<PAGE>   1
                                 FORM 10-K/A
                UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                   
CHECK ONE:

  [X]        ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
             EXCHANGE ACT OF 1934 [NO FEE REQUIRED, EFFECTIVE OCTOBER 7, 1996]
                   FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996
                                       OR
  [ ]        TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
             ACT OF 1934 [NO FEE REQUIRED]

                         COMMISSION FILE NUMBER 0-20606

                        CAPSTONE PHARMACY SERVICES, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

                   DELAWARE                                     11-2310352
        (STATE OR OTHER JURISDICTION OF                      (I.R.S. EMPLOYER
        INCORPORATION OR ORGANIZATION)                      IDENTIFICATION NO.)

            2930 WASHINGTON BOULEVARD,             
                BALTIMORE, MARYLAND                                  21230
     (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)                     (ZIP CODE)

       REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (410) 646-7373

           SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:

                                                       NAME OF EACH EXCHANGE
         TITLE OF EACH CLASS                            ON WHICH REGISTERED
         -------------------                           ---------------------

           SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

                     COMMON STOCK, PAR VALUE $0.01 PER SHARE
                                (TITLE OF CLASS)

     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to the
filing requirements for the past 90 days.

                                   X  Yes     No
                                  ---     ---

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

     The aggregate market value of registrant's voting stock held by
non-affiliates of the registrant, computed by reference to the price at which
the stock was sold, or average of the closing bid and asked prices, as of March
25, 1997, was $12.375.

     On March 25, 1997, 34,066,915 shares of the registrant's $0.01 par value
Common Stock were outstanding.

                       DOCUMENTS INCORPORATED BY REFERENCE

     The following documents are incorporated by reference into Part III, Items
10, 11, 12 and 13 of this Form 10-K: Portions of the Registrant's definitive
proxy materials for its 1997 Annual Meeting of stockholders.





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                                     PART I

ITEM 1. BUSINESS

                                    OVERVIEW

     Capstone Pharmacy Services, Inc. ("Capstone" or the "Company") is a leading
provider of institutional pharmacy services to long-term care facilities and
correctional institutions throughout the United States. The Company provides 
long-term care facilities with comprehensive institutional pharmacy services
that include the purchasing, repackaging and dispensing of pharmaceuticals,
infusion therapy, Medicare Part B services, and pharmacy consulting services,
all of which are supported by computerized record keeping and third-party
billing services. Capstone services approximately 115,000 long-term care beds
in 15 states and over 110,000 inmates in correctional facilities nationwide.
The Company serves its long-term care clients primarily through regional
pharmacies most of which are open 24 hours, seven days a week. The Company has
established regional pharmacies in certain large metropolitan areas, each
capable of serving in excess of 10,000 patients. Management believes that the
Company can compete more effectively in metropolitan markets by providing a
broader range of services to its long-term care clients on a more
cost-effective basis than many of its competitors. Management further believes
that Capstone's expanded national presence enables it to compete more
effectively for larger customers who operate multiple facilities, in part by
achieving purchasing efficiencies and other economies of scale. The Company has
developed relationships with several large operators of long-term care
facilities.

     In the correctional business, where it currently is the largest non-captive
provider of pharmacy services in the United States, the Company provides
pharmaceuticals under capitated and other contracts to correctional institutions
that have privatized their inmate health care services. Management believes the
Company's experience in managing capitated correctional contracts, which
involves the utilization of closed formularies, generic substitution, rigorous
drug utilization review and proactive physician education, will provide a
significant competitive advantage as managed care becomes more prevalent in the
long-term care industry.

     In connection with an investment by Counsel Corporation ("Counsel") in
December 1994, the Company installed a new management team, refocused its
operating strategy on its core institutional pharmacy business and initiated an
aggressive acquisition strategy. As a result of these efforts, the Company's net
sales increased to $144 million for the year ended December 31, 1996 from $56
million for the twelve months ended December 31, 1995. Capstone's profitability
also improved during the same time period, with income from continuing
operations before costs relating to pharmacy closures and restructuring charges
of $6.4 million for the year ended December 31, 1996 compared to a loss from
continuing operations of $736,000 for the twelve months ended December 31,
1995. Capstone's strategy is to enhance its position as a leading provider of
institutional pharmacy services by: (i) acquiring institutional pharmacy
companies in metropolitan markets; (ii) achieving regional market density in
order to enhance its operating leverage; (iii) entering preferred provider
agreements with long-term care companies; and (iv) emphasizing



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internal growth through the addition of new clients and the expansion of
ancillary services. Capstone acquired six institutional pharmacy service
companies in 1996, including Symphony Pharmacy Services, Inc. ("Symphony"), a
subsidiary of Integrated Health Services, Inc. ("IHS"). The Symphony
Acquisition increased the number of long-term care beds served by Capstone by
approximately 40,000 and enabled Capstone to enter six new states. In 1996 the
Company entered into preferred provider agreements with 5 long-term care
companies, including IHS, that operate approximately 30,000 beds pursuant to
which the Company has the right to provide certain institutional pharmacy
services to such beds subject to various terms and conditions. Since December
31, 1994, Capstone has increased its long-term care bed count from
approximately 16,200 to approximately 115,000 and the number of inmates served
in correctional institutions from approximately 65,000 to approximately
110,000.


                               RECENT DEVELOPMENTS

ACQUISITIONS

     During October 1996, the Company acquired the assets of the institutional
pharmacy division of Happy Harry's, Inc., a Delaware based provider of pharmacy
services. The division serves approximately 2,500 long-term care beds, with
annualized revenues of approximately $4.0 million.

     During December 1996, the Company acquired the assets of Institutional
Pharmacy, Inc., a Parsons, Tennessee based provider of institutional pharmacy
services. Institutional Pharmacy services approximately 3,700 long-term care
beds, with annualized revenues of approximately $4.6 million.

     During January 1997, the Company acquired by merger both Clinical Care-SNF
Pharmacy, Inc. and Portaro Pharmacies, Inc., providers of institutional pharmacy
services in southern California. These acquisitions solidify the Company's
leadership position in the California market place, adding an aggregate of
approximately 19,000 beds and approximately $30.0 million annualized revenues.

     Also, during January 1997, the Company acquired the stock of Alger Health
Services, Inc., a California based provider of institutional pharmacy services
to nursing homes in the greater San Francisco metropolitan area. Alger services
approximately 3,500 long-term care beds, with annualized revenues of
approximately $8.5 million.

     During March 1997, the Company acquired substantially all of the assets of
Pennsylvania Prescriptions, Inc., an institutional and retail pharmacy business
operating under the name Emerald Drugs in Harrisburg, Pennsylvania. This
acquisition will significantly expand the Company's presence in Pennsylvania,
adding approximately 2,200 beds and approximately $12 million in annualized 
revenues.

      Also, during March 1997, the Company acquired substantially all of the
assets of Pharmacare Inc., a Virginia based provider of institutional pharmacy
services. Pharmacare services approximately 2,000 long-term care beds, with
annualized revenues of approximately $5.5 million.

CREDIT FACILITY

     In December 1996, the Company entered into a revolving $125 million Credit
Facility with a syndicate of banks for which Bankers Trust Company acts as
agent (the "Credit Facility"). Approximately $32 million of the Credit Facility
was used to pay off borrowings under the



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Company's prior credit facility with Creditanstalt-Bankverein. The Credit
Facility provides the Company with a significant additional source of capital
to fund its aggressive acquisition strategy and an additional source of working
capital for servicing new preferred provider agreements.

SUPPLIER AGREEMENTS

     During the fourth quarter 1996, the Company selected McKesson Health
Systems to be the primary supplier of pharmaceuticals. This agreement will lower
drug acquisition cost and will be fully phased in by the end of the first
quarter 1997.


                                   THE COMPANY

INDUSTRY OVERVIEW

     Institutional pharmacies purchase, repackage and dispense pharmaceuticals
primarily to residents of long-term care facilities such as nursing homes,
sub-acute facilities, assisted living facilities and, in certain instances, to
inmates in correctional institutions. Unlike acute care hospitals, most
long-term care facilities do not maintain on-site pharmacies because they do
not generally require a volume of prescribed medications sufficient to make a
pharmacy cost-effective. Prior to the 1970s, the pharmacy needs of long-term
care facilities generally were fulfilled by local retail pharmacies. In
response to increasingly strict nursing home regulations, changes in the
reimbursement environment and the increasing acuity of long-term care patients,
the breadth of pharmacy services required by long-term care facilities has
increased substantially. In addition to providing oral medications, many
institutional pharmacies provide infusion therapy, Medicare Part B services
such as enteral nutrition services and urologic supplies, and pharmacy
consulting services, including monitoring the control and administration of
pharmaceuticals within a facility, assistance in complying with applicable
regulations, therapeutic monitoring and drug utilization review services. The
Company believes that institutional pharmacy companies are best positioned to
meet evolving market demands in the long-term care industry and to assume a
proactive role in influencing the effectiveness and cost of health care.

     Industry analysts estimate that the provision of institutional pharmacy
services is a $4.5 billion industry that is growing approximately 10% per year.
Management believes this growth is being driven by two primary factors: (i) the
increasing number of residents receiving treatment in long-term care or other
institutional settings and (ii) the increasing acuity of residents in
long-term care and correctional institutions. Management believes that several
factors will continue to influence the increase in the number of patients
residing in long-term care settings including the aging of the population,
earlier discharge of patients from acute care settings into lower cost
institutional settings, growth in the number of assisted living beds and a
decreasing



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tendency for families to maintain the role as primary care giver for elderly
relatives. Factors influencing the increase in medications administered to
institutional patients include advances in medical technology, which have
resulted in new drug therapy alternatives, and the increasing acuity of nursing
home and sub-acute patients as a result of quicker discharge following acute
care procedures. Management believes that the average long-term care patient
receives approximately six to eight medications per day.

     The long-term care segment of the institutional pharmacy industry is highly
fragmented, with small retail pharmacies serving approximately 27% of long-term
care facilities, independent institutional pharmacy companies serving
approximately 43% of long-term care facilities and in-house captive pharmacies
serving the remaining 30% of such facilities. Management believes that
consolidation will accelerate as long-term care providers migrate from
traditional retail pharmacies to larger institutional pharmacy companies.
Factors driving consolidation in the institutional pharmacy industry include:

     Economies of Scale. Larger institutional pharmacies are able to leverage
     corporate purchasing agreements to reduce drug costs. Management believes
     that industry-wide drug costs average between 50% and 60% of sales, making
     purchasing efficiencies critical to controlling costs. Industry
     participants purchase the majority of their drug supplies from large drug
     wholesalers, and larger industry participants have greater bargaining power
     to reduce costs associated with such purchases.

     Ability to Provide a Broad Range of Services. As a result of their ability
     to serve multiple facilities from a single location, larger pharmacies
     generally are able to offer more services at a lower cost per bed. These
     services include 24 hours, seven days per week coverage, clinical
     pharmacists, registered nurses and more frequent deliveries.

     Regulatory Expertise and Systems Capabilities. Long-term care facilities
     are demanding more sophisticated and specialized services from pharmacy
     providers due, in part, to increasingly complex government regulations
     requiring enhanced planning, monitoring and reporting capabilities
     regarding patient care. As a result, long-term care administrators seek
     experienced institutional pharmacy providers which offer computerized
     information and documentation systems designed to monitor patient care and
     to assist in controlling facility and payor costs.

SERVICES

     Pharmacy Services. Capstone's core business is providing pharmaceutical
dispensing services to residents of long-term care facilities and correctional
institutions. The Company purchases pharmaceuticals in bulk quantities from
wholesalers and manufacturers and dispenses both prescription and
non-prescription drugs in patient-specific unit dose or blister packages in
accordance with physician orders. Prescription and non-prescription medications
are delivered at least daily to long-term care facilities for administration to
residents by the nursing staffs of such facilities. Capstone's pharmacists
package drugs to meet each patient's needs for either single-day



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or multi-day dosage requirements. Capstone can customize the timing and 
packaging of its delivery system to meet specific client needs.

     Capstone uses an order processing system that enables its long-term care
clients to order pharmaceuticals using either a pre-printed label or monthly
order forms. Clients generally take delivery of routine orders within 24 hours;
however, many of the Company's pharmacies are open 24 hours to provide emergency
service when needed. Once a physician order is received by Capstone, it is
entered into one of the Company's pharmacy computer systems where information is
screened for drug and food interactions, allergies, and refill limitations. Upon
entry, the prescription becomes part of the permanent patient record, and a
label is printed for application to the Company's blister package. The package
label contains specific patient information as well as physician name,
medication, dosage information and cautionary messages. Prior to delivery to the
long-term care facility, the completed prescription with patient-specific label
attached is reviewed by one of the Company's pharmacists and re-verified against
the original order entry data. Following this final quality assurance check, the
prescription is delivered by courier service to the facility.

     As an additional service, the Company furnishes its clients with customized
information from its computerized medical records and documentation system. This
system aggregates and organizes detailed patient medical records, facility drug
usage and monthly management and quality assurance reports. Management believes
this system of client-tailored information management, combined with the
Company's patient-specific unit dose delivery system, results in improved
efficiency and accuracy in the administration of medications and reduces the
likelihood of drug-related adverse consequences.

     In addition to its core long-term care and correctional business, the
Company also provides pharmacy management services to six acute care hospitals
pursuant to management contracts on either a single-year or multi-year basis.

     Pharmacy Consulting Services. Capstone provides value-added consulting
services that help clients comply with federal and state regulations applicable
to long-term care facilities, manage medication costs more effectively and
maximize the efficacy of drug regimens. These pharmacy consulting services
include (i) a review of each patient's medical record and drug regimen to
facilitate the monitoring of potential adverse drug reactions, (ii)
recommendation of therapeutic alternatives, where appropriate, (iii) monthly
evaluation of facility-wide drug usage and drug costs and (iv) maintenance of
drug administration records that assist the long-term care facility with
regulatory compliance.

     Ancillary Services. Capstone provides long-term care facilities with
infusion therapies and Medicare Part B services, including enteral nutrition and
urologic supplies, as well as counseling and assistance with regulatory
compliance in connection with such services. The Company's registered nurses
provide on-site training to client facility staff members in the use of infusion
and enteral supplies and equipment. Prior to the acquisition of MediDyne Corp.
in July 1996 and the Symphony Acquisition in July 1996, ancillary services did
not comprise a material component of Capstone's net sales.



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OPERATIONS

     Organization. Capstone's long-term care operations are divided into five
geographic regions, each headed by a regional vice president. Management
believes this regional organizational structure provides the flexibility to
accommodate continued growth. Capstone believes that the institutional pharmacy
business is dependent in large part on personal service and encourages its
pharmacists to develop personal relationships and to be responsive to local
market demands. The Company uses more centralized financial and inventory
control systems support than typically available to small, independent pharmacy
operators. Additional services performed at the corporate level include quality
improvement oversight, financial and accounting functions, clinical program
development, group purchasing, marketing, acquisitions and corporate 
development activities.

     Pharmacy Distribution Model. In the long-term care business, the Company
typically provides services through regional pharmacies that have the capability
to serve long-term care facilities within a 150-mile radius. These regional
pharmacies are generally open 24 hours, seven days a week and are staffed with
clinical pharmacists, registered nurses and pharmacy technicians. The Company
provides services from 40 pharmacies in 15 states. In the correctional
business, the Company dispenses pharmaceuticals via overnight delivery
primarily from a centralized mail service pharmacy operation located in
Baltimore, Maryland.

     Formulary Management. Capstone utilizes a closed formulary management
system, Capstone Select(SM), in its capitated correctional business. Under the
Company's closed formulary, Capstone pharmacists assist prescribing physicians
in selecting the most appropriate drug among therapeutic alternatives,
including generic substitutions, and in the use of more cost-effective dosage
amounts.

     Management believes that its experience with formulary management in its
correctional business, combined with Symphony's newly established long-term care
formulary program, should enhance Capstone's ability to implement an effective
formulary management system that will be attractive to long-term care providers
and third-party payors.

     Sales & Marketing. The Company's marketing efforts are directed at
long-term care facility operators and providers of health care services to
correctional institutions. While pricing is an important factor in the selection
of pharmacy providers, Capstone's experience is that the primary factor,
particularly among long-term care operators, is the quality and range of
services offered. Consequently, the Company strives to provide high-quality
services that are tailored to each client's needs. Once a relationship is
established, Capstone then attempts to expand the range of services it provides.

     Capstone's marketing efforts are conducted by its regional vice presidents 
with support from local pharmacy managers and regional salespersons. The 
Company's consultant pharmacists and nurse consultants also are integral to the
marketing effort because of their daily contact with the facility managers and
the residents in those facilities.




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     Suppliers. Capstone purchases substantially all of its pharmaceutical
inventories from wholesalers and manufacturers. During the fourth quarter of
1996, Capstone negotiated a new primary wholesaler agreement with terms that are
more favorable to Capstone than its previous contracts. Capstone also has in
place secondary wholesale agreements to minimize its purchasing channels while
maximizing inventory quality and cost savings. Because of readily available
alternatives, Capstone is not dependent on any one supplier.

     Customers. The primary customers of the Company are long-term care
facilities, correctional facilities, and hospitals. The Company is not dependent
on any one customer. The table below sets forth the percentage of revenues from
continuing operations derived from each payor source for the periods presented:

<TABLE>
<CAPTION>
                                 Year Ended           Ten Months Ended            Year Ended      
Payor Source                  December 31, 1996       December 31, 1995       February 28, 1995   
------------                  -----------------       -----------------       -----------------   
<S>                                  <C>                     <C>                     <C>                
Long-Term Care Facilities            81.5%                   63.3%                   59.2%              
Correctional Facilities              12.1                    23.1                    21.1               
Hospital                              6.4                    13.6                     6.8               
Medical/Surgical                      0.0                     0.0                    12.9               
</TABLE>

COMPETITION

     The institutional pharmacy market is highly fragmented and competition
varies significantly from market to market. The Company's competitors include
small retail pharmacies, large chain pharmacies, in-house captive pharmacies and
a small number of national institutional pharmacies. Management believes that
the competitive factors most important in the Company's lines of business are
quality and range of service offered, reputation with referral sources, ease of
doing business with the provider, ability to develop and to maintain
relationships with referral sources and competitive prices. Some of the
Company's present and potential competitors are significantly larger than the
Company and have, or may obtain, greater financial and marketing resources than
the Company. In addition, there are relatively few barriers to entry in the
local markets served by the Company, and it may encounter substantial
competition from local market entrants.

REIMBURSEMENT

     The Company is reimbursed, directly or indirectly, by government-sponsored
programs for a majority of its institutional pharmacy services.

     The Medicaid program is a federal-state cooperative program designed to
enable states to provide medical assistance to aged, blind or disabled
individuals, or to members of families with dependent children whose income and
resources are insufficient to meet the costs of necessary medical services.
State participation in the Medicaid program is voluntary. To become eligible to
receive federal funds, a state must submit a Medicaid "state plan" to the
Secretary of HHS for approval. The federal Medicaid statute specifies a variety
of requirements which the state plan must


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meet, including requirements relating to eligibility, coverage of services,
payment and administration. For residents eligible for Medicaid, the Company
bills the individual state Medicaid program. Medicaid programs are funded
jointly by the federal government and individual states and are administered by
the states. The reimbursement rates for pharmacy services under Medicaid are
determined on a state-by-state basis subject to review by the Health Care
Financing Administration and applicable federal law. Federal regulations and the
regulations of certain states establish "upper limits" for reimbursement for
prescription drugs under Medicaid. Pharmacy services are priced on a
state-by-state basis at the lower of "usual and customary" charges or cost
(which generally is defined as a function of average wholesale price) plus a
fixed dispensing fee which is adjusted to reflect associated costs on an annual
or less frequent basis. State Medicaid programs generally have long-established
programs for reimbursement which have been revised and refined over time and
have not had a material adverse effect on the pricing policies or receivables
collection for long-term care facility pharmacy services. Any future changes in
such reimbursement program or in regulations relating thereto, such as
reductions in the allowable reimbursement levels or the timing of processing of
payments, could adversely affect the Company's business.

