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

                                    FORM 10-K

                Annual Report Pursuant to Section 13 or 15(d) of
                       The Securities Exchange Act of 1934

For the fiscal year ended December 31, 1998          Commission File No. 0-26206

                          NORLAND MEDICAL SYSTEMS, INC.
             (Exact name of registrant as specified in its charter)

Delaware                                                              06-1387931
(State or other jurisdiction                                    (I.R.S. Employer
of incorporation or organization)                            Identification No.)

106 Corporate Park Drive, Suite 106, White Plains, NY                      10604
(Address of principal executive offices)                              (Zip Code)

Registrant's telephone number, including area code: (914) 694-2285

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

                                      None

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

                    Common Stock, par value $0.0005 per share

            Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|

            Indicate by check mark 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 |_|

            The aggregate market value of the registrant's Common Stock, par
value $0.0005 per share, held by non-affiliates of the registrant as of March
22, 1998 was $1,407,000 based on the price of the last reported sale on the OTC
Bulletin Board.

            As of March 22, 1999 there were 14,164,031 shares of the
registrant's Common Stock, par value $0.0005 per share, outstanding.

                       Documents Incorporated By Reference

            Items 10, 11, 12 and 13 Part III of this Form 10-K are incorporated
by reference to the Norland Medical Systems, Inc. Proxy Statement for the 1999
Annual Meeting of Stockholders. A definitive proxy statement will be filed with
the Securities and Exchange Commission within 120 days after the close of the
fiscal year covered by this Form 10-K.
<PAGE>

                                TABLE OF CONTENTS
                                                                            Page
                                                                            ----

INTRODUCTION...................................................................1

ITEM 1.  BUSINESS..............................................................1

ITEM 2.  PROPERTIES...........................................................13

ITEM 3.  LEGAL PROCEEDINGS....................................................14

ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS..................15

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
         STOCKHOLDER MATTERS..................................................16

ITEM 6.  SELECTED FINANCIAL DATA..............................................16

ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
         CONDITION AND RESULTS OF OPERATIONS..................................18

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
         MARKET RISKS.........................................................25

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA..........................26

ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
         ACCOUNTING AND FINANCIAL DISCLOSURE..................................52

ITEMS 10, 11, 12 and 13.......................................................52

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
         FORM 8-K.............................................................53
<PAGE>

INTRODUCTION

      The statements included in this Report regarding future financial
performance and results and the other statements that are not historical facts
are forward-looking statements. The words "believes," "intends," "expects,"
"anticipates," "projects," "estimates," "predicts," and similar expressions are
also intended to identify forward-looking statements. These forward-looking
statements are based on current expectations and are subject to risks and
uncertainties. In connection with the "safe harbor" provisions of the Private
Securities Litigation Reform Act of 1995, the Company cautions the reader that
actual results or events could differ materially from those set forth or implied
by the forward-looking statements and related assumptions due to certain
important factors, including, without limitation, the following: (i) the
continued development of new products and product enhancements that can be
marketed by the Company; (ii) the importance to the Company's sales growth that
the efficacy of new therapies for the treatment of osteoporosis and other bone
disorders be demonstrated and that regulatory approval of such therapies be
granted, particularly in the United States; (iii) the acceptance and adoption by
primary care providers of new osteoporosis therapies and the Company's ability
to expand sales of its products to these physicians; (iv) the Company may be
adversely affected by changes in the reimbursement policies of governmental
programs (e.g., Medicare and Medicaid) and private third party payors, including
private insurance plans and managed care plans; (v) the high level of
competition in the bone densitometry market; (vi) changes in bone densitometry
technology; (vii) the Company's ability to continue to maintain and expand
acceptable relationships with third party dealers and distributors; (viii) the
Company's ability to provide attractive financing options to its customers and
to provide customers with fast and efficient service for the Company's products;
(ix) changes that may result from health care reform in the United States may
adversely affect the Company; (x) the Company's cash flow and the results of its
ongoing financing efforts; (xi) the effect of regulation by the United States
Food and Drug Administration and other agencies; (xii) the effect of the
Company's accounting policies; (xiii) the outcome of pending litigation; (xiv)
potential Year 2000 compliance problems affecting the Company and third parties
with whom it deals; and (xv) other risks described elsewhere in this Report and
in other documents filed by the Company with the Securities and Exchange
Commission. The Company is also subject to general business risks, including
adverse state, federal or foreign legislation and regulation, adverse publicity
or news coverage, changes in general economic factors and the Company's ability
to retain and attract key employees.

