oxygen. Management believes these factors, including uncertainties as
to how home care providers will respond to the 25% cut, may continue to
adversely affect the Company's revenues from sales of oxygen conserving devices
for the foreseeable future.

Management also believes future revenues may be positively affected by sales of
a new product, the TOTAL 0[subscript]2(TM) Delivery System. The TOTAL
0[subscript]2 system provides stationary oxygen for patients at home, portable
oxygen including an oxygen conserving device for ambulation and a safe and
efficient mechanism for filling portable oxygen cylinders. This should provide
home care dealers with a means to deal with the reimbursement cuts discussed
above by reducing 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 the new product from
the Food and Drug Administration. The Company began shipping TOTAL 0[subscript]2
systems in January and realized approximately $535,000 in sales through March
31, 1998. The sales potential for the new system is significant as the average
selling price is anticipated to be approximately four times that of the OXYMATIC
and OXYLITE systems. No estimate can currently be made regarding the level of
success the Company may achieve with the TOTAL 0[subscript]2 system.

Cost of sales as a percent of net sales increased from 43.4% to 52.3% and from
41.7% to 43.4%, respectively, for the years ended March 31, 1998 and 1997, as
compared to the prior year's periods. Both years have been affected by higher
fixed overhead costs associated with the Company's move to new facilities in
October, 1996. In addition, the year ended March 31, 1998, has been affected by
decreased sales volume and start-up costs associated with the manufacture of the
TOTAL 02 system. Management believes the gross margins should remain at or near
current levels in future periods.



                                                                              19
<PAGE>   17
                    MANAGEMENT'S DISCUSSION AND ANALYSIS OF
                 FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Selling, general and administrative expenditures increased from $5,595,000 to
$6,042,000 and from $4,791,000 to $5,595,000 for the years ended March 31, 1998
and 1997, respectively. These increases related to the Company's move to new
facilities in October 1996, and the costs of preparing to bring the Company's
new TOTAL 02 system product to market. The Company does not anticipate a
decrease in these expenses in the coming years. Research and development
expenses decreased by $197,000 for the year ended March 31, 1998, as compared to
the prior year's period. Currently, management expects research and development
costs to total approximately $800,000 in the fiscal year ended March 31, 1999,
on projects to enhance and expand the Company's product line.


FINANCIAL CONDITION

At March 31, 1998, the Company had cash totaling $1,579,000 or 9% of total
assets, as compared to $2,289,000 (14%) at March 31, 1997. Net working capital
decreased from $10,985,000 at March 31, 1997, to $10,704,000 at March 31, 1998.
Accounts receivable increased $140,000 during the year ended March 31, 1998.
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 $1,070,000. This increase relates
primarily to raw materials purchased for the manufacture of the new TOTAL 02
product line. 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.

Management believes funds derived from operations should be adequate to meet the
Company's present cash requirements. However, should the Company achieve rapid
market penetration with the new TOTAL 02 product line it may need additional
funds on a short term basis. The Company has entered into an agreement with its
bank to provide a line of credit for up to $2,000,000 if such funds are
necessary for expansion of the TOTAL 02 product line. The Company expects
capital expenditures during the next twelve months to be approximately $750,000.
On June 30, 1994, the Company announced that the Board of Directors had
authorized stock repurchases of its common shares in privately negotiated
transactions for a minimum of 10,000 shares. While the Company made no stock
repurchases during the year ended March 31, 1998, the Company may make
additional stock repurchases pursuant to the Board of Directors authorization in
the future. In addition, the Board has authorized the Company to purchase shares
of the Company's common stock in open market transactions. During the year ended
March 31, 1998, the Company purchased approximately 38,000 shares at a cost of
$285,000, however, the number of shares which may be purchased under these
programs in the future can not be predicted at this time. The Company does not
provide post employment retirement benefits.


YEAR 2000

Management has initiated an enterprise-wide program to prepare the Company's
computer systems and applications for the year 2000. The Company expects to
incur internal staff costs as well as consulting and other expenses related to
infrastructure and facilities enhancements necessary to prepare the systems for
the year 2000. The cost of testing and conversion of system applications is
expected to be minimal. A significant proportion of these costs are not likely
to be incremental costs to the Company, but rather will represent the
redeployment of existing information technology resources.


NEWLY ISSUED ACCOUNTING STANDARDS

The Financial Accounting Standards Board issued Statement No. 130, "Reporting
Comprehensive Income" ("FAS 130"), in June 1997. FAS 130 establishes standards
for reporting and display of comprehensive income and its components in
financial statements. FAS 130 is effective for both interim and annual periods
beginning after December 15, 1997. The Company will adopt FAS 130 in the first
quarter of the fiscal year ending March 31, 1999. Management believes that the
adoption of FAS 130 will not have a material impact on the Company's financial
position or results of operations.