     Medicare, a federally-funded health insurance program, consists of two
parts: Medicare Part A, which covers, among other things, pharmaceutical costs
for eligible long-term patients; and Medicare Part B, which covers certain items
and services provided by medical suppliers, including enteral nutrition and
urologic supplies. Medicare Part A requires long-term care facilities to submit
all of their costs for patient care, including pharmaceutical costs, in a
unified bill. Thus, fees for pharmaceuticals provided to Medicare Part A
patients are paid to the Company by the long-term care facility on a monthly
basis. Pricing is consistent with that of private pay residents. Medicare Part A
has a cost-sharing arrangement under which patients must pay a portion of their
costs. These non-covered co-payments are billed by the facility directly to the
residents or the state Medicaid plan, as the case may be.

     Payment for Medicare Part B is based on a fee schedule, which varies
depending on the state in which the patient receiving the items resides, and is
made on a per-item basis directly to the supplier. The Company either bills
Medicare directly for Medicare Part B covered products for each patient or,
alternatively, assists the long-term care facility in meeting Medicare Part B
eligibility requirements and prepares bills on behalf of the facility. Medicare
Part B also has an annual deductible as well as a co-payment obligation on
behalf of the patient, and the portion not covered by Medicare is billed
directly to the patient or appropriate secondary payor.

     The Medicare and Medicaid programs are subject to statutory and regulatory
changes, retroactive and prospective rate adjustments, administrative rulings,
and freezes and funding reductions, all of which may adversely affect the
Company's business. There can be no assurance that payments for pharmaceutical
supplies and services under governmental reimbursement



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programs will continue to be based on the current methodology or remain
comparable to present levels. In this regard, the Company may be subject to rate
reductions as a result of federal budgetary legislation related to the Medicare
and Medicaid programs. In addition, various state Medicaid programs periodically
experience budgetary shortfalls which may result in Medicaid payment delays to
the Company. To date, the Company has not experienced any material adverse
effect due to any such budgetary shortfall.

     In addition, the failure, even if inadvertent, of Capstone and/or its
client institutions to comply with applicable reimbursement regulations could
adversely affect Capstone's business. Additionally, changes in such
reimbursement programs or in regulations related thereto, such as reductions in
the allowable reimbursement levels, modifications in the timing or processing of
payments and other changes intended to limit or decrease the growth of Medicaid
and Medicare expenditures, could adversely affect the Company's business.

     For patients carrying third-party insurance, the patient's individual
insurance plan is billed monthly. For those patients who are ineligible for the
Medicaid and Medicare programs and are not covered by private insurance, the
Company bills the individual or another responsible party monthly based on
prevailing regional market rates or "usual and customary" charges. In New York,
the Company receives the majority of its payments directly from the long-term 
care facilities it serves.

GOVERNMENT REGULATION

     Institutional pharmacies, as well as the long-term care facilities they
serve, are subject to extensive federal, state and local regulation. These
regulations cover required qualifications, day-to-day operations, reimbursement
and the documentation of activities. Capstone continuously monitors the effects
of regulatory activity on its operations.

     States generally require that companies operating a pharmacy within the
state be licensed by the state board of pharmacy. The Company currently has its
pharmacies licensed in each state in which it operates a pharmacy. In addition,
the Company currently delivers prescription drugs from its licensed pharmacies
to many states in which the Company does not operate a pharmacy. Most of these
states regulate the delivery by out-of-state pharmacies of prescription drugs to
patients in such states, and Capstone's pharmacies hold these requisite
licenses. In addition, Capstone's pharmacies are registered with the appropriate
state and federal authorities pursuant to statutes governing the regulation of
controlled substances.

     Long-term care facilities are also required to be licensed in the states in
which they operate and, if serving Medicare or Medicaid patients, must be
certified to be in compliance with applicable program participation
requirements. Long-term care facilities are also subject to state and federal
nursing home regulations which impose strict compliance standards relating to
quality of care for long-term care facilities operations, including extensive
documentation and reporting requirements. In addition, pharmacists, nurses and
other health care professionals who provide services on the


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Company's behalf are in most cases required to obtain and maintain professional
licenses and are subject to state regulation regarding professional standards of
conduct.

     Federal and state laws impose certain repackaging, labeling, and packing
insert requirements on pharmacies that repackage drugs for distribution beyond
the regular practice of dispensing or selling drugs directly to patients at
retail. A drug repackager must be registered with the Food and Drug
Administration. The Company holds all required registration and licenses, and
its repackaging operations are in material compliance with applicable state and
federal requirements.

     The long-term care pharmacy business operates under regulatory and cost
containment pressures from state and federal legislation primarily affecting
Medicaid and, to a lesser extent, Medicare. As is the case for nursing home
services generally, Capstone receives reimbursement from both the Medicaid and
Medicare programs, directly from individual residents (private pay), and from
other payors such as third-party insurers. The Company believes that its
reimbursement mix is in line with long-term care expenditures nationally.

     Federal regulations contain a variety of requirements relating to the
furnishing of prescription drugs under Medicaid. First, states are given broad
authority, subject to certain standards, to limit or specify conditions to the
coverage of particular drugs. Second, federal Medicaid law establishes standards
affecting pharmacy practice. These standards include general requirements
relating to patient counseling and drug utilization review and more specific
requirements for long-term care facilities relating to drug regimen reviews for
Medicaid patients in such facilities. Recent regulations clarify that, under
federal law, a pharmacy is not required to meet the general standards for drugs
dispensed to long-term care facility residents if the long-term care facility
complies with the drug regimen review requirements. However, the regulations
indicate that states may nevertheless require pharmacies to comply with the
general standards, regardless of whether the long-term care facility satisfies
the drug regimen review requirement, and the states in which the Company
operates currently do require its pharmacies to comply therewith. Third, federal
regulations impose certain requirements relating to reimbursement for
prescription drugs furnished to Medicaid patients.

     In addition to requirements imposed by federal law, states have substantial
discretion to determine administrative, coverage, eligibility and payment
policies under their state Medicaid programs which may affect the Company's
operations. For example, some states have enacted "freedom of choice"
requirements which may prohibit a long-term care facility from requiring its
residents to purchase pharmacy or other ancillary medical services or supplies
from particular providers. Such limitations may increase the competition which
the Company faces in providing services to long-term care patients.

     The Company is subject to federal and state laws that govern financial and
other arrangements between health care providers. These laws include the federal
anti-kickback statute and physician self-referral prohibitions. The
anti-kickback statute was originally enacted in 1977 and amended in 1987, and
which prohibits, among other things, knowingly and willfully soliciting,
receiving, offering or paying any remuneration directly or indirectly in return
for or to induce the referral of an individual to a person for the furnishing of
any item or service for which payment may



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be made in whole or in part under Medicare or Medicaid. Many states have enacted
similar statutes which are not necessarily limited to items and services for
which payment is made by Medicare or Medicaid. Violations of these laws may
result in fines, imprisonment, and exclusion from the Medicare and Medicaid
programs or other state-funded programs. Federal and state court decisions
interpreting these statutes are limited, but have generally construed the
statutes to apply if "one purpose" of remuneration is to induce referrals or
other conduct within the statute. In August 1994, the Office of Inspector
General ("OIG") of the Department of Health and Human Services, issued a Special
Fraud Alert regarding prescription drug marketing schemes which it believes may
violate the anti-kickback statute. Among the specific activities identified in
the Fraud Alert were a "product conversion" program in which a drug company
offered cash awards to pharmacies who changed from another company's drug
product to their product. The Fraud Alert also targets marketing programs in
which drug companies offer cash or other benefits to pharmacists in exchange for
marketing tasks in the course of pharmacy practice related to Medicare or
Medicaid.

     The physician self-referral prohibition, commonly referred to as the
"Stark" law, prohibits a physician from referring Medicare or Medicaid patients
to "designated health services" in which the physician (or family member) has a
financial interest, either through ownership or compensation arrangements.
Prohibited referrals will not be reimbursed by Medicare or Medicaid, and the
statute makes it illegal to seek reimbursement from any other source. In
addition, violations may result in fines and/or civil penalties and exclusion
from the Medicare and Medicaid programs. The list of "designated health
services" includes outpatient prescription drugs. Some states have also passed
similar "anti-self referral" legislation. The Company does not believe that the
Stark law or similar state laws, have had, or will have, a significant adverse
impact on the operations of the Company.

     In addition, a number of states have recently undertaken enforcement
actions against pharmaceutical manufacturers involving pharmaceutical marketing
programs, including programs containing incentives to pharmacists to dispense
one particular product rather than another. These enforcement actions arose
under state consumer protection laws which generally prohibit false advertising,
deceptive trade practices, and the like. Further, a number of states involved in
these enforcement actions have requested that the Federal Food and Drug
Administration ("FDA") exercise greater regulatory oversight in the area of
pharmaceutical promotional activities by pharmacists. It is not possible to
determine whether the FDA will act in this regard or what effect, if any, the 
FDA involvement would have on the Company's operations.

     The Company believes its contract arrangements with other health care
providers, its pharmaceutical suppliers and its pharmacy practices are in
compliance with these laws. There can be no assurance that such laws will not,
however, be interpreted in the future in a manner inconsistent with the
Company's interpretation and application.

     Employees. As of March 25, 1997, the Company had approximately 1,363
full-time employees and approximately 539 part-time employees. Management 
believes the company's relationship with its employees is good. None of the
Company's employees are represented by labor unions under any collective
bargaining agreement.



                                       12

<PAGE>   13



ITEM 2. PROPERTIES.

     The following table sets forth certain information regarding significant
properties owned or leased by the Company at December 31, 1996:

<TABLE>
<CAPTION>
                                   SQUARE FEET          EXPIRATION     
        ADDRESS                   (APPROXIMATE)          OF LEASE                       USE
        -------                   -------------        -------------         --------------------------
<S>                                   <C>              <C>                   <C>    
LEASED:

9901 E. Valley Ranch Parkway           7,776           July 1999             Executive Offices
Irving, Texas

2930 Washington Boulevard             63,000           June 2002             Executive Offices and 
Baltimore, Maryland                                                          Pharmacy

414 Alfred Avenue                     23,487           October 1997          Pharmacy
Teaneck, New Jersey                                                                     

700 Washington Blvd.                     198           December 1997         Pharmacy
Baltimore, MD 

5 O'Dell Plaza                         8,300           October 1999          Pharmacy
Yonkers, NY 

</TABLE>




                                       13

<PAGE>   14
<TABLE>
<CAPTION>
                                   SQUARE FEET          EXPIRATION        
        ADDRESS                   (APPROXIMATE)          OF LEASE                      USE
        -------                   -------------        -------------         --------------------------
<S>                                   <C>              <C>                   <C>    
5301 East River Road, #101           13,747            January 31, 2001      Pharmacy
Minneapolis, MN                                                             

2507 Gravel Drive                     9,000            July 31, 1999         Pharmacy
Ft. Worth, TX

4802 Pittsburgh Avenue                5,400            December 15, 2000     Pharmacy
Erie, PA                                               

6250 19th NW 23rd Street              2,750            July 31, 1997         Pharmacy
Gainesville, FL

5350 Alla Road                       21,141            June 30, 2002         Pharmacy
Los Angeles, CA

603 North Eckhoff                     4,800            November 30, 1999     Pharmacy
Orange, CA                                             

3813 Jefferson Highway                5,400            Month to month        Pharmacy
Jefferson, Louisiana

5185 Campus Drive                    11,000            March 22, 2000        Pharmacy
Plymouth Meeting, PA

955 East Fillmore Street              3,250            January 31, 2000      Pharmacy
Colorado Springs, CO
</TABLE>




                                       14

<PAGE>   15
<TABLE>
<CAPTION>
                                   SQUARE FEET          EXPIRATION       
        ADDRESS                   (APPROXIMATE)          OF LEASE                       USE
        -------                   -------------        -------------          --------------------------
<S>                                   <C>              <C>                    <C>    
6576 80th Avenue North                5,000            February 28, 1998      Pharmacy
Pinellas Park, FL                                      

2101 NW 33rd Street                    7,443           February 28, 2000      Pharmacy
1400 A & 1500 A                                        
Pompano Beach, FL

1130 Palmyrita Avenue, #350            6,627           October 31, 2000       Pharmacy
Riverside, CA 

5730 Clark Road                        5,450           January 31, 2000       Pharmacy
Sarasota, FL  

6201 16th Avenue                       4,000           February 28, 1999      Pharmacy
Brooklyn, NY                                   

111 Cedar Lane                         5,000           April 30, 1999         Pharmacy
Englewood, NJ

708 Enterprise Drive                  13,000           January 2006           Pharmacy
Oak Brook, IL

111 Ruthar Drive                      13,600           October 2009           Pharmacy
Newark, DE

325 East Main Street                   8,000           December 1999          Pharmacy
Parsons, TN

153 Stewart Road                       5,312           November 22, 2001      Pharmacy
Wilkes-Barre, PA                                       

10 Bearfoot Road                       9,276           December 1, 2000       Pharmacy
Northborough, MA 

80 Little Falls Road                 13,500            December 31, 2002      Pharmacy
Fairfield, NJ                                          
</TABLE>




                                       15

<PAGE>   16

     The Company considers that, in general, its physical properties are well
maintained, in good operating condition and adequate for their intended
purposes.

ITEM 3.  LEGAL PROCEEDINGS

     A lawsuit, Marvin Levine, Gloria Levine, and John McBay v. Capstone
Pharmacy Services, Inc., Premier Pharmacy, Inc. ("Premier"), and Compuscript, 
Inc., was filed in the Supreme Court of the State of New York, County of
Westchester (No. 19238/95) on November 15, 1995. The plaintiffs sold the stock
of Compuscript, Inc. ("Compuscript") to Premier in 1993 pursuant to the terms
of a purchase agreement (the "Agreement") and claim that Premier, which the
Company has acquired, and Compuscript owe them approximately $1,000,000 under
promissory notes delivered to them as part of the consideration for their
Compuscript stock. Plaintiffs also claim that Compuscript and Premier owe them
an additional $1,100,000 because of the alleged occurrence of certain events
that would give rise to such an obligation under the Agreement. Finally, the
plaintiffs claim the Company is liable for tortiously interfering with their
rights under the Agreement and under the promissory notes. The complaint seeks
total judgments of $7,100,000, plus interest and costs against the defendants.
The defendants, including Capstone, have answered the complaint and are
vigorously contesting the plaintiffs' claims. In addition, Premier has filed a
counterclaim against the plaintiffs for breaches of certain representations and
warranties in the Agreement. Capstone does not believe that this litigation is
likely to have a material adverse effect on the Company's financial position or
results of operations.

     The Company is from time to time subject to claims and suits arising in the
ordinary course of business, including claims for repayment of monies paid to
the Company under Medicare or Medicaid. Although the Company and its
subsidiaries are not parties to any such litigation in which, in management's
opinion, an adverse determination would have a material effect on the Company's
financial position, there can be no assurance that the Company will not become
involved in such litigation in the future.

     Except for the above described proceedings, as of March 25, 1997, there
were no material legal proceedings pending against the Company nor, to the
Company's knowledge, were any material proceedings against it contemplated by
any governmental authority.




                                       16

<PAGE>   17



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

     During the quarter ended December 31, 1996, no matters were submitted to 
a vote of the Company's security holders.

ITEM 5. MARKET FOR COMPANY'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

     The Company's Shares are traded on the NASDAQ National Market System (the
"NASDAQ Stock Market") under the designation "DOSE." The following table
indicates high and low sales quotations for the periods indicated based upon
information supplied by the NASDAQ Stock Market. Such over-the-counter market
quotations reflect inter-dealer prices, without retail mark-up, mark-down or
commission and may not necessarily represent actual transactions:

<TABLE>
<CAPTION>
                                                        BID QUOTATIONS
                                                     --------------------
                                                     HIGH              LOW
TEN MONTHS ENDED DECEMBER 31, 1995(1)                ----              ---
-------------------------------------
<S>                                                 <C>               <C>      
         1st Quarter                                $ 5.00            $2.81
         2nd Quarter                                  5.56             4.00
         3rd Quarter                                  6.94             5.19
         4th Quarter (December only)                  7.88             6.25

YEAR ENDED DECEMBER 31, 1996
------------------------------------
         1st Quarter                                $ 9.25            $7.00
         2nd Quarter                                 13.38             8.50
         3rd Quarter                                 13.63             9.75
         4th Quarter                                 13.13             9.38
</TABLE>

-------------
(1)  Effective December 31, 1995, the Company changed its year end from
     February 28 to December 31.

     As of March 25, 1997, the number of record holders of the Company's shares
was approximately 570, which does not include individual participants in
security position listings. The Company believes that the number of beneficial
owners of the Company's shares exceeds 400, the minimum number required by the
NASDAQ Stock Market. On March 25, 1997, the closing bid quotation for the
Company's common stock was $12.375, as reported by the NASDAQ Stock Market.

     The Company has not paid cash dividends on its common stock and anticipates
that, for the foreseeable future, any earnings will be retained for use in its
business and no cash dividends will be paid. The COMPANY'S LOAN ARRANGEMENTS
PROHIBIT THE PAYMENT OF DIVIDENDS.

     In the past three fiscal years the Company has sold the following
securities without registration under the Securities Act:


<TABLE>
<CAPTION>
 Date         Title                Amount          Purchasers               Consideration
 ----         -----                ------          ----------               -------------
<S>           <C>               <C>                <C>                      <C>
 1/94(1)      $3.50 Warrant        40,000          Equity Group             Services rendered       

12/94(1)      Common Stock      2,000,000          Counsel Corporation      $7.30 million
              $4.50 Warrant     1,000,000       
              $5.50 Warrant       800,000 

 5/95(2)      Common Stock      1,600,000          Private placement to     $5.84 million
              $4.50 Warrant       800,000          various investors
              $5.50 Warrant       640,000          including Counsel
                                                   and Company affiliates

12/95(1)      $7.31 Warrant        15,000          Creditamstalt            Credit Facility adjustment

 8/95(2)      Common Stock      3,500,000          Private placement to     Approximately $15 million
                                                   various investors
                                                   including Counsel and 
                                                   Company affiliates

 1/96(1)      Common Stock      1,007,692          Shareholders of          Sale of business. Stock             
                                                   Geri-Care Systems, Inc.  represented $6.55 million
                                                                            in purchase price consideration

 2/96(1)      $7.50 Warrant        75,000          Shareholder of IMD       Sale of business. Warrant
                                                   Corporation              was part of the 
                                                                            purchase price consideration

 4/96(2)      Common Stock      1,035,000          Equitable Securities     Approximately $9 million
                                                   Corporation acted as
                                                   placement agent to
                                                   various investors

 7/96(1)      Common Stock      2,112,490          IHS                      Sale of business.  
                                                                            Stock represented $25
                                                                            million in purchase price
                                                                            consideration

 7/96(1)      Common Stock      2,112,490          Counsel                  $25 million

 1/97(1)      Common Stock      1,354,402          Shareholder of           Sale of business.
                                                   Clinical Care-SNF        Stock represented $15
                                                                            million in purchase
                                                                            price consideration

 1/97(1)      Common Stock      1,354,402          Shareholder of           Sale of business.
                                                   Portaro Pharmacies       Stock represented $15
                                                                            million in purchase
                                                                            price consideration

 1/97-3/97(1) $12.00 Warrants     213,685          ACA Investors            Issued pursuant to
                                                                            acquisition consulting
                                                                            agreement in connection
                                                                            with various acquisitions

</TABLE>

-----------------
(1) Offering made pursuant to Section 4(2) of the Securities Act in reliance
    upon the limited number of offers and sales and the nature of the
    transaction and the purchaser.

(2) Offering made pursuant to Rule 506 of Regulation D and Section 4(2) of the
    Securities Act in reliance upon criteria set forth in Regulation D.