                                     PART I

ITEM 1. BUSINESS.

            Norland Medical Systems, Inc. ("Norland" or the "Company") develops,
manufactures, sells and services a wide range of bone densitometers used to
assess bone mineral content and density, one of several factors used by
physicians to aid in the diagnosis and monitoring of bone disorders,
particularly osteoporosis. Osteoporosis progresses as a symptomless disease
characterized by bone loss and deterioration of the skeleton, leading to bone
fragility and increased risk of fracture. According to the National Osteoporosis
Foundation ("NOF"), 28 million Americans, 80% of whom are women, are affected by
osteoporosis, and left unchecked, that number is predicted to increase to 41
million by 2015. Driven by the availability of new treatments for bone-related
disorders, the Company is focusing on bringing affordable, state-of-the-art
diagnostic technology directly into the physician's office in order to address a
number of women's healthcare problems.
<PAGE>

      On September 11, 1997 Norland purchased all of the outstanding stock of
Norland Corporation ("Norland Corp.") from Norland Medical Systems B.V. ("NMS
BV"). Norland Corp. develops and manufacturers bone densitometry systems based
on dual-energy x-ray absorptiometry ("DXA") technology, which, since 1987, has
been a standard for measuring bone mass reduction, one of the primary indicators
of osteoporosis. Prior to September 11, 1997, Norland had exclusive worldwide
distribution rights to all products developed and manufactured by Norland Corp.
and Stratec Medizintechnik GmbH ("Stratec"), another subsidiary of NMS BV which
develops and manufacturers bone densitometry systems based on peripheral
quantitative computed tomography ("pQCT") technology. Upon the acquisition of
Norland Corp., Norland entered into a new exclusive Distribution Agreement with
Stratec.

      As used herein, the term "Company" includes Norland and all of its
wholly-owned subsidiaries, including Norland Corp.

      The Company has five product lines utilizing several different types of
technology. The Company manufactures and markets a line of traditional full size
DXA-based bone densitometry products. The Excell, the Eclipse and the XR36 are
highly effective and offer essential features at competitive prices. Because of
the cost, space requirements and training required, these systems are generally
found in hospitals, large clinics and research institutions, as opposed to
physician offices, where patients would benefit from timely and easy access to
bone density testing.

      The Company's peripheral x-ray line consists of the Apollo DXA and the
pDEXA systems, lower priced, high performance portable systems based on DXA
technology. The pDEXA, which scans the forearm, was the first desktop DXA-based
system to receive FDA marketing clearance. It was also the first system to
receive FDA marketing clearance for use in fracture risk assessment. The Apollo
DXA, which performs scans of the heel in fifteen seconds, was introduced in May
of 1998.

      The Company also markets a line of products based on pQCT technology.
Systems using pQCT technology can make separate, three-dimensional measurements
of the cortical and trabecular bone, allowing a more detailed assessment of the
biomechanical soundness of the bone. In addition, pQCT permits the detection of
minute changes within bone that occur over short periods of time.

      The Company's research line includes versions of its pQCT products that
have been purchased by large pharmaceutical companies, including Eli Lilly &
Company, Novartis, Procter & Gamble and Glaxo Wellcome, and several universities
to assist in monitoring the effectiveness of potential new therapies for the
treatment of osteoporosis and related bone disorders. The Company also offers a
DXA-based research product.

      In 1998 the Company introduced its first peripheral ultrasound product.
The Paris ultrasound bone measurement system (the "Paris") was developed and
patented by a Canadian company and measures the velocity of sound and broad band
ultrasound attenuation at the heel. The Paris system is not yet approved for
sale in the United States. Sales to date in Canada, Europe and the Pacific Rim
have not been significant.


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<PAGE>

Background

      Osteoporosis

      Osteoporosis is a disease generally associated with aging and
characterized by excessive loss of bone mineral and deterioration of the
skeleton over time. Bone is a dynamic organ which can be separated into two
basic structural components, outer cortical bone and inner trabecular bone. This
combination of a solid outer bone surrounding the inner bone is constantly
broken down and regenerated through a process known as bone remodeling, which
consists of bone resorption (removal) followed by bone formation. When
remodeling does not function properly, the result is a net loss of bone mass,
often causing the amount of bone to become deficient in meeting the body's
needs. Factors contributing to this condition include low calcium intake,
excessive alcohol consumption and certain drug therapies.