The Financial Accounting Standards Board issued Statement No. 131, "Disclosures
about Segments of an Enterprise and Related Information" ("FAS 131"), in June
1997. FAS 131 establishes standards for the way public business enterprises are
to report information about operating segments in annual financial statements
and requires enterprises to report selected information about operating segments
in interim financial reports issued to shareholders. It also establishes
standards for related disclosures about products and services, geographic areas
and major customers. It replaces the "industry segment" concept of FAS No. 14,
"Financial Reporting for Segments of a Business Enterprise," with a "management
approach" concept as to basis for identifying reportable segments. FAS 131 is
effective for financial statements for periods beginning after December 15,1997.
The Company will adopt FAS 131 in the annual financial statements of the fiscal
year ending March 31, 1999. Management believes the adoption of FAS 131 will not
have a material impact on the Company's financial position or results of
operations.

20
<PAGE>   18

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



OUTLOOK: ISSUES & RISKS

This annual 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.

The Company's future growth in the near term will depend in significant part
upon the commercial success of the TOTAL 02 Delivery System. The success of this
new product will depend upon the health care community's perception of the
system's capabilities, clinical efficacy and benefit to patients. In addition,
prospective sales will be impacted by the degree of acceptance it achieves among
home oxygen dealers and patients requiring supplementary oxygen. As with the
introduction of any new product, the Company's ability to successfully promote
the TOTAL 02 Delivery System cannot be assessed 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. Three major national chains presently account for 24% of
the Company's domestic sales. 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 over the past several years 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 price products which do not
provide oxygen conserving capabilities comparable to the Company's products and
no assurance can be given that increased competition in the home oxygen market
will not continue to have an adverse effect on the Company's 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 and various state legislatures. There are wide
variations among these bills and proposals. Because of the uncertain state of
the health care proposals, it is not meaningful at this time to predict the
effect on the business of the Company if any of these proposals is enacted.

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 would reduce Medicare spending. It cannot be predicted how
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.


PATENTS AND TRADEMARKS

The Company pursues a policy of obtaining patents for appropriate inventions
related to products marketed or manufactured by the Company. The Company
considers the patentability of its products to be significant to the success of
the Company. To the extent that the products marketed by the Company do not
receive patent protection, competitors may be able to manufacture and market
substantially similar products. Such competition could have an adverse impact
upon the Company's business.


PRODUCTS 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 products 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



                                                                              21

<PAGE>   19
adverse impact on the Company's results of operations and financial position.

AVAILABILITY 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 and the Company
expects to continue using outside firms for certain manufacturing processes for
the foreseeable future. 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 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 financial position.


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.



22
<PAGE>   20
                                 CORPORATE DATA


OFFICERS

CHARLES R. ADAMS
Chairman

THOMAS E. JONES
Chief Executive Officer

FRANCIS R. FLEMING
President and
Chief Operating Officer

EARL L. YAGER
Senior Vice President,
Chief Financial Officer and Secretary

OSCAR J. SANCHEZ
Vice President, Development and
Engineering

LOUIE GORYOKA
Vice President, Quality Assurance
and Regulatory Affairs

DIRECTORS

CHARLES R. ADAMS
Chairman
Chad Therapeutics, Inc.

THOMAS E. JONES
Chief Executive Officer
Chad Therapeutics, Inc.

FRANCIS R. FLEMING
President
Chad Therapeutics, Inc.

EARL L. YAGER
Senior Vice President
Chad Therapeutics, Inc.

DAVID L. CUTTER
Retired Chairman Of The Board
Cutter Laboratories, Inc.

NORMAN COOPER
Retires Chairman
Kallir, Philips, Ross, Inc.

JOHN C. BOYD
Retired

PHILIP T. WOLFSTEIN
President
Wolfstein International, Inc.

CORPORATE DATA

CORPORATE HEADQUARTERS
21622 Plummer Street
Chatsworth, CA 91311
(818) 882-0883

LEGAL COUNSEL
Graham & James LLP

AUDITORS
KPMG Peat Marwick LLP
Los Angeles, California

TRANSFER AGENT AND REGISTRAR
American Stock Transfer Company
40 Wall Street
New York, NY 10005


COMMON STOCK PRICE RANGE

The Company's Common Shares were traded on NASDAQ from its initial public
offering on July 20, 1983 through February 10, 1987, under the NASDAQ symbol
3CTHU. From February 10, 1987 to August 3, 1993, the Company's Common Shares
were not part of the automated quotations system. 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 range of high and low closing
bid prices of the Company's Common Shares, as furnished by the National
Quotation Bureau, Incorporated and high and low closing prices as furnished by
the American Stock Exchange. Prices have been adjusted to reflect a 2 for l
split distributed October 15, 1993, and a 3 for 2 split distributed on October
16, 1995.

<TABLE>
<CAPTION>
QUARTER ENDED                  HIGH              LOW
----------------------------------------------------
<S>                          <C>             <C>
June 30, 1996                19-1/8          12-1/2
September 30, 1996           19-7/8          15-1/4
December 31, 1996            20-5/8          14-1/8
March 31, 1997                   16          10-5/8
June 30, 1997                    12           5-3/4
September 30, 1997          12-3/16           7-5/8
December 31, 1997           12-5/16           8-7/8
March 31, 1998               9-5/16           6-1/4
</TABLE>


Prices prior to August 3, 1993, represent quotations between dealers without
adjustment for retail markups, markdown or commissions and may not represent
actual transactions. As of June 12, 1998, there were approximately 311
shareholders of record 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:

Senior Vice President
Chad Therapeutics, Inc.
21622 Plummer Street
Chatsworth, CA 91311



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