                                       17

<PAGE>   18




ITEM 6.  SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                              YEAR         TEN MONTHS         YEAR             YEAR              YEAR
                                              ENDED          ENDED            ENDED            ENDED             ENDED
                                           DECEMBER 31,   DECEMBER 31,     FEBRUARY 28,     FEBRUARY 28,      FEBRUARY 28,
                                              1996           1995             1995             1994               1993
                                           ------------   ------------     ----------       ------------      ------------
<S>                                        <C>            <C>              <C>              <C>               <C>         
RESULTS OF OPERATIONS
    Net sales                              $   144,398    $    48,841      $   43,608       $   51,254        $   39,555
    Income (loss) from continuing
    operations                                   3,365           (645)        (10,781)            (521)           (1,351)
    Income (loss) from operations of
    discontinued business segments                                 19            (135)            (340)             (241)
    Gain (loss) on disposal of
    discontinued business segments, net                           565            (503)
    Net income (loss)                            3,125            222         (11,420)            (862)           (1,593)
EARNINGS PER SHARE DATA
Primary:
    Continuing operations                  $      0.15    $     (0.06)     $    (1.67)      $    (0.08)       $    (0.22)
    Discontinued operations                                      0.05           (0.10)           (0.06)            (0.04)
    Extraordinary Item                           (0.01)          0.03
                                           -----------    -----------      ----------       ----------        ----------
    Net income (loss)                      $      0.14    $      0.02           (1.77)      $    (0.14)       $    (0.26)
                                           ===========    ===========      ==========       ==========        ==========
Fully diluted:
    Continuing operations                  $      0.14    $     (0.05)     $    (1.67)      $    (0.08)       $    (0.22)
    Discontinued operations                                      0.05           (0.10)           (0.06)            (0.04)
    Extraordinary item                           (0.01)          0.02
                                           -----------    -----------      ----------       ----------        ----------
    Net income (loss)                      $      0.13    $      0.02      $    (1.77)      $    (0.14)       $    (0.26)
                                           ===========    ===========      ==========       ==========        ==========
Weighted average number of
    common shares outstanding
    Primary                                 22,916,764     11,337,997       6,458,891        6,071,687         6,187,376
                                           ===========    ===========      ==========       ==========        ==========
    Fully Diluted                           23,214,767     12,398,401       6,458,891        6,071,687         6,187,376
                                           ===========    ===========      ==========       ==========        ==========

SUMMARY OF BALANCE SHEETS
    Total Current Assets                   $    80,884    $    21,950      $   11,758       $   15,617        $   17,654
    Total Assets                               271,001         42,131          19,212           24,360            26,717
    Total Current Liabilities                   24,203         11,135           5,848           13,685            16,134
    Total Long-Term Liabilities                 42,053          4,156           8,586            2,358             1,506
    Total Stockholders' Equity                 204,746         26,840           4,778            8,316             9,077
</TABLE>


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

     The following discussion should be read in conjunction with the information
contained in the Consolidated Financial Statements, including the related notes,
and the other financial information incorporated by reference herein.




                                       18

<PAGE>   19


     RISK FACTORS. In connection with the "safe harbor" provisions of the 
Private Securities Litigation Reform Act of 1995, the Company hereby makes
reference to items set forth under the heading "Risk Factors" in the Company's
Registration Statement on Form S-3, as amended (Registration No. 333-08403).
Such cautionary statements identify important facts that could cause the
Company's actual results to differ materially from those projected in forward
looking statements made by or on behalf of the Company in this or any other
section of this annual report on Form 10-K.

GENERAL

     Capstone is a leading provider of institutional pharmacy services to
long-term care facilities and correctional institutions throughout the United
States. The Company provides its long-term care clients with comprehensive
institutional pharmacy services that include (i) the purchasing, repackaging and
dispensing of pharmaceuticals, (ii) infusion therapy and Medicare Part B
services, which are comprised of enteral nutrition and urologic supplies, and
(iii) pharmacy consulting services, all of which are supported by computerized
recordkeeping and third-party billing services. The Company serves its long-term
care clients primarily through regional pharmacies that are open 24 hours, seven
days a week. In the correctional business, the Company provides pharmaceuticals
primarily under capitated contracts at correctional institutions that have
privatized inmate health care services.

     Health care providers are continuing to be challenged to reduce costs while
maintaining the quality of patient care. Management believes that these factors
will result in the continuing consolidations of institutional pharmacy providers
during the new few years. In addition, the Company believes that its strategy of
creating larger regional pharmacies in metropolitan areas will allow it to
reduce the costs of providing services to the residents it serves. The Company
is also developing a formulary and various other clinical programs which it
believes will enhance the quality of patient care while reducing the costs of
providing this care.

     In May 1995, the Company implemented a corporate restructuring plan that
included installation of a new management team, refocusing the Company's
operations on core institutional pharmacy businesses and the initiation of an
aggressive acquisition strategy. In conjunction with the restructuring, the
Company exited certain non-strategic, unprofitable lines of business. The
Company sold its medical/surgical supply operation, closed a long-term care
pharmacy in Missouri, discontinued its long-term care mail order pharmacy
operations and sold its computer software division. The Company took certain
charges and realized certain gains relating to the discontinuation of these
operations.

     During the third quarter of 1996, the Company implemented a restructuring
plan that will consolidate and integrate the Company's recent acquisitions with
existing operations, as well as promote an efficient structure to support
continued growth. Key aspects of this plan include the consolidation of
California, Pennsylvania and Maryland long-term care pharmacies and the closure
of excess facilities. The Company will relocate its corporate headquarters to
Irving, Texas during 1997.

     The acquisition of institutional pharmacy companies has resulted in a
significant change in the Company's financial profile. Since May 1, 1995 the 
Company has completed 12 acquisitions. On a pro forma basis for all
acquisitions, the Company's net sales and net income for the year ended
December 31, 1996, were $276,976,000 and $8,317,000 respectively, compared to
actual net sales of $144,398,000 and $3,125,000 of net income. All of these
acquisitions have been accounted for using the purchase method of accounting,
and as a result the Company will incur significant future amortization expense
associated with goodwill.



                                       19

<PAGE>   20


Fiscal Year Ended December 31, 1996 Compared to the Ten Months Ended December
31, 1995

     NET SALES. Net sales increased to $144,398,000 in 1996 from $48,841,000 in
1995, an increase of $95,557,000 or 196%. This increase is primarily
attributable to the acquisition of Symphony and other institutional pharmacy
businesses during 1996. Additionally, the Company anticipates that continued 
acquisitions of institutional pharmacies will be a significant contributor to
revenue growth in the next few years. Net revenue in 1997 will also be higher
than 1996 as a result of realizing a full year's contribution from businesses
that were acquired during 1996. In addition to growth through acquisitions, the
Company anticipates net revenues will increase in future years as a result of
new contracts, preferred provider agreements and the increase in ancillary
services provided such as infusion therapy and Medicare Part B services.

     COST OF SALES. Cost of sales includes the cost of pharmaceuticals sold to
patients and institutions. Cost of sales increased to $85,532,000 in 1996 from
$30,654,000 in 1995 an increase of $54,878,000 or 179%. The increase in dollar
amount of cost of sales is due to the corresponding increase in revenue levels
for 1996. As a percentage of net sales, cost of sales decreased to 59.2% in 1996
from 62.8% in 1995. This is a result of more favorable reimbursement in the
markets of the acquired companies, the addition of higher margin infusion
therapy, Medicare Part B services and purchasing efficiencies related to
greater purchasing volume. In addition, the Company entered into a new prime
vendor and group purchasing organization agreements during the fourth quarter
of 1996. The Company anticipates that these agreements will result in a further
reduction in the cost of pharmaceuticals purchased in 1997.

     SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses include salaries, benefits, facility and delivery 
expenses and other administrative overhead. Selling, general and administrative
expenses increased to $46,592,000 in 1996 from $17,469,000 in 1995, an increase
of $29,123,000 or 167%. The increase in the amount of selling, general and
administrative expenses during 1996 was due to the six acquisitions finalized
in 1996. As a percentage of net sales, selling, general and administrative
expenses were 31.6% in the 1996 period compared to 35.8% in the 1995 period.
This decrease is a result of the corporate restructuring discussed above and
initial operational synergies achieved through the acquisition of Symphony.

     DEPRECIATION AND AMORTIZATION. Depreciation and amortization increased to $
4,634,000 in 1996 from $1,103,000 in 1995, an increase of $3,531,000 or 320%.
This increase is attributable to assets and goodwill associated with
acquisitions completed during 1996.

     NON-OPERATING EXPENSE. Non-operating expenses include interest, acquisition
financing fees and expenses and other non-operating items. Non-operating
expenses increased to $6,324,000 in


                                       20

<PAGE>   21



1996 from $245,000 in 1995. During 1996, the increase in non-operating expenses
is attributable to one time charges of $4,574,000 related to acquisition
financing fees for the Symphony transaction and increased interest expense
primarily resulting from borrowings related to 1996 acquisitions. The ten 
months ended December 31, 1995 include a gain on the sale of the Company's
medical/surgical business.

     INCOME TAXES. Income taxes in the 1996 and 1995 periods consist of accruals
for estimated state and local incomes taxes based upon apportioned state taxable
income, offset by estimated refundable federal income taxes resulting from the
benefit of net operating loss carryforwards. In 1996, the Company realized a
benefit for income taxes of $5,120,857 which was primarily a result of the
reversal of a deferred tax asset valuation allowance established in prior
periods.

Ten Months Ended December 31, 1995 Compared with the Fiscal Year Ended February
28, 1995

     NET SALES. Net sales for the ten months ended December 31, 1995 were
$48,841,000 compared to $43,608,000 for the fiscal year ended February 28, 1995.
Of this difference, net revenues increased by approximately $13,815,000 due to
the acquisition of Premier. Net sales decreased substantially due to the sale of
the medical/surgical business, partially offset by the addition of new
correctional contracts.

     COST OF SALES. Cost of sales for the ten months ended December 31, 1995 was
$30,654,000 compared to $27,970,000 for the fiscal year ended February 28, 1995.
Of this difference, approximately $8,148,000 was attributable to the Premier
acquisition. As a percentage of net sales, cost of sales for the ten months
ended December 31, 1995 was 62.8% compared to 64.1% for fiscal 1995. The
decrease as a percentage of net sales was primarily due to the sale of the lower
margin medical/surgical supply business. In addition, the Company renegotiated
its purchasing contracts during the 1995 period, lowering its cost of sales.

     SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses for the ten months ended December 31, 1995 were
$17,469,000 compared to $18,637,000 for the fiscal year ended February 28, 1995.
As a percentage of net sales, selling, general and administrative expenses for
the ten months ended December 31, 1995 were 35.8% compared to 42.7% for fiscal
1995. The decrease as a percentage of net sales was due to the sale of the
medical/surgical supply business and reduced costs as a result of the corporate
restructuring discussed above. The Premier acquisition added approximately
$4,800,000 of additional selling, general and administrative expense.

     INTEREST EXPENSE. Net interest expense for the ten months ended 
December 31, 1995 was $677,000 compared to $905,000 for the fiscal year ended
February 28, 1995. This decrease primarily resulted from the reduction of the
Company's debt using proceeds from private placements and the difference
between the ten month and twelve month periods.


                                       21

<PAGE>   22



     OTHER INCOME. Other income for the ten months ended December 31, 1995 was
$432,000 compared to $104,000 for the fiscal year ended February 28, 1995. The
difference primarily resulted from a gain on the sale of assets from the
Company's medical/surgical supply business.

     INCOME TAXES. Benefit for income taxes for the ten months ended December
31, 1995 was $225,000 compared to $466,000 for the fiscal year ended February
28, 1995. The benefit for income taxes for the ten months ended December 31,
1995, primarily resulted from the carry back of a prior year taxable loss to
prior periods.


LIQUIDITY, CAPITAL RESOURCES AND CASH FLOW

     The Company requires capital primarily for the acquisition of institutional
pharmacy companies, to finance its working capital requirements and for the
purchase of equipment for existing pharmacies.

     The Company's net cash flows from operating activities were ($6,899,000),
($3,588,000) and ($1,123,000), respectively, for the year ended December 31,
1996, the ten months ended December 31, 1995, and the year ended February 28, 
1995, respectively. Generally, the cash flows from operating activities in each
of the periods resulted from increased working capital requirements associated
with the Company's acquisitions. During 1996, cash flows from operations were
affected primarily by cash paid for acquisition financing fees related to the
Symphony acquisition of $4,574,000. Net cash from operating activities was
impacted by a $11,420,000 net loss and a $3,500,000 litigation settlement
payment by the Company in the fiscal year ended February 28, 1995. These
capital needs are met through bank financing, and private and public equity
offerings. The continuing availability of capital is crucial to the Company's
future acquisition strategy. There can be no assurance that additional
financing will be available to the Company on terms acceptable to the Company
or at all.

     The Company's net cash flows for investing activities were $(161,106,000),
$(6,559,000) and $9,000 for the year ended December 31, 1996, the ten months
ended December 31, 1995 and the year ended February 28, 1995, respectively. The
Company's net cash to investing activities were primarily impacted by
$158,703,000 related to the acquisition of Geri-Care, IMD, MediDyne, Symphony, 
Happy Harry's and Institutional Pharmacy Services during 1996 and by $4,169,000
of acquisition spending for Premier, and a $2,243,000 advance associated with a
subsequent acquisition during the ten months ended December 31, 1995.



                                       22

<PAGE>   23



     Net cash flows from financing activities were approximately $174,649,000,
$12,364,000 and $1,218,000 for the year ended December 31, 1996, the ten months
ended December 31, 1995 and the year ended February 28, 1995, respectively. Net
cash flows from financing activities were impacted by public and private equity
offerings for net proceeds of $145,048,000, net borrowings of $32,497,000 and
$2,500,000 related to Symphony acquisition financing fees in 1996. Net cash
flows from financing activities in 1995 were impacted by equity offerings for
net proceeds of $21,682,000 and net debt repayments of $8,934,000 in the ten
months ended December 31, 1995.

     During December 1996, the Company entered into a revolving $125 million
credit facility (the "Credit Facility") with a syndicate of banks for which 
Bankers Trust Company acts as agent. Approximately $32,000,000 of the Credit 
Facility was used to retire amounts outstanding under the Company's prior
credit facility. Borrowings under the agreement are secured by substantially
all of the assets of the Company. The Credit Facility bears interest, at the
option of the Company, at (a) Bankers Trust Company's prime rate plus between
0% to .50%, based on the Company's leverage ratio, or (b) the prevailing
Eurodollar rate quoted by Bankers Trust Company, plus between .50% to 1.50%,
based on the Company's leverage ratio. Borrowings under the Credit Facility are
subject to other provisions and covenants, all as defined by the underlying
agreement. The Company incurred an extraordinary loss of approximately 
$240,000 related to the retirement. As of March 25, 1997, the Company had
outstanding borrowings of approximately $81,500,000.00 under the Credit
Facility.

     The Company's current ratio was 3.32:1 at December 31, 1996 and 1.97:1 at 
December 31, 1995. The increased current ratio at December 31, 1996 was due
primarily to an increase in accounts receivable, inventories and prepaid
expenses partially offset by increases in accounts payable, accrued expenses
and other current liabilities, all as a result of acquisitions.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     Financial Statements and Supplementary Data are attached hereto, following
page 26.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

     None.





                                       23

<PAGE>   24
ITEM 10.          DIRECTORS AND EXECUTIVE OFFICERS

         The Company's Directors and Executive Officers are as follows:

<TABLE>
<CAPTION>
                      Name                          Age                             Position
                      ----                          ---                             --------
<S>                                                 <C>                                                   
R. Dirk Allison.................................    41     President, Chief Executive Officer and Director
James D. Shelton................................    42     Executive Vice President, Chief Financial Officer & Secretary
Robert Della Valle..............................    45     Executive Vice President and Chief Operating Officer
Joseph F. Furlong, III(1).......................    48     Director
John Haronian (2)(3)............................    64     Director
Morris A. Perlis (1)............................    48     Vice Chairman
Albert Reichmann(1).............................    68     Director
Allan C. Silber.................................    48     Chairman
Edward Sonshine, Q.C.(2)........................    50     Director
Gail Wilensky, Ph. D. (3).......................    53     Director
John E. Zuccotti(2).............................    59     Director
</TABLE>

(1)   Member of Compensation Committee
(2)   Member of Audit Committee.
(3)   Member of Disinterested Stock Option Plan Committee.

         Mr. Allison has served as President and Chief Executive Officer of the
Company since May 1995. He served as President and Chief Executive Officer of
Premier Pharmacy, Inc., an institutional pharmacy company ("Premier"), from
July 1993 to May 1995. Mr. Allison served as President and Chief Executive
Officer of Allied Pharmacy Management, Inc., a pharmacy company ("Allied"),
from February 1988 to June 1993.

         Mr. Shelton has served as Executive Vice President, Chief Financial
Officer and Secretary of the Company since February 1997. Mr. Shelton served as
Vice President-Chief Financial Officer of Allied from December 1993 to
January 1997. Mr. Shelton served as Vice President-Chief Financial Officer
of Evergreen Healthcare, Inc., a long-term care company, from October 1992 to
December 1993, and as Vice President-Chief Financial Officer of its predecessor,
National Heritage, Inc., from February 1990 to October 1992.

         Dr. Della Valle joined the Company as Executive Vice President and 
Chief Operating Officer in July 1996. Prior to joining the Company, Dr. Della
Valle was President and Chief Executive Officer and Vice President of Allied. He
had been employed by Allied since June 1987 and held the position of President
and Chief Operating Officer from July 1993 to July 1996.

         Mr. Furlong has served as a Director of the Company since December
1994. Mr. Furlong has been President of Adirondack Capital Advisors, L.L.C., a
financial advisory firm since May 1996. He was a partner of Colman Furlong &
Co., a merchant banking firm, from February 1991 to April 1996 and he was a
partner of Robertson Stephens & Company, an investment banking firm from
November 1984 to January 1991. Mr. Furlong has served as a director of American
HomePatient, 


                                      24

<PAGE>   25

Inc., a home health care provider ("American HomePatient"), since June 1994. He
has served as a director of Healthy Planet Products, an environmentally
friendly greeting card manufacturer, since August 1996.


         Mr. Haronian has served as a Director of the Company since January
1994. Mr. Haronian has served as Chairman of Vision World, Inc. and President
of Tri-State Group, since April 1991. Mr. Haronian has served as President of
Peoples Liquor, Inc. since November 1991. From May 1965 until November 1990,
Mr. Haronian served as President of Douglas Drug, Inc.

         Mr. Perlis has been Vice Chairman of the Company since May 1995 and a
Director since December 1994. Mr. Perlis served as interim chief executive
officer of the Company from December 1994 to May 1995. He has served as a
director of and consultant to Counsel, a Canadian corporation primarily engaged
in the health care industry, since September 1992, and as President of Counsel
since January 1994. Mr. Perlis has served as a director of American HomePatient
since March 1993, and as its Chairman since May 1994. He has served as a
director of NOMA, Inc., a manufacturer of consumer wire and cable, since
September 1993. Mr. Perlis was President of Morris A. Perlis & Assoc., an
executive management consulting firm, from September 1992 until January 1994
and President of American Express Canada, Inc. from September 1988 until
September 1992. Mr. Perlis served as interim President of Stadtlander Drug Co.,
Inc., a mail order pharmacy company ("Stadtlander"), from September 1996 to
December 1996. He has served as director of Stadtlander since July 1996 and as
Chief Executive Officer since September 1996.

         Mr. Reichmann has served as a Director of the Company since August
1995. He has served as Chairman and a Director of Olympia & York Developments,
Limited, a privately held Canadian real estate company, for at least five years
prior to February 1993. Mr. Reichmann currently participates in major
philanthropic activities in addition to serving on the boards of several major
hospitals in Canada.

         Mr. Silber has served as Chairman since February 1995 and a director
of the Company since December 1994. Mr. Silber has been Chairman, Chief
Executive Officer and a director of Counsel since August 1979. He served as
President of Counsel from August 1979 until January 1994. Mr. Silber has served
as a director of American HomePatient since September 1991. Mr. Silber served
as chairman of American HomePatient from September 1991 to May 1994. He has
served as director of Stadtlander since July 1996 and as Chairman since
September 1996.



                                      25

<PAGE>   26

         Mr. Sonshine has served as a Director of the Company since December
1994. He has been President and Chief Executive Officer of RioCan Real Estate
Investment Trust of Toronto, Canada since July 1995. Mr. Sonshine has served as
a director of American HomePatient since September 1991. Mr. Sonshine has
served as Vice Chairman of Counsel since January 1994, as a director of Counsel
since August 1979, and as Chairman, President and Chief Executive Officer of
Counsel Management Services, Inc. since October 1993. Mr. Sonshine served as
Executive Vice President of Counsel from February 1987 until January 1994. Mr.
Sonshine served as President and Chief Executive Officer of Icarus Realty Corp.
from February 1987 until September 1993. He has served as a director of
Stadtlander since July 1996.

         Dr. Wilensky has served as a Director since August 1995. She has
served as the John M. Olin Senior Fellow, Project HOPE since January 1993, and
as Chair, Physician Payment Review Commission since May 1995. Dr. Wilensky
served as Deputy Assistant to the President for Policy Development from March
1992 to January 1993. She was Administrator of the Health Care Financing
Administration of the Department of Health and Human Services from January 1990
to March 1992. Dr. Wilensky also serves as a director for Advanced Tissue
Sciences, Coram Healthcare, Neopath Inc., Quest Diagnostics, St. Jude Medical,
Syncor International, SMS Corporation and United Healthcare.