      Osteoporosis is a "silent disease" and typically has no overt symptoms in
its early stages. The first sign of osteoporosis is often bone fracture.
Osteoporosis leads to increased risk of fracture, chronic pain and immobility,
usually at the hip, forearm or spine. As indicated above, the NOF estimates that
osteoporosis affects more than 28 million people in the United States (80% of
whom are women), a number which, if unchecked, is predicted to increase to 41
million by 2015. The post-menopausal female population has the highest incidence
of osteoporosis and the highest rate of morbidity (loss of quality of life) and
mortality due to osteoporosis. Hip fractures produce the most serious
consequences. According to the NOF, there are more than 300,000 hip fractures
per year in the United States and 50% of hip fracture patients never walk
independently again. The NOF estimates that in the United States osteoporosis
contributes to more than 1.5 million fractures annually, a majority of which
were of the spine and hip, and that annual direct medical expenditures for
osteoporosis and associated fractures is $13.8 billion, a figure that is
expected to increase to $62 billion by the year 2020.

      Until recently, osteoporosis was thought to be an inevitable and
untreatable consequence of aging. The Company believes that recent availability
of more effective drug therapies, the aging of the population and an increased
focus on women's health issues and preventive medical practices have created a
growing awareness among patients and physicians that osteoporosis is in many
cases a disease which can be treated.

      Therapies

      The Company believes that the historic limitations of treatment options in
the United States contributed to a low level of demand for the diagnosis of
osteoporosis and other bone disorders. Until 1995, available therapies for
osteoporosis were limited. Most were classified as anti-resorptive and were
designed to maintain bone mass by decreasing the effective rate of bone
resorption. There was no proof that they promoted bone formation. Such therapies
included calcitonin, hormone replacement therapy using estrogen and
first-generation bisphosphonates. In the United States, available therapies were
limited to calcitonin, estrogen and over-the-counter calcium and vitamin D
supplements; and only two therapies, calcitonin and estrogen, were approved
specifically as therapies for bone disorders. However, women's concerns
regarding possible complications relating to the prolonged use of hormone
replacement therapy using estrogen and the availability of calcitonin only in
injectable form contributed to low patient acceptance.

      In September 1995, the FDA approved the drug Fosamax for the treatment of
established osteoporosis in post-menopausal women. Fosamax, developed by Merck &
Co., Inc. ("Merck"), is a second generation bisphosphonate that acts by coating
the bone surface and inhibiting bone resorption. Fosamax was shown in clinical
trials to increase bone density without significant adverse side effects. Other
therapies approved by the FDA in 1995 to treat osteoporosis include Miacalcin,
an intra-nasal formulation of


                                       3
<PAGE>

calcitonin developed by Novartis, and Premarin MPA, a one-tablet hormone
replacement therapy combining estrogen and progestin developed by Wyeth-Ayerst
Laboratories.

      Merck's Fosamax was originally approved only for the treatment of patients
with established osteoporosis. In April 1997, the FDA expanded the permitted use
of Fosamax to include the prevention of osteoporosis. In December 1997, Eli
Lilly & Company received FDA approval for its new osteoporosis drug, Evista, a
selective estrogen receptor modulator. Drugs of this type are being studied for
their selective ability to act like estrogen in certain tissues but not in
others.

      The Company believes that worldwide there are more than 50 pharmaceutical
and biotechnology companies with programs to develop new therapies for
osteoporosis, some of which are in late-stage clinical trials. Therapeutic
products under development include new anti-resorptive agents and bone-formation
stimulators. New generations of bisphosphonates are being developed by Procter &
Gamble (Actonel), Sanofi Winthrop (tiludronate) and Boehringer-Mannheim
(ibandronate), while anti-estrogens (estrogen analogs) are being developed by
Pfizer (draloxifene). While these therapies are all in Phase III clinical
trials, others are in the New Drug Application review stage. These include Alora
(estradiol matrix transdermal system - Procter & Gamble), Calcimar Intranasal
(calcitonin - Rhone Poulenc Rorer) and Neosten (slow release fluoride - Mission
Pharmacal).