         Mr. Zuccotti has served as a Director of the Company since August 
1995. He has served as Chairman, CEO and President of World Financial
Properties, Inc., a real estate company, since November 1996, and had served as 
President and Chief Executive  Officer of its predecessor company Olympia &
York Companies (U.S.A.), since January 1990. Mr. Zuccotti served as a director
of Olympia & York Companies (U.S.A.) since the inception of a board of
directors in July 1993. He has served as a director of Dreyfus Strategic
Municipal Bond Fund, Inc. since November 1989. Mr. Zuccotti also serves as
director of Dreyfus California Tax Exempt Money Market Fund, Dreyfus Capital
Value Fund, Inc., Dreyfus Insured Municipal Bond Fund, Dreyfus New Leaders
Fund, Inc., Dreyfus Strategic Municipals, Inc., Dreyfus Municipal Bond Fund,
Inc., Dreyfus Municipal Money Market Fund, Inc., and Starrett Housing
Corporation. He also serves on the Board of Trustees of Columbia University.

         Pursuant to a Stock Purchase Agreement by and between Capstone and
Counsel, dated December 16, 1994, so long as Counsel continues to own the
common stock acquired under the Stock Purchase Agreement, Capstone will use its
best efforts to cause the election to its Board of Directors of four (4)
individuals designated by Counsel who are reasonably acceptable to Capstone,
currently Messrs. Silber, Perlis, Sonshine and Furlong. The Stock Purchase
Agreement also specifies that Capstone will use its best efforts to maintain a
Board of Directors consisting of eleven (11) members. Currently Mr. Silber
serves as Chairman of the Board and Mr. Perlis as Vice Chairman.

                      COMPLIANCE WITH SECTION 16(A) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

         Section 16(a) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), requires the Company's executive officers and directors, and
persons who own more than 10% of a registered class of the Company's equity
securities, to file reports of ownership and changes in 


                                       26

<PAGE>   27

ownership with the Securities and Exchange Commission ("SEC") (and, if such
security is registered on a national securities exchange, also with the
exchange). Such executive officers, directors and greater than 10% stockholders
are required by SEC regulations to furnish the Company with copies of all
Section 16(a) forms they file.

         Based solely upon representations submitted by the Company's directors
and executive officers and the Company's review of filings on Forms 3, 4 and 5,
including amendments thereto, the Company has concluded that all such forms
were timely filed.


ITEM 11.  EXECUTIVE COMPENSATION

EXECUTIVE COMPENSATION

         The following table sets forth the compensation for the services in
all capacities to the Company for the fiscal year under December 31, 1996 (the
"1996 Fiscal Year"), the ten months ended December 31, 1995 and fiscal year
ended February 28, 1995 of those persons who were, at any time during the 1996
Fiscal Year, the Company's chief executive officer or, at December 31, 1996,
the Company's other executive officers, and who received annual salary and
bonus in excess of $100,000:


                           SUMMARY COMPENSATION TABLE


<TABLE>
<CAPTION>
                                                                                         LONG-TERM COMPENSATION
                                                                                      --------------------------
                                            ANNUAL COMPENSATION                                AWARDS           
                                            -------------------                       --------------------------
                                                                                                    SECURITIES  
                                                                                      RESTRICTED    UNDERLYING  
        NAME AND                                                  OTHER ANNUAL           STOCK       OPTIONS/   
   PRINCIPAL POSITION      YEAR(S)   SALARY($)      BONUS ($)  COMPENSATION (1)( $)   AWARD(S)($)    SARS  (#)  
------------------------ ----------- -----------  ------------ -------------------- -------------- -------------
<S>                      <C>           <C>         <C>                 <C>               <C>         <C>        
R. Dirk Allison......... Dec 1996(3)   230,000     104,425(4)          -0-               -0-          327,500   
  President and CEO(2)   Dec 1995(3)   123,000        -0-              -0-               -0-           65,000    
                         Feb 1995         *            *                *                 *              *      
                                                                                                                
Robert Della Valle...... Dec 1996       79,719      40,000(4)          -0-               -0-          150,000   
  Chief Operating        Dec 1995         *            *                *                 *              *      
  Officer(5)             Feb 1995         *            *                *                 *              *      
                             
Donald W. Hughes........ Dec 1996(3)   150,000        -0-              -0-               -0-           30,000    
  Former CFO(6)          Dec 1995        9,230        -0-              -0-               -0-           20,000
                         Feb 1995         *            *                *                 *              *      
</TABLE>  
          

<TABLE>
<CAPTION>         
                           --------
                           PAYOUTS
                           -------
        NAME AND          LTIP           ALL OTHER
   PRINCIPAL POSITION    AYOUTS  ($)    COMPENSATION($)
------------------------ ------------  ----------------
<S>                          <C>              <C>
R. Dirk Allison.........     -0-              -0-
  President and CEO(2)       -0-              -0-
                              *                *
                         
Robert Della Valle......     -0-              -0-
  Chief Operating             *                *
  Officer(5)                  *                *
                         
Donald W. Hughes........     -0-              -0-
  Former CFO(6)              -0-              -0-
                              *                *
</TABLE>                 
                         
--------------------------

* Indicates periods prior to employment with the Company.

(1)      Perquisites for each executive officer are in amounts which do not
         require disclosure.
(2)      Mr. Allison joined the Company in May, 1995.
(3)      Represents a ten-month period.
(4)      Earned in 1996 and paid in 1997.
(5)      Mr. Della Valle joined the Company in July, 1996.
(6)      Mr. Hughes resigned in February, 1997.


OPTION GRANTS


                                       27

<PAGE>   28



      The table below provides information on grants of stock options
pursuant to the Company's Option Plans (the "Option Plans") during the 1996
Fiscal Year, to the officers named in the Summary Compensation Table.
Additional grants have been made to certain officers, directors and other
employees since December 31, 1996. See "Security Ownership of Directors,
Executive Officers and Principal Holders". The Company grants no stock
appreciation rights.


          OPTION/SAR GRANTS IN THE FISCAL YEAR ENDED DECEMBER 31, 1996


<TABLE>
<CAPTION>
                                                                                              
                                        INDIVIDUAL GRANTS                                     
                       ---------------------------------------------------                    
                                             PERCENT OF                                          POTENTIAL REALIZABLE VALUE AT
                           NUMBER OF            TOTAL                                            ASSUMED ANNUAL RATES OF STOCK
                          SECURITIES        OPTIONS/SARS                                            PRICE APPRECIATION FOR
                          UNDERLYING         GRANTED TO        EXERCISE OR                             OPTION TERM (1)
                         OPTIONS/SARS       EMPLOYEES IN       BASE PRICE      EXPIRATION       ----------------------------
        NAME             GRANTED (#)         FISCAL YEAR         ($/SH)           DATE               5%   ($)      10%   ($)
---------------------  ----------------- ------------------ ---------------- ---------------    ----------------------------
<S>                         <C>                 <C>               <C>           <C>                <C>              <C>     
R. Dirk Allison              75,000              4.7%              8.50          03/15/06            400,920        1,016,011
                            250,000             15.7%             10.50          11/29/06          1,650,848        4,183,574
                              2,500               *               11.25          12/31/06             17,688           44,824 
                                                                                                                              
Robert Della Valle           50,000              3.1%             10.13          07/30/06            318,535          807,231 
                            100,000              6.3%             10.50          11/29/06            660,339        1,673,430

Donald W. Hughes (2)         25,000              1.6%              8.50          02/02/98            133,640          338,670   
                              5,000                *              10.13          02/02/98             31,854           80,723
</TABLE> 

---------------------

* Less than one percent.

(1)      The dollar amounts under these columns are the result of calculations
         at 5% and 10% rates set by the Securities and Exchange Commission and,
         therefore, are not intended to forecast possible future appreciation,
         if any, of the Company's Common Stock price.

(2)      Mr. Hughes resigned February 2, 1997. 8,333 and 1,667 of the options
         shown in the table remain exercisable by Mr. Hughes following his
         resignation.


                                      28

<PAGE>   29



OPTION EXERCISES AND VALUES

         The table below provides information as to exercises of options by the
executive officers named in the Summary Compensation Table during the 1996
Fiscal Year under the Company's option plans and the year-end value of
unexercised options. The Company grants no stock appreciation rights.

               AGGREGATED OPTION/SAR EXERCISES IN THE FISCAL YEAR
            ENDED DECEMBER 31, 1996 AND PERIOD-END OPTION/SAR VALUES


<TABLE>
<CAPTION>
                                                                      NUMBER  OF SECURITIES       VALUE OF UNEXERCISED
                                                                     UNDERLYING UNEXERCISED           IN-THE-MONEY
                                                                         OPTIONS/SARS AT              OPTIONS/SARS
                                                                        DECEMBER 31, 1996         AT DECEMBER 31, 1996
                                                                       FISCAL YEAR-END (#)      FISCAL  YEAR-END ($)  (1)
                                                                       -------------------      -------------------------
                                    SHARES
                                  ACQUIRED ON          VALUE              EXERCISABLE/                EXERCISABLE/
            NAME                 EXERCISE (#)      REALIZED ($)           UNEXERCISABLE               UNEXERCISABLE
-----------------------------  ----------------  ----------------  --------------------------     ---------------------
<S>                                  <C>               <C>              <C>                         <C>     
R. Dirk Allison                      -0-               -0-              142,499/250,001             $367,587/526,338
Robert Della Valle                   -0-               -0-               33,333/116,667               29,333/121,167
Donald W. Hughes(2)                  -0-               -0-                   16,667/-0-                   61,951/-0-
</TABLE>


--------------------

(1)      Options are classified as "in-the-money" if the fair market value of
         the underlying Common Stock exceeds the exercise price of the option.
         The per share value of such in-the-money options is the difference
         between the option exercise price and $11.38, the per share fair
         market value of the underlying Common Stock as of December 31, 1996.
         Such amounts may not necessarily be realized. Actual values which may
         be realized, if any, upon the exercise of the options will be based on
         the per share market price of the Common Stock at the time of exercise
         and are thus dependent upon future performance of the Common Stock.

(2)      Mr. Hughes resigned February 2, 1997. The number of securities
         underlying options granted to Mr. Hughes prior to his resignation were
         20,000, 25,000 and 5,000 shares issuable upon the exercise of options
         at $6.00, $8.50 and $10.13, respectively. The table sets forth the
         amounts that remain exercisable by Mr. Hughes following his
         resignation.


COMPENSATION COMMITTEE REPORT

         The following Compensation Committee Report is not deemed to be part
of a document filed with the SEC pursuant to the Securities Act of 1933 (the
"Securities Act") or the Exchange Act and is not to be deemed incorporated by
reference in any documents filed under the Securities Act or the Exchange Act
without the express written consent of the persons named below.

         Decisions on compensation of the Company's senior executives, except
for decisions related to awards under the Company's Option Plans, are made by
the Compensation Committee of the Company's Board of Directors. It is the task
of the Compensation Committee to establish executive compensation guidelines
for the Company which are reasonable and appropriate, meet their stated purpose
and effectively serve the needs of the Company and its stockholders.



                                      29

<PAGE>   30



      The current members of the Compensation Committee have met with the
entire Board of Directors in setting the compensation for the current executive
officers and have set forth policies to govern such compensation currently and
in the future. The Committee continues to review all management compensation in
light of these policies.

Compensation Philosophy and Policies for Executive Officers

         The Company's primary business goal is to provide high quality service
while maximizing stockholder value. The Company believes it can best achieve
this goal by achieving leadership in the provision of relevant and high quality
health services, expanding its operations primarily through acquisitions and
internal growth without imperiling the achievement of other strategic
objectives, and establishing a reputation as a desirable employer and
responsible corporate citizen. In late 1995, the Company reviewed and
reformulated its compensation philosophy and policies and has subsequently
followed such philosophy and policies in setting compensation. The Compensation
Committee has continued to review the Company's compensation philosophy and
policies, as well as their effect on individual compensation. The Compensation
Committee seeks to forge a strong link between the Company's business goals and
its compensation program by aligning the interests of its stockholders and
management personnel, including executive officers. The Company's executive
compensation program is intended to be consistent with this overall philosophy
for compensation at all management levels. The Company believes that by
aligning management compensation with the Company's business goal, the
likelihood of the Company's success on both a short-term and long-term basis is
increased.

         The Company's current executive compensation program supports the
Company's strategy and objective of creating stockholder value by:

         -        Emphasizing pay for performance by linking a significant
                  portion of executive compensation to the performance of both
                  the Company and the individual executive officer.

         -        Directly aligning the interest of executives with the
                  long-term interest of stockholders by awarding stock options
                  at current market prices to give value to the executives
                  through long-term stock appreciation.

         -        Providing compensation opportunities that attract and retain
                  talented and committed executives on a long-term basis.

         -        Appropriately balancing the Company's short-term and
                  long-term business, financial and strategic goals.

         Currently, the Company's executive compensation program is comprised
of three principal components: base salary, annual cash incentive (bonus) and
long-term incentive opportunity through stock options. The annual executive pay
targets (base salary plus incentive) are intended to be



                                      30

<PAGE>   31


competitive with executive compensation of other U.S. public health care
companies, particularly institutional pharmacy companies, when the Company
meets or exceeds its annual operating goals.

         The Company attempts to compare its executive pay targets with the
annual pay of other publicly held companies, particularly institutional
pharmacy companies, subject to available information. These other companies
include companies from the Peer Group reflected in the Stock Performance Graph
found elsewhere in this Report. Since the Peer Group is small, however, the
Compensation Committee retains the discretion to compare the Company's
executive pay targets with those of companies outside of this group. The
Compensation Committee also has considered the turnaround situation faced by
current management in setting compensation. The Compensation Committee expects
compensation for the current fiscal year to be below the median even if
incentive targets are reached.

         The Compensation Committee intends to review its compensation packages
in light of the recently announced merger that would combine Capstone with
Pharmacy Corporation of American ("PCA") a subsidiary of Beverly Enterprises,
Inc. The Compensation Committee believes that compensation should meet the
following goals in connection with the proposed merger: incentivise current
management and employees during the interim period prior to the merger; retain
management and employees to participate in managing and operating the combined
entity; and, ultimately, fit with the internal compensation system of the
combined entity.

Base Salary

         All management salaries, including those of the executives, are
evaluated on a regular basis. In making its decision on salary levels, the
Company does not use a predetermined formula. In determining the salaries of
the Company's new executive team, the Company considered past earnings of those
individuals as well as historical Company compensation and the new executives'
potential to contribute to the Company's future. In evaluating appropriate pay
levels and salary increases for Company executives, the Compensation Committee,
without assigning particular weight to any, intends to consider the following
factors: level of responsibility of the executive, individual job performance,
internal salary structure, pay practices of other companies, size of the
Company and achievement of the Company's strategic goals. In the past, salary
ranges have been based primarily on individual job performances and past
earnings.

Annual Cash Incentives

         Annual cash incentive awards are designed to focus management
attention on key operational goals for the current fiscal year. The key
operational goals are specific to each executive's area of responsibility.
Specific weighting is assigned for identified financial, strategic and
management practices goals. At least 50% of the available bonus percentage for
each named executive officer is now tied to Company profitability, generally
defined by achievement of the annual budget as approved by the Board of
Directors. The remaining percentages are based on specific goals set for each
executive, such as quality of care, revenue growth, accounts receivable
management, control



                                      31

<PAGE>   32



expenses and integration of acquisitions. The nature of the operational
goals and the weighting assigned to each is subject to change annually.

         Company executives may earn a bonus of between 20% and 50% of their
annual base salaries based upon achievement of their specific operational goals
and achievement by the Company or business unit of its financial targets. At
the end of the year, performance in light of these goals is determined on an
arithmetic scale with the pre-established weighting. Discretionary adjustments
by the Compensation Committee are possible if the Committee believes the
circumstances so warrant. Bonuses awarded to Messrs. Allison and Della Valle
were $104,425 (45.0% of base compensation) and $40,000 (24.2% of base
compensation), respectively.

Long-Term Incentives

         The Company's long-term incentive compensation program consists of
incentive and nonqualified stock options which are related to improvement in
long-term stockholder value. Stock option grants are designed to focus an
executive's attention on managing the Company from the perspective of long-term
owner with an equity stake in the business. Stock options are granted under the
Option Plans by the Disinterested Stock Option Plan Committee.

         The option grants to executive officers offer the right to purchase
shares of Common Stock at their fair market value on the date of the grant.
These options will have value only if the Company's stock price increases. The
number of shares covered by each grant is selected based on the executive's
level of responsibility and past and anticipated contributions to the Company.

Chief Executive Officer Compensation

         Mr. Allison is the Company's Chief Executive Officer. Generally, the
Chief Executive Officer is eligible to participate in the same executive
compensation plans available to the Company's other senior executive officers.
The Compensation Committee's general approach in setting the Chief Executive
Officer's annual compensation is derived from the same considerations described
above, that is to be competitive with other U.S. publicly held health care
corporations, but also to have a significant portion of annual incentive
compensation based upon specific corporate-wide operating performance criteria.

         The Compensation Committee approved a $230,000 base salary for Mr.
Allison for the 1996 Fiscal Year and established his range of incentive bonus
at between 35-50% of this base salary, or a maximum of $115,000. Mr. Allison's
compensation package was developed primarily based upon his historical
compensation elsewhere and his experience in the industry and with turn-around
situations. According to market data, such base salary and annual incentive
target were below the median of the comparison companies mentioned above and
appropriately within the Company's overall internal pay practices. For the 1996
Fiscal Year, Mr. Allison received a bonus of $104,425. In 1996, stock options
to acquire 325,000 shares of Common Stock were granted to Mr. Allison in
connection with his position as Chief Executive Officer.




                                      32

<PAGE>   33



Tax Regulations

         Section 162(m) of the Internal Revenue Code of 1986, as amended,
generally disallows a tax deduction to public companies for executive
compensation in excess of $1 million. It is not anticipated that the Company
will pay any of its executive officers compensation in excess of $1 million in
the current fiscal year and, accordingly, to date the Company has not adopted a
policy in this regard.

         THE FOREGOING REPORT IS SUBMITTED BY ALL OF THE MEMBERS OF THE
COMPENSATION COMMITTEE OF THE COMPANY'S BOARD OF DIRECTORS, WHOSE
MEMBERS ARE AS FOLLOWS: ALBERT REICHMANN, MORRIS A. PERLIS AND
JOSEPH F. FURLONG, III.

COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION

         The following current directors served on the Compensation Committee
during the 1996 Fiscal Year: Reichmann, Perlis and Furlong. No member of the
Compensation Committee is an employee of the Company.



                                      33

<PAGE>   34



STOCK PERFORMANCE GRAPH

         The stock performance graph depicted below is not deemed to be part of
a document filed with the Securities and Exchange Commission pursuant to the
Securities Act or the Exchange Act and is not to be deemed incorporated by
reference in any documents filed under the Securities Act or the Exchange Act
without the express written consent of the Company.

         The following graph compares the cumulative total returns of the
Company with those of the Nasdaq Market Index and a peer group index.
Cumulative return assumes $100 invested in the Company or respective index on
February 28, 1992, with dividend reinvestment through December 31, 1996. The
Company has selected a peer group known as the DOSE Group as compiled by
Research Data Group. This peer group index is comprised of approximately 7
companies, excluding the Company. These companies are Care Group, Inc., Genesis
Health Ventures Inc., Mednet Mpc Corp, Omnicare Inc., Synetic Inc., Vitalink
Pharmacy Services Inc. and Grancare Inc. Delaware.




                             [GRAPH TO BE INSERTED]








                                      34

<PAGE>   35

                                    [GRAPH]




                                      35
<PAGE>   36
RESEARCH                                             TOTAL RETURN- DATA SUMMARY



                                     DOSE

<TABLE>
<CAPTION>
                                                          Cumulative Total Returns
                                                --------------------------------------------------
                                                2/92   2/93      2/94      2/95     12/95    12/96
<S>                                     <C>     <C>    <C>       <C>       <C>       <C>       <C>
Capstone Pharmacy Svcs Inc              Dose    100    43        40        43        92        140

PEER GROUP                              PPERI   100    82        99        133       179       241

S&P 500                                 1500    100   111       120        129       166       204
</TABLE>



                                      36
<PAGE>   37

         To date, the Company has not directly tied executive compensation to
stock performance. The future impact of stock performance on executive
compensation will be determined by the Compensation Committee.



                                      37

<PAGE>   38



ITEM 12. SECURITY OWNERSHIP OF DIRECTORS, EXECUTIVE OFFICERS AND PRINCIPAL
HOLDERS

         The following table sets forth, as of April 29, 1997, the number and
percentage of shares of the Company's Common Stock owned by (i) all persons
known to the Company to be holders of 5% or more of such securities, (ii) each
director, (iii) each of the executive officers named in the Summary
Compensation Table appearing elsewhere herein, and (iv) all directors and
executive officers of the Company, as of April 29, 1997, as a group. Unless
otherwise indicated, all holdings are of record and beneficial.


<TABLE>
<CAPTION>
                                                                       Number of
                                                                  Shares Beneficially           Percentage of Total
                           Name                                         Owned(1)                   Outstanding(2)
-----------------------------------------------------------       -------------------           -------------------
<S>                                                                     <C>                             <C> 
Counsel Corporation(3).....................................             8,356,815                      23.0%
   Exchange Tower                                                                          
   Two First Canadian Place, Suite 1300                                                    
   Toronto, Ontario, Canada  M5X 1E3                                                       

Integrated Health Services, Inc............................             2,112,490                       6.2
   10065 Red Run Blvd.                                                                     
   Owings Mills, Maryland 21117   

Denis A. and Sandra Lou Portaro Revocable Trust of 1992 and 
Ronald Belville.........................................                2,513,804                       7.4
   2596 Mission Street
   San Marino, California 91108

Northwestern Mutual Life Insurance Co......................               866,300                       5.6
   720 E. Wisconsin Avenue
   Milwaukee, Wisconsin 53202
                                                                                           
Dirk Allison (3)...........................................               225,245                        *
                                                                                           
James D. Shelton...........................................                   -0-                        *
                                                                                           
Robert Della Valle (5).....................................                33,333                        *
                                                                                           
Allan C. Silber (6)........................................               498,333                       1.4
                                                                                           
Morris a. Perlis (6).......................................               498,333                       1.4
                                                                                           
Joseph F. Furlong, III (7,8,12)............................               242,505                        *
                                                                                           
John Haronian (8,10).......................................               145,000                        *
                                                                                           
Edward Sonshine, Q.C.(7,8).................................                77,000                        *
                                                                                           
Gail Wilensky, Ph.D. (9)...................................                17,500                        *
                                                                                           
Albert Reichmann (9).......................................                17,500                        *
                                                                                           
John E. Zuccotti (9,11)....................................                27,000                        *
                                                                                           
All directors and executive officers                                                       
as a group (11 persons)(13)................................             1,781,749                       5.0%
</TABLE>

*  Indicates less than 1%

1        Unless otherwise indicated, the persons or entities identified in this
         table have sole voting and investment power with respect to all shares
         shown as beneficially owned by them, subject to community property
         laws, where applicable.

2        The percentages shown are based on 34,005,266 shares of Common Stock
         outstanding on April 25, 1997, plus, as to each individual and group
         listed, the number of shares of Common Stock deemed to be owned by
         such holder pursuant to Rule 13d-3 under the Securities Exchange Act
         of 1934 (the "Exchange Act"), which includes shares subject to stock
         options and warrants held by such holder which are exercisable within
         sixty (60) days of such date.

3        Includes 1,298,181 and 1,038,545 shares issuable upon the exercise of
         warrants at $4.50 and $5.50 per share, respectively. Directors Silber,
         Sonshine and Perlis are directors of Counsel and director Silber
         beneficially owns or controls approximately 18% of the common stock of
         Counsel, a majority of which is pledged to a lender. Directors
         Sonshine and



                                      38

<PAGE>   39



         Perlis own in the aggregate less than 5% of Counsel's common stock.
         All of the directors listed in this footnote (3) disclaim beneficial
         ownership of shares of Common Stock in their capacity as directors of
         Counsel, and Mr. Silber disclaims beneficial ownership of shares of
         Common Stock in his capacity as a significant stockholder of Counsel.

4        Includes 15,170 and 12,136 shares issuable upon the exercise of
         warrants at $4.50 and $5.50 per share, respectively and 16,666,
         15,000, 50,000, 83,333 and 2,500 shares issuable upon the exercise of
         options at $4.31, $4.44, $8.50, $10.50 and $11.25 per share,
         respectively.

5        Includes 33,333 shares issuable upon the exercise of options at $10.50
         per share.

6        Includes 25,000 and 20,000 shares issuable upon the exercise of
         warrants at $4.50 and $5.50 per share, respectively and 15,000, 2,500,
         250,000, 50,000, 83,333 and 2,500 shares issuable upon the exercise of
         options at $4.44, $7.50, $4.31, $8.50, $10.50 and $11.25 per share,
         respectively.

7        Includes 15,000 and 12,000 shares issuable upon the exercise of
         warrants at $4.50 and $5.50 per share, respectively.

8        Includes 15,000, 2,500 and 2,500 shares issuable upon the exercise of
         options at $4.44, $7.50 and $11.25 per share, respectively.

9        Includes 15,000 and 2,500 shares issuable upon the exercise of options
         at $4.44 and $11.25 per share, respectively.

10       Includes 15,000 and 15,000 shares issuable upon the exercise of
         options at $2.85 and $3.50 per share, respectively, and 25,000 and
         20,000 shares issuable upon the exercise of warrants at $4.50 per
         share, and $5.50 per share, respectively.

11       Includes 2,500 and 2,000 shares issuable upon the exercise of warrants
         at $4.50 and $5.50 per share, respectively.

12       Includes 165,505 shares issuable upon the exercise of warrants at
         $12.00 per share.

13       Includes 1,536,309 shares issuable upon the exercise of options and
         warrants.




                                      39

<PAGE>   40



ITEM 13.  CERTAIN RELATIONSHIP AND RELATED TRANSACTIONS

CERTAIN SERVICES BY NON-EMPLOYEE DIRECTORS

         Since his election to the Board of Directors in December 1994, Mr.
Silber has provided various services to the Company in connection with
improving the financial position, results of operations and capital structure
of the Company. These have included his service as Co-Chairman and Chairman of
the Board of Directors, assistance with routine acquisitions, assistance with
the completion of certain private placements and direction of the replacement
of the Company's bank line of credit. Mr. Silber has received no cash
compensation for such services.

         Since his election to the Board of Directors in December 1994, Mr.
Perlis has provided various services to the Company in connection with the
Company's long term strategy and decisions concerning the retention or
disposition of the Company's lines of business. These have included his service
as Vice Chairman of the Board of Directors and interim Chief Executive Officer,
negotiation of modifications to material contracts and indebtedness of the
Company, assistance with personnel and operational matters, and assistance with
the Company's regulatory compliance program. Mr. Perlis has received no cash 
compensation for such services.

         Set forth below is a summary of various transactions involving the
Company and certain directors, officers, stockholders or other affiliates. It
is the policy of the Company to notify the Board of Directors and seek the
approval of a majority of the members of the Board or an appropriate committee
who are not related to an interested party in connection with transactions
between the Company and a related party.

PRIVATE OFFERINGS BY THE COMPANY

         On July 29, 1996, Counsel purchased from the Company in a private
placement transaction, 2,112,490 shares of common stock at a price of
approximately $11.83 per share for net proceeds to the Company of $25 million.
The proceeds were used as part of the purchase price for the Symphony
acquisition.

         Counsel Corporation beneficially owns approximately 23.0% of the
outstanding Common Stock and voting power of the Company and, as such, is the
Company's largest stockholder. As a result of the Counsel's investment in the
Company, the Company has agreed to use its best efforts to cause four Counsel
nominees to serve on the Company's Board of Directors. As a result of the
foregoing, Counsel has a significant influence on matters brought before the
stockholders or the Board of Directors, although it cannot control the outcome
of any vote.

CONSULTING SERVICES

         Director Furlong is a principal of Adirondack Capital Advisors LLC
("Adirondack"). The Company has entered into an agreement with Adirondack,
dated June 25, 1996 pursuant to which Adirondack will assist the Company in
identifying and negotiating transactions with acquisition



                                      40

<PAGE>   41


targets. Adirondack receives as compensation 3.0% of the first $10.0 million of
aggregate transaction value plus .7% of aggregate transaction value in excess
thereof as well as a number of warrants to buy the Company's common stock set
according to a formula, not to exceed 200,000 in the aggregate, at a strike
price of $12.00. As of April 25, 1997 the Company had issued warrants to
purchase 200,000 shares and had paid approximately $1,109,740 in connection
with this Agreement. An additional $87,000 was earned, but unpaid in connection
with this Agreement.

         Adirondack and the Company have also entered into an agreement, dated
December 10, 1996, pursuant to which Adirondack serves as financial advisor to
the Company in connection with the proposed merger of PCA with and into the
Company. In connection with its services to the Company hereunder, Adirondack
will receive $4.0 million plus a fee for rendering a fairness opinion if the
proposed transaction is consummated.

         An affiliate of Director Reichmann received fees of $445,000 in
connection with the Geri-Care and IMD acquisitions.

         Directors Silber and Perlis received fees of $600,000 and $400,000,
respectively in connection with the Symphony acquisition.

         Curtis B. Johnson, the general counsel of DCAmerica Inc. ("DCA"), a
Counsel Corporation subsidiary, has provided legal services to the Company
since April 1995 pursuant to an agreement between the Company and DCA providing
for reimbursement of DCA's allocable costs related to such services. Mr.
Johnson has options to acquire 25,000 shares of Capstone's common stock for an
exercise price of $4.31 per share.

         Marvin Sirota, a former officer and director of the Company, is
providing consulting services pursuant to a Severance and Consulting Agreement
dated January 15, 1995. Under the Severance and Consulting Agreement, Mr.
Sirota receives $11,607.00 per month through May 31, 1997 plus expenses
incurred in connection with his obligations to the Company.

         Frank Mandelbaum, a former officer and director of the Company, is
providing consulting services pursuant to a Severance and Consulting Agreement
dated January 26, 1995. Under the Severance and Consulting Agreement, Mr.
Mandelbaum receives $11,607.00 per month through May 31, 1997 plus expenses
incurred in connection with his obligations to the Company.

         Charles Lathrop, Jr., a former officer and director of the Company, is
providing consulting services pursuant to a Severance and Consulting Agreement
dated March 8, 1995. Under the Severance and Consulting Agreement, Mr. Lathrop
receives $10,000 per month through April 14, 1997 and $4,583 per month for
twelve months thereafter, plus expenses incurred in connection with his
obligations to the Company.

         For a discussion of the relationships between the Company and its
affiliates, directors, officers and principal stockholders, please see
"Security Ownership of Directors, Executive Officers and Principal Holders,"
and "Directors and Executive Officers."

         It is the policy of the Company to notify the Board of Directors and
seek the approval of a majority of the members of the Board or its Executive
Committee who are not related to Counsel in connection with transactions
between the Company and its affiliates, including Counsel.



                                      41



<PAGE>   42


                                     PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

     (a) (1) & (2) and (d) Financial Statements and Financial Statement
Schedules. See Index to Financial Statements included elsewhere in this Annual
Report.

     (a) (3) and (c) Exhibits. See Index of Exhibits annexed hereto.

     (b) Reports on Form 8-K.

     The Company filed the following reports on Form 8-K dated within
the quarter ended December 31, 1996:

         The Company filed a periodic report on Form 8-K dated October 2, 
         1996, to report pursuant to Item 5 certain unaudited restated 
         quarterly financial data for 1995 to reflect the Company's fiscal 
         year change.



                                      42

<PAGE>   43



                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Company has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

 
                                         CAPSTONE PHARMACY SERVICES, INC.

                                          By: /s/  James D. Shelton
                                              ------------------------------- 
                                                 James D. Shelton,
                                                 Chief Financial Officer
                                                 April 30, 1997

  
     Pursuant to the requirements of the Securities Act of 1934, this report has
been signed below by the following persons on behalf of the registrant and in
the capacities and on the dates indicated.

<TABLE>
<CAPTION>
        SIGNATURE                         TITLE                        DATE
        ---------                         -----                        ----   
<S>                              <C>                               <C> 
        *                        Chief Executive Officer and       April 30, 1997
-----------------------          Director 
R. Dirk Allison                  

/s/ James D. Shelton             Chief Financial Officer           April 30, 1997
-----------------------
James D. Shelton

         *                       Chairman                          April 30, 1997
-----------------------
Allan C. Silber

         *                       Vice Chairman                     April 30, 1997
-----------------------
Morris A. Perlis

         *                       Director                          April 30, 1997
-----------------------
Albert Reichmann


         *                       Director                          April 30, 1997
-----------------------
John E. Zuccotti
</TABLE>

                                      43

<PAGE>   44


<TABLE>
<S>                              <C>                               <C> 

        *                        Director                          April 30, 1997
-----------------------------
Gail Wilensky, Ph.D.

        *                        Director                          April 30, 1997
-----------------------------
Joseph F. Furlong, III

        *                        Director                          April 30, 1997
-----------------------------
John Haronian

        *                        Director                          April 30, 1997
-----------------------------
Edward Sonshine, Q.C.
</TABLE>
*  Signed by James D. Shelton pursuant to a duly granted power-of-attorney



                                      44

<PAGE>   45



                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES
                          INDEX TO FINANCIAL STATEMENTS

(a) 1. Financial Statements:

The following financial statements of the Company are included herein.

<TABLE>
<CAPTION>
                                                                             
                                                                                  PAGE
                                                                                  ----
<S>                                                                               <C>
Report of Independent Public Accountants                                          F-2

Consolidated Balance Sheets - As of December 31, 1996 and 1995                    F-3

Consolidated Statements of Operations - For the year ended December 31, 1996,
  the ten months ended December 31, 1995 and the year ended February 28, 1995     F-5

Consolidated Statements of Changes in Stockholders' Equity - For the year ended
  December 31, 1996, the ten months ended December 31, 1995 and the year ended    
  February 28, 1995                                                               F-6

Consolidated Statements of Cash Flows - For the year ended December 31, 1996,
  the ten months ended December 31, 1995 and year ended February 28, 1995         F-7

Notes to Consolidated Financial Statements                                        F-8
</TABLE>



                                       F-1



<PAGE>   46



                   REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To the Board of Directors and Stockholders
of Capstone Pharmacy Services, Inc. and subsidiaries:

We have audited the accompanying consolidated balance sheets of Capstone
Pharmacy Services, Inc. (a Delaware corporation and formerly Choice Drug
Systems, Inc.) and subsidiaries as of December 31, 1996 and 1995, and the
related consolidated statements of operations, changes in stockholders' equity
and cash flows for the year ended December 31, 1996, the ten months ended
December 31, 1995 and the year ended February 28, 1995. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our 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 consolidated financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the consolidated
financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Capstone Pharmacy
Services, Inc. and subsidiaries as of December 31, 1996 and 1995, and the
results of their operations, changes in stockholders' equity and their cash
flows for the year ended December 31, 1996, the ten months ended December 31,
1995 and the year ended February 28, 1995, in conformity with generally
accepted accounting principles.


/s/ Arthur Andersen LLP

Baltimore, Maryland
  March 14, 1997


                                     F-2
<PAGE>   47
               CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                        AS OF DECEMBER 31, 1996 AND 1995

                                     Assets
<TABLE>
<CAPTION>
                                                                 1996              1995
                                                             ------------      ------------
<S>                                                          <C>               <C>        
Current Assets:
     Cash and cash equivalents                               $  9,407,354      $ 2,763,416

     Accounts receivable, net of allowance
     for doubtful accounts of $5,778,000
     and $1,294,000                                            50,503,619       12,646,087

     Inventories                                               13,541,511        5,023,008

     Refundable income taxes                                         --            828,628

     Prepaid expenses and other current assets                  1,523,194          688,549

     Deferred tax asset                                         5,408,381             --
                                                             ------------      -----------

         Total Current Assets                                  80,384,059       21,949,688

Equipment and leasehold improvements, net                      10,468,963        2,692,298
Goodwill, net of accumulated amortization of
   $4,074,000 and $1,554,000                                  178,778,162       14,580,564
Advances to affiliates                                               --          2,242,841
Other assets                                                    1,369,982          665,204
                                                             ------------      -----------

     Total Assets                                            $271,001,166      $42,130,595
                                                             ============      ===========
</TABLE>




The accompanying notes are an integral part of these consolidated balance sheets



                                       F-3
<PAGE>   48



               CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                        AS OF DECEMBER 31, 1996 AND 1995


                      Liabilities and Stockholders' Equity


<TABLE>
<CAPTION>
                                                     1996          1995
                                                 ------------   -----------
<S>                                              <C>            <C>
Current Liabilities:
   Accounts payable and accrued expenses         $ 18,337,485   $ 6,137,272
   Current portion of long-term debt                3,557,199     4,222,608
   Current portion of non-compete agreements          200,000       200,000
   Accrued restructuring charges                    2,107,846       575,349
                                                 ------------   -----------

      Total Current Liabilities                    24,202,530    11,135,229
                                                 ------------   -----------

Deferred income taxes                                  --           542,787
Non-compete agreements, net of current portion        200,000       400,000
Long-term debt, net of current portion             39,165,739     2,692,202
Restructuring charges, 
   net of current portion                           2,687,068       520,640
                                                 ------------   -----------

      Total Liabilities                            66,255,337    15,290,858
                                                 ------------   -----------

Commitments and Contingencies

Stockholders' Equity
   Common stock $.01 par value; 50,000,000
   shares authorized at December 31, 1996
   and 30,000,000 shares authorized at
   December 31, 1995; 31,134,221 shares
   issued and 30,795,769 outstanding as of
   December 31, 1996 and 13,610,810 issued
   and outstanding as of December 31, 1995            307,957       136,108
   Additional paid-in capital                     213,593,829    38,985,006
   Accumulated deficit                             (9,155,957)  (12,281,377)
                                                 ------------   -----------

      Total Stockholders' Equity                  204,745,829    26,839,737
                                                 ------------   -----------

   Total Liabilities and Stockholders' Equity    $271,001,166   $42,130,595
                                                 ============   ===========
</TABLE>

The accompanying notes are an integral part of these consolidated balance sheets


                                      F-4
<PAGE>   49

               CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS

             For the Year Ended December 31, 1996, the Ten Months
         Ended December 31, 1995, and the Year Ended February 28, 1995

<TABLE>
<CAPTION>
                                                                Year Ended       Ten Months Ended        Year Ended
                                                            December 31, 1996    December 31, 1995    February 28, 1995
                                                            -----------------    -----------------    -----------------
<S>                                                            <C>                  <C>                 <C>                        
Net sales                                                      $144,397,836         $48,841,443         $43,607,946
Cost of sales                                                    85,531,996          30,654,118          27,969,532
                                                               ------------         -----------         -----------
        Gross profit                                             58,865,840          18,187,325          15,638,414
                                                               ------------         -----------         -----------

Operating expenses:
  Selling, general and administrative expenses                   46,591,975          17,468,930          18,637,213
  Depreciation and amortization                                   4,633,787           1,102,892             988,974
  Costs in connection with litigation                                  --                  --             4,389,163
  Costs relating to pharmacy closure                                246,446                --                  --
  Restructuring charges                                           2,825,000             240,000           2,069,432
                                                               ------------         -----------         -----------
        Total operating expenses                                 54,297,208          18,811,822          26,084,782
                                                               ------------         -----------         -----------

         Operating income (loss)                                  4,568,632            (624,497)        (10,446,368)
                                                               ------------         -----------         -----------

Non-operating expense (income):
  Interest expense, net                                           1,899,784             677,009             905,404
  Acquisition financing fees and expenses                         4,573,530                --                  --
  Other income, net                                                (149,206)           (431,900)           (104,076)
                                                               ------------         -----------         -----------
        Total non-operating expense (income), net                 6,324,108             245,109             801,328
                                                               ------------         -----------         -----------

     Loss from continuing operations
         before income taxes, discontinued opera-
         ions and extraordinary items                            (1,755,476)           (869,606)        (11,247,696)
Benefit for income taxes                                         (5,120,857)           (225,082)           (466,214)
                                                               ------------         -----------         -----------

         Income (loss) from continuing operations
         before discontinued operations and
         extraordinary items                                      3,365,381            (644,524)        (10,781,482)

Discontinued operations:
   Gain (loss) from operations of discontinued business
   segments                                                            --                18,667            (135,430)

   Gain (loss) on disposal of business segments, net                   --               564,844            (503,067)
                                                               ------------         -----------         -----------
   Net income (loss) before extraordinary items                   3,365,381             (61,013)        (11,419,979)

Extraordinary items:
Discount on repayment of vendor debt                                                    283,364
Loss on extinguishment of debt, net of 
  tax benefit of $123,616                                          (239,961)               --                  --
                                                               ------------         -----------         -----------
           Net income (loss)                                   $  3,125,420         $   222,351        $(11,419,979)
                                                               ============         ===========         ===========

Earnings (loss) per common and common equivalent share:
Primary
    Continuing operations                                      $       0.15         $     (0.06)        $     (1.67)
    Discontinued operations                                            --                  0.05               (0.10)
    Extraordinary items                                               (0.01)               0.03                --
                                                               ------------         -----------         -----------
           Net income (loss)                                   $       0.14         $      0.02         $     (1.77)
                                                               ============         ===========         ===========

Fully diluted
    Continuing operations                                      $       0.14         $     (0.05)        $     (1.67)
    Discontinued operations                                            --                  0.05               (0.10)
    Extraordinary items                                               (0.01)               0.02                --
                                                               ------------         -----------         -----------
           Net income (loss)                                   $       0.13         $      0.02         $     (1.77)
                                                               ============         ===========         ===========


Weighted average common and common equivalent shares outstanding:

Primary                                                          22,916,764          11,337,997           6,458,891
                                                               ============         ===========         ===========

Fully diluted                                                    23,214,767          12,398,401           6,458,891
                                                               ============         ===========         ===========
</TABLE>

             The accompanying notes are an integral part of these
                           consolidated statements.