      The Company believes that advances in treatment options for osteoporosis
will increase the demand for the diagnosis and monitoring of osteoporosis and
other bone disorders. Merck and other pharmaceutical companies have launched
extensive educational and marketing campaigns targeting gynecologists and family
practice physicians to promote education and awareness that osteoporosis is now
a treatable disease. Patients and physicians will become increasingly aware of
the importance of early diagnosis and treatment of osteoporosis. The Company
believes that as this awareness increases, more people will be tested for
osteoporosis and that primary care providers such as gynecologists and family
practice physicians will play a key role in providing such tests.

      Diagnosis and Monitoring of Osteoporosis

      Typically, there are no overt symptoms of early stage osteoporosis.
Diagnostic efforts have focused on an individual's propensity for fracture by
determining bone mass and comparing it to normal healthy and age-related
reference populations, as well as monitoring bone mass over time for changes.
Absorptiometry is the primary technique for measuring bone mass and is based on
the principle that bone absorbs radiation at a different rate than does soft
tissue. The inner trabecular region, which is a lattice-like structure crucial
to the maintenance of bone strength, absorbs radiation at a rate different from
the cortical region, enabling systems capable of separately measuring cortical
and trabecular bone to more effectively assess biomechanical soundness.

      There are a number of different types of technologies that can be used to
assess bone mineral status. Single photon absorptiometry (SPA) uses a single
energy radioactive source and has limited ability to measure bone in complex
body regions. Dual photon absorptiometry (DPA) reduces measurement error through
complex body regions by using a dual-energy radioactive source. X-ray-based
systems provide improved precision, faster scan times and lower operating costs
as compared to single and dual photon absorptiometry and have largely replaced
SPA and DPA technology. Single-energy x-ray absorptiometry ("SXA") technology
replaces the radioactive source with a single energy X-ray source. DXA, which
has become the standard for bone mass analysis, uses a dual-energy X-ray source.
Radiographic absorptiometry ("RA") measures bone density from two X-ray images
of the hand. Although it does not require a dedicated


                                       4
<PAGE>

bone densitometry system since it uses traditional X-ray equipment, RA does not
provide point of care measurement of bone density, as the radiographs have to be
sent out to a laboratory for interpretation. All of these technologies produce
only two-dimensional (planar) measurements. Quantitative computed tomography
(QCT) is capable of separate, three-dimensional measurement of cortical and
trabecular bone, providing volumetric density and allowing more precise
assessment of the biomechanical soundness of the bone. Ultrasound technology
measures the velocity of sound and broad band attenuation. Ultrasound has
recently been improved to the point that it has gained acceptance as a viable
technology to assess bone at peripheral sites. In vitro diagnostic testing
(biochemical markers) measures the level of certain byproducts in body fluids to
determine the rate of bone resorption and bone formation. However, these tests
do not provide information about bone mass or bone structure and cannot be used
independently to diagnose osteoporosis or assess fracture risk. The Company
believes that biochemical marker testing may complement bone densitometry in
monitoring the effectiveness of drug therapies.

Products

      Product Lines

      The Company believes it markets the broadest line of bone densitometers
available today with a wide range of price points and capabilities to satisfy
diverse customer needs. The Company currently offers five product lines and 13
models. The following is a description of each of the Company's product lines.

      1. Peripheral DXA-Based Systems

      The Apollo DXA and the pDEXA are the Company's peripheral DXA-based
systems. These affordable, easy-to-use systems are designed for physician
offices, small clinics and other settings beyond large hospitals and clinics,
including pharmacies and other consumer environments. Like the much larger
traditional DXA systems, they measure bone mass and compare it to a normal
reference population. However, the peripheral systems measure only specific
sites such as the heel and forearm that correlate well to hip and spine
measurements, enabling them to be more compact, and, therefore, more affordable
than traditional DXA systems.

      The Apollo DXA, the Company's newest peripheral DXA-based system, was
introduced in May of 1998. The Apollo DXA measures weight-bearing trabecular
bone in the heel in just 15 seconds. It provides quantitative analysis of bone
mass, including bone mineral density (BMD) as well as comparisons to normal
reference populations, from an easy-to-use hand held control console. The Apollo
DXA's Fracture Risk Assessment Option allows the bone density measurements from
the Apollo DXA to be used as an aid to physicians in determining fracture risk.