                                      F-5
<PAGE>   50
                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES
           CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

           For the Year Ended December 31, 1996, the Ten Months Ended
             December 31, 1995 and the Year Ended February 28, 1995

                                                                  
<TABLE>
<CAPTION>
                                                 Common Stock              Additional    
                                            -----------------------         paid-in           Accumulated
                                             Shares        Amount           capital             deficit
                                            ----------    ---------      -------------        -----------

<S>                                         <C>            <C>           <C>                  <C>                   
Balance, February 28, 1994                  6,086,810      $ 60,868      $   9,339,340       ($ 1,083,749)

Issuance of common stock:
  Stock issued to Counsel Corporation
  in connection with stock purchase
  agreement, net of related issuance
  costs                                     2,000,000        20,000          7,171,300               --

  Stock issued in connection with
  exercise of stock options                    34,000           340             89,410

  Stock issued in connection with
  settlement of litigation                       --            --              600,000               --

Net loss                                         --            --                 --          (11,419,979)
                                           ----------      --------      -------------       ------------
Balance, February 28, 1995                  8,120,810        81,208         17,200,050        (12,503,728)

Issuance of common stock:
  Stock issued in connection with
  private placements, net of related
  issuance costs                            5,100,000        51,000         20,769,231               --

  Stock issued in connection with the
  acquisition of PremierPharmacy Inc.          35,000           350            157,150               --

  Stock issued in connection with
  exercise of stock options                   355,000         3,550            858,575               --

Net income                                       --            --                 --              222,351
                                           ----------      --------      -------------       ------------
Balance, December 31, 1995                 13,610,810       136,108         38,985,006        (12,281,377)

Issuance of common stock:
  Stock issued in connection with
  private placements, net of related
  issuance costs                            3,147,490        31,475         33,350,784               --

  Stock issued in connection with
  settlement of litigation                     98,563           986               (986)              --

  Stock issued in connection with
  the acquisitions of Symphony
  Pharmacy Services, Inc., Geri-Care
  Systems, Inc. and Scripts & Things,
  Inc.                                      2,781,720        27,817         29,469,051               --

  Stock issued in connection with
  conversion of warrants                      685,010         6,850          3,928,401               --

  Stock issued in connection with
  public offering                          10,350,000       103,500        107,235,306               --

  Stock issued in connection with
  exercise of stock options, net              122,166         1,221            626,267

Net income                                       --            --                 --            3,125,420
                                           ----------      --------      -------------       ------------

Balance, December 31, 1996                 30,795,759      $307,957      $ 213,593,829       ($ 9,155,957)
                                           ==========      ========      =============       ============
</TABLE>


The accompanying notes are an integral part of these consolidated statements.

                                     F-6
<PAGE>   51
                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

 For the Year Ended December 31, 1996, the Ten Months Ended December 31, 1995, 
                      and the Year Ended February 28, 1995

<TABLE>
<CAPTION>

                                                                                      Ten Months
                                                                    Year Ended           Ended            Year Ended
                                                                   December 31,       December 31,        February 28,
                                                                       1996              1995                1995
                                                                  -------------       ------------       ------------
<S>                                                               <C>                 <C>                <C>          
CASH FLOWS FROM OPERATING ACTIVITIES:
   Net income (loss)                                              $   3,125,420       $    222,351       $(11,419,979)
   Adjustments to reconcile net income (loss) to net
   cash used in operating activities:
       Depreciation and amortization                                  7,316,345          1,145,669            988,974
       Gain on sale of pharmacies                                      (150,267)              --                 --
       (Gain) loss on disposal of business segments                        --             (564,844)           503,067
       Settlement of litigation                                            --                 --            3,500,000
       Change in assets and liabilities, net of effects of
       acquisitions and dispositions:
          (Increase) decrease in accounts receivable                 (9,938,491)        (2,644,719)         2,161,906
          (Increase) decrease in inventories                           (109,400)           357,029          1,297,829
          Decrease (increase) in refundable income taxes                848,726           (238,168)          (108,699)
          (Increase) decrease in prepaid expenses and
               other current assets                                    (508,342)           (51,870)           779,825
          Increase in deferred tax asset                             (5,408,381)              --                 --
          Increase in other assets                                     (439,468)          (133,629)          (333,011)
          Decrease in accounts payable and accrued expenses          (3,734,342)          (988,497)          (145,061)
          Increase (decrease) in accrued restructuring
          charges                                                     2,098,925           (691,200)         1,652,033
                                                                  -------------       ------------       ------------
   Net cash flows from operating activities                          (6,899,275)        (3,587,878)        (1,123,116)
                                                                  -------------       ------------       ------------

CASH FLOWS FROM INVESTING ACTIVITIES:
       Purchase of equipment and leasehold improvements              (2,643,629)        (1,076,976)          (252,943)
       Proceeds from sale of equipment and leasehold
            improvements                                                230,960               --                 --
       Acquisitions, net of cash acquired                          (158,702,741)        (4,168,872)              --
       Proceeds from sale of business segment                              --              700,000               --
       Advances to affiliates                                              --           (2,242,841)              --
       Repayments of notes receivable                                     9,277            229,571            261,555
                                                                  -------------       ------------       ------------
   Net cash flows from investing activities                        (161,106,133)        (6,559,118)             8,612
                                                                  -------------       ------------       ------------

CASH FLOWS FROM FINANCING ACTIVITIES:
       Net proceeds from commercial bank borrowings                  82,173,525         11,600,000               --
       Net repayments of commercial bank borrowings                 (46,922,852)        (9,650,000)              --
       Net proceeds from acquisition bridge loan                    100,000,000               --                 --
       Net repayments of acquisition bridge loan                   (100,000,000)              --                 --
       Payment of acquisition financing costs                        (2,500,000)              --                 --
       Loan proceeds from affiliate                                        --            1,268,250               --
       Loan repayments to affiliate                                        --           (1,268,250)              --
       Non-compete agreement payments                                  (200,000)          (200,000)              --
       Repayments of other long-term debt                            (2,753,210)       (10,884,850)        (5,902,723)
       Principal payments of capital lease obligations                 (196,224)          (183,992)          (160,183)
       Proceeds from issuance of common stock, net                  145,048,107         21,682,356          7,281,050
                                                                  -------------       ------------       ------------
   Net cash flows from financing activities                         174,649,346         12,363,514          1,218,144
                                                                  -------------       ------------       ------------

Net increase in cash and cash equivalents                             6,643,938          2,216,518            103,640
CASH AND CASH EQUIVALENTS, beginning of period                        2,763,416            546,898            443,258
                                                                  -------------       ------------       ------------
CASH AND CASH EQUIVALENTS, end of period                          $   9,407,354       $  2,763,416       $    546,898
                                                                  =============       ============       ============

Supplemental Disclosure of Cash Flows Information
       Cash paid for:

          Interest                                                $   3,678,922       $    659,184       $    887,691
                                                                  =============       ============       ============

          Taxes                                                   $     181,500       $    144,149       $    224,477
                                                                  =============       ============       ============
</TABLE>


The accompanying notes are an integral part of these consolidated statements.

                                     F-7
<PAGE>   52


              CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES
                                      
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
               DECEMBER 31, 1996 AND 1995 AND FEBRUARY 28, 1995

1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Organization and Business

     Capstone Pharmacy Services, Inc., (formerly known as Choice Drug Systems,
Inc.) together with its subsidiaries (the "Company"), a Delaware Corporation, is
principally engaged in the business of providing pharmaceuticals and related
services to long-term care facilities, correctional institutions, hospitals and
health maintenance organizations.

     On August 28, 1995, the Company changed its state of incorporation from New
York to Delaware. Effective October 2, 1995, the Company changed its name from
Choice Drug Systems, Inc. to Capstone Pharmacy Services, Inc. Additionally,
effective December 31, 1995, the Company changed its year-end from February 28
to December 31.

     As of December 31, 1996, Counsel Corporation, an Ontario corporation
("Counsel"), owned approximately 6,020,000 shares of the Company's common stock
together with warrants to purchase approximately 2,337,000 additional shares.
Counsel is a management and business development company operating primarily in
the United States health care industry.

Principles of Consolidation

     The consolidated financial statements include the accounts of Capstone
Pharmacy Services, Inc. and its wholly-owned subsidiaries. All material
intercompany accounts and transactions have been eliminated.

Use of Estimates

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions. These estimates and assumptions 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,
expenses, gains and losses during the reporting periods. Actual results could
differ from these estimates.

Reclassifications

     Certain prior year amounts have been reclassified to conform to the current
period presentation.


                                     F-8

<PAGE>   53


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Cash and Cash Equivalents

     The Company considers all highly liquid investments purchased with a
maturity of three months or less to be cash equivalents.

Inventories

     Inventories are stated at the lower of cost (first-in, first-out method) or
market. Inventories consist principally of purchased pharmaceuticals.

Equipment and Leasehold Improvements

     Equipment and leasehold improvements are recorded at cost. Depreciation and
amortization are computed using the straight-line method over the following
estimated useful lives or with respect to leasehold improvements, over the term
of the lease if shorter.

        Furniture, fixtures and equipment                   3-10 years
        Automobiles and trucks                              3- 4 years
        Leasehold improvements                              5-10 years
        Equipment under capital leases                      3-5 years

Equipment and leasehold improvements obtained in acquisitions of subsidiaries
are depreciated or amortized based on their remaining useful lives at the
acquisition date.

Goodwill

     Costs in excess of fair values of businesses acquired are recorded as
goodwill and amortized using the straight-line method over periods of twenty to
forty years. Amortization of goodwill amounted to approximately $2,474,000,
$417,000, and $384,000 for the year ended December 31, 1996, the ten months
ended December 31, 1995 and the year ended February 28, 1995, respectively.

401(k) Benefit Plan

     Effective May 22, 1995, employees of the Company may participate in a
supplemental retirement program established under Section 401(k) of the Internal
Revenue Code, as amended. Contributions by the Company may be made to the plan
subject to the discretion of the Board of


                                     F-9

<PAGE>   54


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Directors. No Company contribution was made for the year ended December 31,
1996, or the ten months ended December 31, 1995.

Revenue Recognition

     Revenues are recorded as products are shipped and services rendered. A
portion of the Company's sales are covered by various state and Federal
reimbursement programs, which are subject to review and/or audit. Reimbursement
programs are also subject to change from time to time.

Income Taxes

     The Company files a consolidated Federal income tax return. Income tax
expense is based on reported earnings before income taxes. Deferred taxes on
income are provided for those items for which the reporting period and methods
used for income tax purposes differ from those used for financial statement
purposes, using the asset and liability method. Deferred income taxes are
recognized for the tax consequences of "temporary differences" by applying
enacted statutory rates applicable to future years to differences between the
financial statement carrying amounts and the tax bases of existing assets and
liabilities.

Earnings Per Share

     Net loss per common share for the year ended February 28, 1995, was
computed by dividing the net loss by the average weighted number of common
shares outstanding. For the ten months ended December 31, 1995, and the year
ended December 31, 1996, primary and fully diluted earnings per common share
were computed by dividing net income by the weighted average number of shares of
common stock and common stock equivalents outstanding. The amount of common
stock equivalents outstanding was computed using the treasury stock method.

2. ACQUISITIONS

Acquisitions during the year ended December 31, 1996

     In January 1996, the Company purchased Geri-Care Systems, Inc. and Scripts
& Things, Inc. ("Geri-Care") which provide institutional pharmacy services to
long-term care facilities in the New York metropolitan area. The purchase price
was approximately $6,000,000, payable $1,320,000 in cash and promissory notes,
with the remainder representing 669,230 shares of the Company's common stock. 
The agreement also includes an additional 338,462 shares of the Company's
common stock held in escrow as a contingent incentive payment for certain new

  

                                     F-10

<PAGE>   55


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


business to be generated through 1998 by the selling shareholders of Geri-Care.
Total goodwill at the date of acquisition was $6,259,000.

     In February 1996, the Company purchased IMD Corporation ("IMD") which
provides institutional pharmacy services to long-term care facilities in the
Chicago metropolitan area. The total purchase price was $15,882,000. Total
goodwill at the date of acquisition was $13,146,000.

     In July 1996, the Company acquired DCMed, Inc. and its wholly-owned
subsidiary MediDyne Corporation (collectively, "MediDyne"), a provider of
Medicare Part B services, which consist of enteral nutrition and urologic
supplies, as well as counseling and assistance with regulatory compliance in
connection with such services. The total purchase price was $7,500,000. The
agreement also provides for an earn-out based on the future adjusted earnings 
of the business, payable in cash. Total goodwill at the date of acquisition was
$7,667,000.

     In July 1996, the Company acquired the institutional pharmacy business of
Symphony Pharmacy Services, Inc. ("Symphony"), a subsidiary of Integrated Health
Services, Inc. ("IHS"). Symphony provides institutional pharmacy services,
including infusion therapy and Medicare Part B services, to long-term care
facilities in eight states. The total purchase price was $150,000,000, including
$25,000,000 representing the issuance of 2,112,490 shares of the Company's
common stock. Total goodwill at the date of acquisition was $131,303,000.

     In October 1996, the Company acquired the institutional pharmacy business
of Happy Harry's, Inc., a Delaware based retail drug store operator. The total
purchase price was $3,695,000. Total goodwill at the date of acquisition was
$2,407,000.

     In December 1996, the Company purchased Institutional Pharmacy, Inc., which
provides institutional pharmacy services to long-term care facilities in the
state of Tennessee. The total purchase price was $4,839,000. Total goodwill at
the date of acquisition was $4,068,000.

Acquisitions During the Ten Months Ended December 31, 1995

     In May 1995, the Company acquired PremierPharmacy, Inc. ("Premier"), which
provides pharmacy services to long-term care facilities located in the New York
metropolitan area and hospitals located in the southeastern United States. The
total purchase price was $4,250,000. Total goodwill at the date of acquisition
was $10,494,000.

     All business acquisitions described above have been accounted for by the
purchase method of accounting with the assets and liabilities of the acquirees
recorded at their estimated fair market values at the date of acquisition. The
operations of the acquirees, since the dates of acquisition, are included in the
accompanying consolidated statements of operations. Goodwill for these business
acquisitions is being amortized over twenty to forty years.



                                     F-11
<PAGE>   56


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                       PRO FORMA FINANCIAL INFORMATION

     Unaudited pro forma combined results of operations of the Company for the
year ended December 31, 1996, and the ten months ended December 31, 1995, are
presented below. Such pro forma presentation has been prepared assuming that the
acquisitions described above and in Note 17 have been made as of March 1, 1995
(in thousands, except per share data).


<TABLE>
<CAPTION>
                                             Year Ended         Ten Months Ended
                                          December 31, 1996     December 31, 1995
                                          -----------------     -----------------
                                                        (unaudited)
<S>                                           <C>                    <C>
Net revenues                                  $276,976               $236,224

Gross profit                                   117,524                101,486

Net income before extraordinary                  8,557                  3,013
item

Net income                                       8,317                  2,793

Primary and fully diluted, net
income per share                              $   0.23               $   0.08
                                              ========               ========
</TABLE>


     The unaudited pro forma results include the historical accounts of the
Company and the acquired businesses adjusted to reflect (1) depreciation and
amortization of the acquired identifiable tangible and intangible assets based
on the new cost basis of the acquisitions, (2) the interest expense resulting
from the financing of the acquisitions, (3) the per share effect of stock issued
as part of the acquisition and (4) the related income tax effects. The pro forma
results are not necessarily indicative of actual results which might have
occurred had the operations and management teams of the Company and the acquired
companies been combined in prior years.

  

                                     F-12
<PAGE>   57


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


3. EQUIPMENT AND LEASEHOLD IMPROVEMENTS

     Equipment and leasehold improvements at December 31, 1996 and 1995, are 
comprised of the following:


<TABLE>
<CAPTION>
                                                  1996               1995
                                               ------------      ------------
     <S>                                        <C>               <C>         
     Leasehold improvements                    $     474,546     $    544,272
     Furniture, fixtures and equipment            12,471,101        3,945,149
     Data processing equipment                     2,376,750        1,512,500
     Automobiles and trucks                          290,186          258,379
                                               -------------     ------------
                                                  15,612,583        6,260,300
     Accumulated depreciation and
       amortization                               (5,143,620)      (3,568,002)
                                               -------------     ------------
     Equipment and leasehold improvements,
       net                                     $  10,468,963     $  2,692,298
                                               =============     ============
</TABLE>

     Depreciation and amortization of equipment and leasehold improvements
amounted to approximately $2,160,000, $686,000 and $605,000 for the year ended
December 31, 1996, the ten months ended December 31, 1995 and the year ended
February 28, 1995, respectively.



                                       F-13
<PAGE>   58


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


4. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS

Long term debt at December 31, 1996 and 1995, consisted of the following:

<TABLE>
<CAPTION>
                                                                      1996                        1995
                                                                  -------------               -------------
<S>                                                               <C>                         <C>        
Borrowings under a $125,000,000 revolving credit                  $37,200,000                 $      -
facility with a group of five commercial banks,
interest at varying rates based on the type of
borrowing, secured by substantially all assets of the
Company, due at scheduled maturities through December 2001.

Unsecured note payable to former owners of                          1,651,086                        -
MediDyne, non-interest bearing, payable quarterly
based on MediDyne's financial performance,
due January 1998

Borrowings under a $10,000,000 revolving loan with                        -                    1,950,000
CreditAnstalt, interest at prime plus 0.5% secured by
substantially all assets of the Company, due on
demand

Unsecured note payable to relative of                                 215,319                    297,938
former stockholder, payable in quarterly
installments with interest at 9% through
January 2000

Amounts due under a Medicare settlement                             1,933,330                  2,537,500
with the United States Government,
payable in quarterly installments with
interest at 7.75% through 2001

Unsecured notes payable to former                                   1,000,000                  1,000,000
stockholders of a Premier subsidiary,
interest at 6%, currently payable

Unsecured notes payable to former                                     309,641                    464,752
stockholders of a Premier subsidiary, due
in monthly installments of $14,898,
including interest at 6% through 
October 31, 1998

Unsecured note payable to a former                                        -                      153,334
stockholder of a Premier subsidiary,
interest at 7%, due August 11, 1996
</TABLE>


                                       F-14
<PAGE>   59


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


<TABLE>
<S>                                                     <C>           <C> 
Unsecured notes payable to former                       $    90,000   $   120,000
stockholders of a Premier subsidiary,
interest at 7%, due in annual installments of
$30,000 through June 30, 1999

Capital lease obligations (Note 10)                         316,092       364,844

Other                                                         7,470        26,442
                                                        -----------   -----------
                                                         42,722,938     6,914,810
Less:  Current portion                                   (3,557,199)   (4,222,608)
                                                        -----------   -----------
Long-term portion                                       $39,165,739   $ 2,692,202
                                                        ===========   ===========
</TABLE>

     Future maturities of long-term debt, exclusive of capital lease obligations
at December 31, 1996, follow:

                           1997                       $  3,426,957
                           1998                            757,090
                           1999                            539,480
                           2000                            483,319
                           2001                         37,200,000
                                                       -----------
                                                       $42,406,846
                                                       ===========

     To finance acquisitions, the Company extinguished its outstanding debt
under the revolving loan agreement with CreditAnstalt and replaced it with a
$125,000,000 revolving credit facility through a group of five commercial banks
("new credit facility") on December 6, 1996. Extinguishment of the existing debt
included payoff of the outstanding balance of $31,422,852 and an incurred loss
$239,961, net of tax, resulting from the write-off of unamortized deferred
financing costs. The loss is recorded as an extraordinary item in the
accompanying consolidated statement of operations. The Company incurred
approximately $1,010,000 in debt acquisition costs associated with the new
credit facility, which are to be amortized over the life of the debt.

     Under the new credit facility, the Company has the option to borrow under
base rate and eurodollar rate revolving loans, swing line loans, and letters of
credit. Interest rates on base rate and swing line loans are at the higher of
the prime rate or 0.5% in excess of the federal funds effective rate, plus an
applicable margin based on the Company's leverage ratio at the time of
borrowing. The


                                       F-15
<PAGE>   60


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


swing line loans are also adjusted for a commitment fee percentage tied to the
Company's leverage ratio. Interest on base rate and swing line loans is due
quarterly in arrears. Interest rates on eurodollar rate loans are calculated at
the eurodollar rate plus an applicable margin based on the Company's leverage
ratio at the time of borrowing. Interest is due at the end of the one, two, or
three month interest period elected by the Company. If the Company elects a six
month eurodollar rate loan, interest is payable in arrears at the end of the
third and sixth month. Letter of credit fees are based on the eurodollar loan
margin, plus the greater of 0.25% of the maximum available to be drawn for
letters of credit, as defined in the agreement, or $500, and is to be paid
quarterly in arrears. As of December 31, 1996, the Company's outstanding
borrowings total $37,200,000 under a base rate loan at an effective interest
rate, including the amortization of deferred financing costs, of 8.29%.

     Scheduled reductions of the $125,000,000 maximum balance allowed under the
new credit facility on December 1 of each year are as follows:

                       1997                        $       -
                       1998                           10,000,000
                       1999                           35,000,000
                       2000                           40,000,000
                       2001                           40,000,000
                                                   -------------
                                                   $ 125,000,000
                                                   =============

     The new revolving credit facility is secured by substantially all assets of
the Company and stipulates certain covenants applicable to capital expenditures,
cash consideration on acquisitions, and sale of assets, as well as minimum
financial ratios. As of December 31, 1996, the Company is in compliance with all
debt covenants.

     The average effective interest rate on amounts outstanding under the
CreditAnstalt agreement for the periods outstanding during 1996 and 1995 were
approximately 7.5% and 8.75%, respectively. A letter of credit fee at an 
annual rate of  1.25% was paid on a monthly basis. Amounts available to be
borrowed under this agreement were based upon levels of accounts receivable and
inventories. The weighted average and highest outstanding balance under this
agreement for the period outstanding through December 6, 1996 were $21,581,000
and $31,422,852, respectively.

     In connection with the Symphony acquisition, the Company entered into a
senior subordinated credit facility with a group of lenders pursuant to which
the lenders funded a $100 million bridge loan. The proceeds of the bridge loan
were used to pay a portion of the Symphony acquisition purchase price. The
bridge loan bore interest at a floating interest rate of LIBOR plus 6.01% to
6.25%. In connection with the bridge loan, the Company incurred a commitment fee
of $2,500,000, net of an early loan repayment discount. The bridge loan was
repaid in full by the Company on September 26, 1996, using the proceeds of the
September 1996 public offering.


                                       F-16
<PAGE>   61


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     Included as acquisition financing fees and expenses in the accompanying
consolidated statement of operations is the $2,500,000 commitment fee, bridge
loan interest of approximately $1,813,000 and bridge loan closing costs of
approximately $261,000. In connection with the acquisition of MediDyne (See
Note 2), the Company incurred a $2,900,000 note payable to the former owners of
MediDyne in consideration for the purchase. The note is non-interest bearing
and is to be repaid quarterly based on MediDyne's earnings before taxes,
depreciation and amortization in excess of $600,000. As of December 31, 1996,
the outstanding balance of $1,651,084 is expected by management to be paid
within one year and, therefore, has been included in current portion of
long-term debt in the accompanying consolidated balance sheet.

     On November 1, 1995, the Company elected not to make a scheduled
installment payment on a note payable to former stockholders of a Premier
subsidiary in the aggregate principal amount of $1,000,000, due to a dispute
with these former stockholders. This amount is recorded as current portion of
long-term debt in the accompanying consolidated balance sheets as of December
31, 1996 and 1995.

     On October 31, 1994, the Company entered into an agreement with the United
States Government settling an investigation conducted by the U.S. Attorney for
the Eastern District of Pennsylvania into claims for reimbursement made by
certain of the Company's subsidiaries to the Medicare Program. The subject of
the investigation was the Company's claims documentation and Medicare
reimbursement practices for December 1993 and prior. Under the terms of the
settlement, without admitting any liability, the Company has agreed to repay, as
a return of revenue previously received, over a six-year period, $3,400,000 to
settle the Government's claims. Initially, $100,000 was paid upon the execution
of the agreement and $400,000 was paid on December 31, 1994. Thereafter,
$2,900,000 plus interest at an annual rate of 7.75% is payable in quarterly
installments over a six year period ending January 1, 2001. The full amount of
the settlement, including related legal fees, is included in costs in connection
with litigation in the accompanying consolidated statement of operations for the
year ended February 28, 1995.

     Interest expense for the year ended December 31, 1996, the ten months ended
December 31, 1995, and the year ended February 28, 1995, was approximately
$3,713,000, $677,000 and $905,000 respectively. These amounts include
amortization of deferred financing costs of approximately $183,000, $43,000 and
$0, respectively.

     Based on the borrowing rates currently available to the Company, the fair
value of long term debt, exclusive of capital lease obligations, as of December
31, 1996, is approximately $42,410,000.



                                      F-17
<PAGE>   62


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


5. PUBLIC STOCK OFFERING

     In September 1996, the Company completed an offering of 10,350,000 shares
of common stock to the public at a price of $11.00 per share. Net proceeds of
approximately $107,235,000 were received, net of direct costs of approximately
$6,615,000. Direct costs included the underwriters discount, accounting and
legal fees, printing and marketing expenses and other miscellaneous costs.

6. PRIVATE PLACEMENTS

     In December 1994, the Company entered into a Stock Purchase Agreement with
Counsel. Pursuant to the Stock Purchase Agreement, Counsel acquired 2,000,000
shares of the Company's common stock for net proceeds of approximately
$7,191,000. Counsel was also granted two three-year warrants, the first of which
grants Counsel the right to purchase up to 1,000,000 shares of the Company's
common stock at an exercise price of $4.50 per share, and the second of which
grants Counsel the right to acquire up to 800,000 shares of the Company's common
stock at an exercise price of $5.50 per share.

     In May 1995, the Company completed a private placement of 1,600,000 units
(the "Units"). Each Unit consisted of one share of common stock, a three year
warrant to acquire 0.5 shares of common stock at the exercise price of $4.50 per
share, and a three year warrant to acquire 0.4 shares of common stock at the
exercise price of $5.50 per share. The offering of Units raised proceeds of
approximately $5,759,000, net of related costs, at a price of $3.65 per Unit.
The proceeds of the private placement were used to fund the acquisition of
Premier and to retire the debt to a major vendor in the amount of approximately
$1,776,000, resulting in a gain on the discount of debt of approximately
$283,000. The gain on the discount of debt is reflected in the accompanying
consolidated statement of operations for the ten months ended December 31, 1995,
as an extraordinary item.

     In August 1995, the Company completed a second private placement of its
common stock. This offering consisted of 3,500,000 shares at a price of $4.38
per share. The net proceeds of this private placement were approximately
$15,061,000, net of related costs including placement commissions. There were no
warrants issued in connection with this second private placement. The proceeds
of this private placement were used to retire outstanding debt of $9,650,000 due
to CreditAnstalt and for general working capital purposes.

     In April 1996, the Company completed a third private placement of its
common stock. This offering consisted of 1,035,000 shares at a price of $8.50
per share. The net proceeds of this private placement were $8,400,000, net of
related costs. The proceeds from this private placement were used to fund
acquisitions and provide general working capital for the Company.

     In July 1996, the Company completed a private placement of its common 
stock with Counsel. Counsel acquired 2,112,490 shares of common stock for
proceeds of $25,000,000. The proceeds from this private placement were used to
fund the acquisition of Symphony.



                                      F-18
<PAGE>   63


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


7. RESTRUCTURING CHARGES

     In February 1995, the Company adopted a formal plan of restructuring in
order to realign and consolidate businesses, concentrate resources, and better
position itself to achieve its strategic growth objectives. This plan included
the termination and sale of the medical/surgical supply operations of a wholly
owned subsidiary, B.T. Smith, Inc., and the closing of the Company's long-term
care pharmacy operation in Missouri, Choice Drug Systems of Missouri, Inc., on
June 30, 1995.

     Prior to the closing and ultimate sale of its medical/surgical supply
operations, the Company consolidated the medical/surgical operation of B.T.
Smith, Inc. with the medical/surgical supply division of J & J Drug & Medical
Services, Inc. in its Baltimore, Maryland pharmacy location. Accounting and
administration functions previously based at the Inwood, New York and Teaneck,
New Jersey pharmacy locations were also consolidated and moved to the Baltimore
office location. The effect of this consolidation was to refocus the Inwood and
Teaneck pharmacies on the core long-term care business; to consolidate the
Company's medical/surgical supply business in one location in anticipation of
its sale; and to consolidate accounting functions at the Baltimore headquarters
location. The Company initiated these actions to streamline and reduce the cost
of operating its medical/surgical supply business and its accounting function
and to exit the unprofitable Missouri long-term care market.

     The Company recorded restructuring charges of $2,069,432 for the year ended
February 28, 1995, which includes the write-down of accounts receivable,
inventories and fixed assets to net realizable value and the accrual for the
termination of leases, employee severance costs, and the estimated
administrative costs of terminating operations. Also included in the
restructuring costs are amounts due to former executives of the Company under
consulting agreements which expire in May 1997 and other long-term contractual
obligations related to the restructured business. During the ten months ended
December 31, 1995, the Company recorded, as a change in estimate, an additional
$100,000 write-down of accounts receivable for the medical/surgical supply
operations.

     The net sales and loss from continuing operations of the medical/surgical
supply operations and the Missouri location are as follows:


<TABLE>
<CAPTION>
                                          Ten Months
                                             Ended             Year Ended
                                       December 31, 1995    February 28, 1995
                                       -----------------    -----------------
<S>                                      <C>                  <C>
Net Sales                                $     854,018        $    3,983,533
                                         =============        ==============
Loss from continuing operations          $    (157,218)       $   (2,406,438)
                                         =============        ==============
</TABLE>


                                      F-19
<PAGE>   64


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     In December 1995, the Company adopted a formal plan of restructuring in
order to consolidate certain of its satellite locations. The Company recorded
restructuring costs of $140,000 for the ten months ended December 31, 1995,
which includes the write-down of fixed assets to net realizable value, the
accrual for employee severance costs and the termination of leases.

     In connection with the February 1995 restructuring, the Company made
severance payments of approximately $459,000 and $335,000 and paid other exit
costs of approximately $154,000 and $227,000 during the year ended December 31,
1996 and the ten months ended December 31, 1995, respectively.

     During July 1996, in connection with the Symphony acquisition, the Company
adopted a plan to restructure its long-term care pharmacy operations in Los
Angeles by consolidating two of its existing facilities into a new, more
centralized location. The Company has assumed liabilities, included in the
acquisition cost allocation, of approximately $1,600,000 for costs to
involuntarily terminate employees of Symphony and to close the pharmacy
location.

     During August 1996, the Company adopted a plan of restructuring to
consolidate its Aston, Pennsylvania and Baltimore, Maryland long-term care
pharmacies into one of its existing Mid-Atlantic pharmacies. The Company has
recorded restructuring costs of $450,000 for the year ended December 31, 1996
which includes employee severance costs and the termination of leases.

     Also, during September 1996, the Company adopted a formal plan of
restructuring to close its Baltimore, Maryland corporate offices and
correctional pharmacies. The corporate offices will be relocated to Irving,
Texas and the correctional pharmacy will be relocated to another location in the
Baltimore area. The Company has recorded restructuring costs of $2,375,000 for
the year ended December 31, 1996, which primarily includes employee severance
costs and lease termination costs. The Company made severance payments related
to the corporate office restructuring of approximately $107,000 during the year
ended December 31, 1996.

8. DISCONTINUED OPERATIONS

     In February 1995, in connection with adoption of its formal restructuring
plan, the Company decided to discontinue the operations of its mail order and
computerized health care software businesses. The mail order business was closed
effective August 1, 1995 and the assets of the computerized health care software
business were sold to an unrelated party on June 30, 1995 for $700,000, which
resulted in a gain in the amount of $564,844, net of related income taxes of
$38,000.

     The net gains or losses of these operations for the ten months ended
December 31, 1995 and the year ended February 28, 1995 are included in the
consolidated statements of operations under


                                      F-20
<PAGE>   65


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


gain (loss) from operations of discontinued business segments. The loss on
disposal of $503,067 reflected in the consolidated statement of operations for
the year ended February 28, 1995, includes the write-down of the assets of the
mail order and computer software businesses to estimated net realizable value
and the estimated costs of disposing of these operations, including a pro-rata
share of the Company's expense for office space in Baltimore.

     The Company had net sales from discontinued operations of approximately
$909,000 and $2,731,000 for the ten months ended December 31, 1995 and the year
ended February 28, 1995, respectively.

9. INCOME TAXES

     The benefit for income taxes consisted of the following:

<TABLE>
<CAPTION>

                        Year Ended         Ten Months Ended         Year Ended
                     December 31, 1996     December 31, 1995     February 28, 1995
                     -----------------     -----------------     -----------------
                                                (In Thousands)
<S>                      <C>                    <C>                    <C>
Federal:
         Current         $        -             $  (219)               $  (466)
         Deferred            (5,510)               ( 46)                     -
                         ----------             -------                -------
                             (5,510)               (265)                  (466)
State and local                 389                  40                     -
                         ----------             -------                -------
                         $   (5,121)            $  (225)               $  (466)
                         ==========             =======                =======

</TABLE>


                                      F-21

<PAGE>   66


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     For the year ended December 31, 1996, the Federal benefit for income taxes
is primarily due to the reversal of the valuation allowance recorded on the
Company's deferred tax assets. Based on the current operating profitability of
the Company and budgeted taxable income for 1997, management believes that it
is now more likely than not that the Company's deferred tax assets will be
realized. As a result of this change in estimate, the valuation allowance of
$5,186,000 on deferred tax assets was reversed during the year ended December
31, 1996.

     The actual income tax benefit for the year ended December 31, 1996, the ten
months ended December 31, 1995 and the year ended February 28, 1995 is different
from the amounts computed by applying the statutory Federal income tax rates to
losses from continuing operations before income taxes. The reconciliation of
these differences follow:

<TABLE>
<CAPTION>

                                          Year Ended         Ten Months Ended          Year Ended
                                       December 31, 1996     December 31, 1995      February 28, 1995
                                       -----------------     -----------------      -----------------
                                                              (in thousands)
<S>                                       <C>                   <C>                   <C>        
Tax benefit at statutory  rate            $    (597)            $    (296)            $   (3,824)

Additional funds received                         -                  (219)                     -
  
Increase resulting from:

         State income taxes, net                257                    26                      -
         of federal income tax
         effect

         Current loss not
         available for carryback                  -                   172                  3,206

         Tax effect of
         permanent differences                  276                    68                    152

         Reduction of valuation
         allowance                           (5,186)                    -                      -

         Other items, net                       129                    24                      -
                                          ---------             ---------              ---------

         Benefit for income taxes         $  (5,121)            $    (225)             $    (466)
                                          =========             =========              =========
</TABLE>

     At December 31, 1996, the Company had a net operating loss carryforward of
approximately $16,663,000 for Federal income tax purposes, expiring in
increments through 2011. The utilization


                                      F-22
<PAGE>   67


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


of approximately $11,106,000 of such losses is restricted to offset only
future taxable income generated by Choice Maryland and Premier.

     The tax effect of cumulative temporary differences at December 31, 1996 and
1995 follow:

<TABLE>
<CAPTION>
                                                  1996                    1995
                                              ----------               ---------
                                                        (in thousands)
<S>                                           <C>                      <C>
Current Deferred Tax Assets:                 
Tax carry forwards                            $    5,665               $   4,172
Accounts receivable allowances                        85                     413
Accrued litigation costs                             657                   1,255
Accrued restructuring charges                      1,104                     536
Accrued liabilities                                  440                     280
Other                                              1,178                     254
                                              ----------               ---------
                                                   9,129                   6,910
Less:  Valuation allowance                        (1,724)                 (6,910)
                                              ----------               ---------

  Net deferred tax asset                      $    7,405               $       -
                                              ==========               =========
Deferred Tax Liabilities:
Puerto Rico withholding tax                   $      425               $     425
Goodwill Amortization                              1,330                       -
Depreciation and other                               242                     118
                                              ----------               ---------
  Net deferred tax liability                  $    1,997               $     543
                                              ==========               =========
</TABLE>

10. COMMITMENTS

Leases

     The Company leases office and warehouse space, automobiles and equipment.
Rental expense under these leases aggregated approximately $1,664,000, $781,000,
and $719,000 for the year ended December 31, 1996, the ten months ended December
31, 1995, and the year ended February 28, 1995, respectively.


                                      F-23
<PAGE>   68


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     Future minimum lease payments, follow:

<TABLE>
<CAPTION>
                        Year Ending              Capital         Operating
                        December 31,              Leases           Leases
                       -------------             --------        ----------
         <S>                                     <C>             <C>
                          1997                  $ 157,074        $1,741,995
                          1998                    113,863         1,612,177
                          1999                     74,538         1,411,448
                          2000                     26,788         1,013,377
                          2001                      6,571           933,803
                          2002 and Thereafter          -          1,938,370
                                                ---------        ----------
         Total minimum lease payments             378,834        $8,651,170
                                                                 ==========
         Less:  amount representing interest      (62,742)
                                                ---------
           Present value of net minimum
           lease payments                         316,092
         Less:  current portion                  (130,242)
                                                ---------
         Long-term portion                      $ 185,850
                                                =========
</TABLE>

11. CONTINGENCIES

     A lawsuit has been filed against the Company by the former shareholders of
a subsidiary of Premier. The plaintiffs sold their business to Premier in 1993
and claim that the company owes them approximately $1,000,000 under promissory
notes delivered to them as part of the consideration for their stock. (See Note
4). The plaintiffs also claim that the Company owes them an additional
$1,100,000 under an earn-out agreement. Finally, the plaintiffs claim the
Company is liable for tortiously interfering with their rights under the
purchase agreement and under the promissory notes. The plaintiffs seek total
judgments of $7,100,000, plus interest and costs against the Company. The
Company has answered the complaint and is vigorously contesting the plaintiff's
claims. In addition, the Company has filed a counterclaim against the plaintiffs
for breaches of certain representations and warranties in the agreement.
Management of the Company does not believe that this litigation is likely to
have a material adverse effect on its financial position and results of
operations.

     The Company is subject to various claims and litigation in the ordinary
course of its business. In the opinion of management and outside counsel,
settlement of these claims and litigation will not have a material adverse
effect on the financial position or future operating results of the Company.


                                      F-24
<PAGE>   69


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


12. STOCKHOLDER'S EQUITY

Common Stock Authorized

     On August 28, 1995, the Company's stockholders approved an increase in the
authorized common stock of the Company from 15,000,000 shares to 30,000,000
shares. On September 28, 1996 the Company's stockholders approved an increase in
the authorized common stock of the Company from 30,000,000 shares to 50,000,000
shares.

Stock Option Plans

     The Company has eight stock option plans and an employee stock purchase
plan covering up to 3,029,168 shares of the Company's common stock, pursuant to
which officers, directors and employees of the Company are eligible to receive
either incentive or non-qualified options. Stock options generally expire five
or ten years from the date of grant. The exercise price of an incentive stock
option is equal to the fair market value of the Company's common shares on the
date such option was granted. The exercise price of non-qualified stock options
may be less than the fair market value on the date of grant.