      The pDEXA was the first system to bring DXA-based technology to the
desktop. The pDEXA measures the forearm at a site that is mostly cortical bone
and at another site that is mostly trabecular bone. The software used in the
pDEXA measures bone mineral content (BMC) and BMD as well as making comparisons
to normal reference populations and to the patient's prior examinations. It also
provides skeletal images of the region of interest as well as graphical
presentation of the results. In January 1998, the pDEXA became the first bone
densitometry system to receive FDA approval of a Fracture Risk Assessment
Option.

      2. Traditional DXA Systems

      The traditional DXA-based bone densitometers marketed by the Company are
the compact Excell and Eclipse and the full size XR36. The target market for
these systems is hospitals, clinics and group


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practices. With its low price relative to other traditional systems, the Excell
can also be attractive to primary care physicians. Each system is capable of
performing axial (hip and spine) and peripheral scans. The XR36 also performs
full body scans. All three systems measure BMD and BMC and make comparisons to
reference populations and to the patient's prior examination. Price and service
are the primary competitive factors among DXA products offering similar basic
capabilities.

      3. pQCT - Clinical Systems

      The XCT line of systems brings a unique type of bone densitometer based on
pQCT technology to the market. Unlike DXA-based densitometers, pQCT systems
permit separate, three-dimensional measurement of cortical and trabecular bone
by taking multiple images in a 360-degree rotation around the scanned limb,
providing true volumetric density and allowing more precise assessment of
biomechanical soundness of the bone. The ability to measure trabecular bone
precisely also permits detection over short periods of time of minute changes in
bone, indicating changes in metabolic status. The pQCT systems use the same
miniaturized low-radiation X-ray source as the pDEXA. The XCT2000 scans the
forearm and is marketed to hospitals, clinics and private practices. The XCT3000
can also scan the tibia, the femur and is capable of three-dimensional
measurement of the entire femoral neck, providing more precise assessment of hip
fractures and monitoring of implants following hip replacements.

      4. Research Systems

      The Company markets a series of pQCT-based research scanners: the XCT
Research SA, the XCT Research M and the XCT3000A, for research involving
laboratory animals, and the XCT Microscope, for research in vitro at a maximum
resolution of 20 microns. The Company also markets the Sabre, a DXA-based system
for research with small laboratory animals. The XR36 and the Eclipse can also be
used in research to scan animals.

      5. Peripheral Ultrasound Systems

      The Company has exclusive United States manufacturing rights and worldwide
distribution rights for the Paris dry ultrasound system, pursuant to an
agreement with the Canadian company that developed the system. The Paris
measures the velocity of sound and broad band ultrasound attenuation at the
heel. To date sales have been made only in Canada, Europe and the Pacific Rim.
The Paris system is not yet approved for sale in the United States. The Company
has applied with the FDA for pre-market approval. As with peripheral x-ray
systems, the target market for the Paris is physician offices.

      Other Uses

      The Company has received FDA approval of a Body Composition Option for its
pDEXA and traditional DXA-based systems. This option assesses the non-bone
tissue determined during the bone density scans and estimates such items as soft
tissue mass, fat mass, lean mass, and ratio of total bone mineral content to
lean body mass. These measurements are useful to physicians in their management
of diseases such as chronic renal failure, anorexia nervosa, excessive obesity,
AIDS/HIV and cystic fibrosis. It is also a convenient alternative to hydrostatic
weighing and skin fold measurements.

Product Development

      The Company focuses its product development on DXA-based bone densitometry
systems. At March 9, 1999, the Company had 14 persons engaged in research and
development, nine of whom were devoted to software development. Product
development work with respect to pQCT-based systems is performed by Stratec.