     The Company applies APB Opinion 25 and related interpretations in
accounting for its plans. Accordingly, no compensation expense has been 
recognized for its fixed stock option plans and its stock purchase plan. Had
compensation cost for the Company's stock-based compensation plans been
determined based on the fair value at the grant dates for awards under those
plans consistent with the method of FASB Statement 123, the Company's net
income and earnings per share would have been reduced to the pro forma amounts
indicated below:

<TABLE>
<CAPTION>

                                            Year Ended        Ten Months Ended
                                         December 31, 1996    December 31, 1995
                                         -----------------    -----------------
<S>                                          <C>                 <C>          
Net income:

         As reported                        $ 3,125,420         $   222,351
         Pro forma                           (7,763,229)         (3,155,567)

Primary           Earnings per share:

         As reported                               0.14                0.02
         Pro forma                                (0.34)              (0.28)
</TABLE>


                                      F-25
<PAGE>   70


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


Fully diluted Earnings Per Share:

<TABLE>
<S>                                               <C>             <C>
As reported                                        0.13            0.02
Pro forma                                         (0.33)          (0.25)
</TABLE>

     The fair value of each option grant is estimated on the date of grant using
the Black-Scholes option-pricing model.

     A summary of option transactions during the year ended December 31, 1996,
the ten months ended December 31, 1995 and the year ended February 28, 1995
follow:

<TABLE>
<CAPTION>
                                                   Number of Shares
                             --------------------------------------------------------------
                                                      Ten Months      
                                  Year Ended            Ended                 Year Ended
                             December 31, 1996     December 31, 1995      February 28, 1995
                             -----------------     -----------------      -----------------
<S>                               <C>              <C>                    <C>
Shares under option at            1,564,000           1,094,500                918,500
beginning of period

Granted ($2.86-$11.25)            1,589,000             949,500                564,000

Canceled ($2.85-$6.00)               (1,666)           (125,000)              (354,000)

Exercised ($1.88-$8.50)            (122,166)           (355,000)               (34,000)
                                  ---------           ---------              ---------
Options outstanding at end        3,029,168           1,564,000              1,094,500
of period ($2.85-$11.25)          =========           =========              =========


Shares available for future         856,250             693,750                568,250
grant                             =========           =========              =========


Options exercisable at end        1,828,149           1,289,000                994,500
of period                         =========           =========              =========


Weighted average fair
value of options granted              $6.85               $3.56
                                      =====               =====
</TABLE>


                                      F-26
<PAGE>   71


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     The following table summarizes information about stock options outstanding
at December 31, 1996:

<TABLE>
<CAPTION>
                                         Options Outstanding                       Options Exercisable
                  -----------------------------------------------------        ----------------------------
                                              Weighted
                                               Average         Weighted                            Weighted
   Range of               Number              Remaining         Average              Number        Average
   Exercise            Outstanding           Contractual       Exercise         Exercisable at     Exercise
    Prices        at December 31, 1996          Life            Price          December 31, 1996    Price
    ------        --------------------       -----------       --------        -----------------    ------          
<S>                     <C>                  <C>                <C>               <C>               <C>
$2.85-5.00              1,052,334             7.8 Years         $ 4.10               968,998        $ 4.08
$5.00-$7.50               377,000             5.1 Years         $ 5.65               350,332        $ 5.63
$7.50-$10.00              400,834             9.2 Years         $ 8.45               134,158        $ 8.41
$10.00-$11.25           1,199,000             9.9 Years         $10.48               374,661        $10.55

$2.85-$11.25            3,029,168             8.5 Years         $ 7.39             1,828,149        $ 6.02
</TABLE>




                                      F-27
<PAGE>   72



              CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES
 
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Warrants

     During 1994, in exchange for consulting services, the Company issued
warrants exercisable for 40,000 shares of common stock with an exercise price of
$3.50.

     In August 1995, the company's Board of Directors extended the expiration
date of certain outstanding redeemable warrants issued as part of the Company's
initial public offering (The "IPO Warrants") to March 31, 1996, and subsequently
extended the expiration date to August 23, 1996. During August 1996, the Company
registered the shares underlying its outstanding Series A and B warrants. Series
A warrants representing 643,344 of a total of 650,000 shares of common stock
were exercised before expiring, at an exercise price of $6.00 per share. The
expiration date of the 643,344 Series B Warrants (which are exercisable at
$10.00 per share) issued upon exercise of the IPO Warrants is August 16, 1997.

     In connection with the private placements discussed in Note 5, the Company
issued warrants to purchase 3,240,000 shares of stock at prices ranging from
$4.50 to $5.50 per share. These warrants expire through May 1998.

     In December 1995, as part of their debt agreement, the Company issued
warrants to CreditAnstalt which grants CreditAnstalt the right to purchase
15,000 shares of common stock at a price of $7.31 per share. These warrants
expire in December 2000.

     In January 1996, as part of the acquisition of IMD Corporation, the Company
issued warrants to purchase 75,000 shares of common stock at a price of $7.50
per share. These warrants expire in January 1999.

     Total warrants for 4,132,684 shares were outstanding at December 31, 1996,
including the IPO warrants, warrants issued in connection with private
placements and 100,000 warrants issued in connection with prior acquisitions, at
exercise prices ranging from $4.50 to $12.00 per share. 46,615 (excluding the
Series A warrants) warrants were exercised during the year, at exercise prices
ranging from $3.50 to $5.50 per share.

13. MAJOR VENDOR

     The Company utilizes a primary supplier arrangement for its pharmaceutical
purchases. During both 1995 and 1996, the Company changed its primary supplier.
Purchases of inventory under primary supplier relationships during the year
ended December 31, 1996, the ten months ended December 31, 1995, and the year
ended February 28, 1995, were approximately 82%, 87% and 55% of total inventory
purchases, respectively.


                                      F-28

<PAGE>   73


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


14. ACCOUNTS PAYABLE AND ACCRUED EXPENSES

     Accounts payable and accrued expenses consisted of the following as of
December 31, 1996 and 1995:

<TABLE>
<CAPTION>
                                                         1996                      1995
                                                      -----------              -----------
<S>                                                   <C>                       <C>
Trade accounts payable                                $11,390,194               $4,671,435
Accrued salaries, payroll taxes and benefits            4,172,362                  669,860
Miscellaneous accrued expenses                          2,385,929                  795,977
                                                      -----------               ----------                
                                                      $17,948,485               $6,137,272
                                                      ===========               ==========
</TABLE>

15. RELATED PARTIES

     As a result of the Company's acquisition of Symphony (See Note 2),
Symphony's former parent company, IHS, is a significant Company stockholder. The
Company provides institutional pharmacy services to several long-term care
facilities owned and managed by IHS. Since the Company's acquisition of Symphony
during 1996, net revenues of approximately $8,139,000 have been generated from
sales to IHS owned and managed long-term care facilities. Amounts due from IHS
owned and managed long-term care facilities of approximately $6,983,000 at
December 31, 1996 are included in accounts receivable, net in the accompanying
consolidated balance sheet.

     To facilitate the timely purchase of MediDyne an interim purchase of
MediDyne was made by Counsel Corporation, a significant stockholder of the
Company. The terms of the agreement are described in Note 2.

     The Company entered into arrangements with a company which owns long-term
care facilities in the state of Minnesota to provide pharmacy services and
certain administrative functions in exchange for a monthly management fee. These
management fees, totaling approximately $58,000, have been included in other
income in the accompanying consolidated statement of operations for the year
ended December 31, 1996. In addition, the Company has provided working capital
funding. At December 31, 1996, amounts due of approximately $661,000 are
included in the accompanying consolidated balance sheet.



                                      F-29
<PAGE>   74


                CAPSTONE PHARMACY SERVICES, INC. AND SUBSIDIARIES

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


16. NEW ACCOUNTING STANDARDS

     In March 1995, the Financial Accounting Standards Board issued SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of." SFAS No. 121 requires that long-lived assets and
certain identifiable intangibles to be held and used by an entity be reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. SFAS No. 121 is effective
for financial statements with fiscal years beginning after December 15, 1995.
The adoption of SFAS No. 121 as of January 1, 1996 had no impact on the
Company's financial position or results of operations. 

     In March 1997, the Financial Accounting Standards Board issued SFAS No.
128 "Earnings Per Share." SFAS No. 128 simplifies the standards for computing
earnings per share previously found in APB No. 15, "Earnings Per Share." It
replaces the presentation of primary EPS with a presentation of basic EPS and
requires a reconciliation of the numerator and denominator of the basic EPS
calculation to the numerator and denominator of the diluted EPS calculation.
Basic EPS excludes dilution and is computed by dividing income available to
common stockholders by the weighted average number of common shares outstanding
for the period. Diluted EPS is computed similarly to fully diluted EPS pursuant
to APB Opinion No. 15.

     SFAS No. 128 is effective for fiscal years ending after December 15, 1997,
and early adoption is not permitted. When adopted, it will require restatement
of prior years' EPS. When adopted for the year ended December 31, 1997, the
Company will report basic EPS instead of primary EPS. Basic EPS for the year
ended December 31, 1996 and the ten months ended December 31, 1995 is $0.16 and
$0.02, respectively.

17. SUBSEQUENT EVENTS

     In January 1997, the Company entered into purchase agreements with
Clinical Care-SNF, Inc., Portaro Pharmacies, Inc. and Alger Health Services. 
These three acquisitions expand the Company's presence in the State of 
California and represent institutional pharmacy revenues of approximately
$15,000,000, $15,000,000 and $8,500,000, respectively.

     The purchase price for Clinical Care-SNF, Inc. was $20,000,000, payable 
$5,000,000 in cash and the remainder representing 1,354,402 shares of the 
Company's common stock. The purchase price for Portaro Pharmacies, Inc. was
$20,000,000, payable $5,000,000 in cash and the remainder representing
1,354,402 shares of the Company's common stock. The purchase price for Alger 
Health Services was $4,200,000.

     In March 1997, the Company acquired Pennsylvania Prescriptions, Inc., a
Harrisburg, Pennsylvania institutional and retail pharmacy doing business as
Emerald Drugs. The purchase price was $6,200,000 and includes an earn-out
provision.

     In March 1997, the Company acquired Pharmacare, Inc., a Virginia based
provider of institutional pharmacy services. The purchase price was
approximately $8,500,000.

                                      F-30
<PAGE>   75



                                INDEX OF EXHIBITS
[UPDATE]

<TABLE>
<CAPTION>
Exhibit
Number            Description
------            -----------
<S>      <C>
2.1      Asset Purchase Agreement dated February 29, 1996, by and among IMD 
         Corporation, Dennis Ruben, the Trust, Illinois Pharmacy Acquisition Co. 
         and Capstone Pharmacy Services, Inc. (the "Company") (incorporated by 
         reference to Exhibit 2 to Form 8-K dated February 29, 1996).

2.2      Asset Purchase Agreement among Integrated Health Services, Inc. ("IHS"), 
         Symphony Pharmacy Services, Inc., various of its subsidiaries ("Symphony")
         and the Company, dated June 20, 1996 (incorporated by reference to 
         Exhibit 2 to the Company's Current Report on Form 8-K dated July 18, 1996).

2.3**    Amendments No. 1 to the Asset Purchase Agreement by and between IHS, 
         Symphony and the Company, dated July 30, 1996.

2.4      Stock Purchase Agreement by and between DCAmerica and the Company
         effective July 1, 1996 (incorporated by reference to Exhibit 2.3 to
         Form 10-Q dated September 30, 1996).

2.5      Agreement and Plan of Merger dated January 3, 1997, by and among
         Clinical Care-SNF, Inc., Ron Belville, the Company and Institutional
         Pharmacy Services, Inc. ("IPS") (incorporated by reference to Exhibit 
         2.1 to Form 8-K dated January 31, 1997).

2.6      Agreement and Plan of Merger dated January 3, 1997, by and among Portaro 
         Pharmacies, Inc., Denis Portaro, Sandra Portaro, Denis A. and Sandra Lou 
         Portaro Revocable Trust of 1992, the Company and IPS (incorporated by 
         reference to Exhibit 2.2 to Form 8-K dated January 31, 1997).

2.7**    Stock Purchase Agreement among Alger Health Services, Inc., IPS
         and the Company, dated January 24, 1997.

2.8**    Asset Purchase Agreement between Pennsylvania Prescriptions, Inc. d/b/a 
         Emerald Drug Store, dated March 6, 1997.

2.9**    Asset Purchase Agreement by and between Pharmacare, Inc. and IPS,
         dated March 24, 1997.

3.1      Certificate of Incorporation of Choice Drug Systems, Inc. (incorporated
         by reference to Exhibit 3.1 to Form 10-Q for period ending August 30, 1995).

3.2      Certificate of Ownership and Merger Merging Choice Mergeco, Inc. into 
         Choice Drug Systems, Inc. (incorporated by reference to Exhibit 3.2 to 
         Form 10-Q for period ending August 30, 1995).
</TABLE>



<PAGE>   76


<TABLE>
<S>      <C>
3.3      Certificate of Amendment (incorporated by reference to Exhibit A to the
         Company's Proxy Statement for Special Meeting of Stockholders on August
         15, 1996).

3.4      Bylaws of Choice Drug Systems, Inc. (incorporated by reference to 
         Exhibit 3.3 to Form 10-Q for period ending August 30, 1995).

4.1      Form of Series B Warrant Certificate (incorporated by reference to 
         Exhibit 4.1 to the Registrant's Registration Statement on Form S-3
         (Reg. No. 3643).

4.2      Form of Series B Warrant Agreement, dated as of August 7, 1996, between
         the Registrant and First Union National Bank of North Carolina
         (incorporated by reference to Exhibit 4.2 to the Registrant's
         Registration Statement on Form S-3 (Reg. No. 3643)).

4.4      Form of Warrant ($4.50) for Purchase of Common Stock (incorporated by
         reference to Exhibit 4.5 to the 1995 Annual Report on Form 10-K for
         fiscal year ended February 29, 1995).

4.5      Form of Warrant ($5.50) for Purchase of Common Stock (incorporated by
         reference to Exhibit 4.6 to the 1995 Annual Report on Form 10-K for
         fiscal year ended February 29, 1995).

4.6      Stock Purchase Agreement, dated December 16, 1994, between Registrant
         and Counsel Corporation (incorporated by reference to Exhibit 4.7 to
         the 1995 Annual Report on Form 10-K for fiscal year ended February 29,
         1995).

4.7      Warrant to Purchase Shares of Common Stock, dated December 16, 1994,
         for the purchase of 800,000 shares (incorporated by reference to
         Exhibit 4.8 to the 1995 Annual Report on Form 10-K for fiscal year
         ended February 29, 1995).

4.8      Warrant to Purchase Shares of Common Stock, dated December 16, 1994,
         for the purchase of 1,000,000 shares (incorporated by reference to
         Exhibit 4.9 to the 1995 Annual Report on Form 10-K for fiscal year
         ended February 29, 1995).

4.9**    Warrant to purchase shares of Common Stock dated January 1, 1996, for
         the purchase of 75,000 shares.

4.10**   Warrant to purchase shares of Common Stock dated December 20, 1995 for 
         the purchase of 15,000 shares.

4.11**   Form of ACA Investors Warrant ($12.00) for purchase of Common Stock.

10.1     1987 Stock Option Plan, adopted by the Board of Directors on March 11,
         1987 and by the Shareholders on July 29, 1987 (incorporated by
         reference to Exhibit 100 to the 1987 Annual Report*).
</TABLE>


                                       
<PAGE>   77


<TABLE>
<S>      <C> 
10.2     1988 Stock Option Plan, adopted by the Board of Directors on February
         26, 1988 and by the shareholders on August 17, 1988 (incorporated by
         reference to Exhibit 10CC to the 1988 Annual Report*).

10.3     1991 Stock Option Plan, adopted by the Board of Directors on May 22,
         1991 and by the Shareholders on December 16, 1991 (incorporated by
         reference to Exhibit 10KK to the 1991 Annual Report*).

10.4     1992 Stock Option Plan, adopted by the Board of Directors on July 14,
         1992 and by the shareholders on September 2, 1992 (incorporated by
         reference to Exhibit B to the Registrant's 1992 Proxy Statement*).

10.5     Agreement, dated December 23, 1993, between the Registrant and Mediquest,
         Inc. (incorporated by reference to Exhibit NN to 1994 Form 10-K).

10.6     Credit Agreement Among Choice Drug Systems, Inc. and Creditanstalt Corporate 
         Finance, Inc., dated May 19, 1995 (incorporated by reference to Exhibit
         10.19 to the 1995 Annual Report on Form 10-K for fiscal year ended 
         February 29, 1995).

10.7     Revolving Credit Note dated May 19, 1995, made in favor of
         Creditanstalt Corporate Finance, Inc. (incorporated by reference to
         Exhibit 10.20 to the 1995 Annual Report on Form 10-K for fiscal year
         ended February 29, 1995).

10.8     Agreement and Plan of Merger, dated April 5, 1995, by and among the 
         Registrant, Choice Acquisition Corp. and Premier Pharmacy, Inc. 
         (incorporated by reference to Exhibit 2.1 to the 1995 Annual Report on 
         Form 10-K for fiscal year ended February 29, 1995).

10.9     1995 Nonqualified Stock Option Plan for Directors of the Company
         (incorporated by reference to Exhibit A to Schedule 14A filed August 2,
         1995).

10.10    1995 Incentive and Nonqualified Stock Option Plan for Key Personnel and
         Directors of the Company (incorporated by reference to Exhibit B to
         Schedule 14A filed August 2, 1995).

10.11    Amendment to Choice Drug Systems, Inc. 1992 Stock Option Plan 
         (incorporated by reference to Exhibit C to Schedule 14A filed 
         August 2, 1995).

10.12    1996 Employee Stock Purchase Plan of the Company (incorporated by
         reference to Exhibit D to Schedule 14A filed August 2, 1995).

10.13    Form of Registration Rights Agreement dated May 22, 1995 (incorporated
         by reference to Exhibit 4.4 on Form 8-K dated May 22, 1995).

10.14    Form of Amendment to Registration Rights Agreement dated August 30,
         1995 (incorporated by reference to Exhibit 4.2 to Form 8-K dated August
         31,1995).
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<PAGE>   78


<TABLE>
<S>      <C>
10.15    Form of Second Amendment to Registration rights Agreement dated March
         20, 1996 (incorporated by reference to Exhibit 10.1 to Form 10-Q dated
         March 31, 1996).

10.16    Form of Third Amendment to Registration rights Agreement dated April
         11, 1996 (incorporated by reference to Exhibit 10.2 to Form 10-Q dated
         March 31, 1996).

10.17    Form of Registration Rights Agreement dated April 17, 1996 (incorporated 
         by reference to Exhibit 10.1 to Form 10-Q dated September 10, 1996).

10.18**  Registration Rights Letter Agreement, dated December 19, 1996 regarding
         Registration Rights in connection with the purchase by Counsel
         Corporation of 2,112,490 shares of Common Stock of Capstone Pharmacy
         Services, Inc. on July 29, 1996.

10.19**  Registration Rights Amendment dated January 3, 1997 by and among Capstone 
         Pharmacy Services, Inc. and  Ron Belville, Denis A. Portaro and Sandra 
         Lou Portaro and the Denis A. and Sandra Lou Revocable Trust of 1992.

10.20**  Senior Subordinated Credit Agreement dated December 6, 1996 by and 
         between the Company and Bankers Trust Company as agent and lender.

10.21**  Form of Revolving Credit Note by and between the Company and lender. 
       
10.22    Agreement and Plan of Merger, dated September 30, 1995, by and among 
         Geri-Care Systems, Inc., Scripts and Things, Inc., Abraham Wieder, Raphael 
         Lieberman, Capstone Pharmacy Services, Inc., Geri Mergeco, Inc. and 
         Scripts Mergeco, Inc. (incorporated by reference to Exhibit 2 to
         Form 8-K for December 31, 1995).

10.23**  Adirondack Capital Advisors Consulting Agreement dated June 25, 1996.

21**     List of Subsidiaries.

23       Consent of Arthur Andersen LLP.

24**     Power of Attorney (included on signature page).

27**     Financial Data Schedule (for SEC use only).

</TABLE>


* Denotes a management contract or compensatory plan, contract or arrangement.
** Filed with original annual report on Form 10-K.