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<PAGE>

Sales and Marketing

      The Company currently employs six regional sales managers, three who cover
the United States and three who cover Europe, the Middle East and Asia (other
than the Pacific Rim), Latin America and the Pacific Rim, respectively. The
Company's customers are primarily third party dealers and distributors. The
Company also sells directly to end-users in those markets where the Company does
not have third party dealers or distributors. The Company typically uses an
exclusive dealer, independent representative or distributor to cover one or more
states, or a single country or portions thereof. Each Company regional sales
manager is responsible for the support and supervision of several dealers,
distributors and independent representatives within their geographic region.
Support includes participation in trade shows, symposiums, customer visits,
product demonstrations, ongoing distribution of literature and publications,
sales training and presentations of financing programs. In 1997, the Company
opened small sales offices in London, from which the regional manager for
Europe, the Middle East and Asia operates, and Singapore, where the regional
manager for the Pacific Rim operates. The Company intends to expand its network
of third party dealers, distributors and independent representatives to exploit
the large market of gynecologists and primary care physicians.

      In 1997, the Company expanded its marketing department, which presently
consists of seven employees. Marketing efforts are focused primarily on
supporting the regional sales managers in their management of dealers and
distributors, developing and maintaining relationships and joint programs with
pharmaceutical companies, managing sales lead generation programs, managing
product introductions and new product financing programs.

      The Company sold products in 40 countries in 1998. For a more detailed
breakdown of the Company's 1998 sales by geographic territory, see Note 14 to
the Company's financial statements included in Item 8 of this Report.

      The Company's peripheral bone densitometers have been used in several
programs in conjunction with major pharmaceutical companies, including Merck's
National Osteoporosis Risk Assessment (N.O.R.A.) program. Through N.O.R.A.,
valuable patient demographic and risk factor data from postmenopausal women, age
50 and over, is being collected to gain better understanding of the progression
of osteoporosis and associated patient outcomes. The program is expected to
include up to 500,000 postmenopausal women and 5,000 physicians within two
years. Approximately 50 of the Company's systems were sold to Merck and are
being used to provide bone density measurements for women in the program.

Manufacturing

      Manufacturing consists primarily of testing of components, final assembly
and systems testing. The Company manufactures its traditional DXA-based systems
and the Apollo DXA for sale worldwide and the pDEXA for sale in North America
and Latin America. The Company also manufactures certain pQCT systems for sale
in the United States and Canada. All establishments, whether foreign or
domestic, manufacturing medical devices for sale in the United States are
subject to periodic inspections by or under the authority of the FDA to
determine whether the manufacturing establishment is operating in compliance
with FDA Quality System Regulation ("QSR") requirements . The Company's
manufacturing facility is located in Fort Atkinson, Wisconsin. Stratec
manufactures pDEXA systems for sale outside North America


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<PAGE>

and Latin America and pQCT systems for sale outside the United States and
Canada. Stratec's manufacturing facilities are located in Pforzheim, Germany.

      Some components are manufactured in accordance with custom specifications
and require substantial lead times. While efforts are made to purchase
components from more than one source and to use generally available parts,
certain components, including X-ray tubes and detectors, are available from only
one or a limited number of sources. In the past, there have been delays in the
receipt of certain components, although to date no such delays have had a
material adverse effect on the Company. The Company believes that the Company
and Stratec have sufficient capacity to supply the Company's product needs for
at least the next twelve months.

      Manufacturing processes for the products marketed by the Company are
subject to stringent federal, state and local laws and regulations governing the
use, generation, manufacture, storage, handling and disposal of certain
materials and wastes. In the United States, such laws and regulations include
the Occupational Safety and Health Act, the Environmental Protection Act, the
Toxic Substances Control Act, and the Resource Conservation and Recovery Act.
The Company believes that it has complied in all material respects with such
laws and regulations. There can be no assurance that the Company will not be
required to incur significant costs in the future with respect to compliance
with such laws and regulations.

Customer Support Services

      The Company offers one-year warranties on both the hardware and software
included in its systems, as well as extended warranty contracts. The Company
provides warranty services to its customers. Any costs incurred by the Company
in connection with a warranty of a system not manufactured by the Company are
borne by such manufacturer.

      The Company has no obligation to provide any other services to its third
party dealers or distributors or other customers. However, the Company does
offer non-warranty services and a range of other product support services in
cooperation with its third-party dealers, including a telephone hotline for
customer inquiries, product installation, product enhancements and maintenance
releases. The Company is party to an agreement with OEC Medical Systems, Inc.
("OEC"), pursuant to which OEC services the Company's DXA-based systems
installed in the United States. The Company also offers training at customer
locations and the Company's facilities to end-user customers, third-party
dealers and service technicians.

Stratec Distribution Agreement

      Upon the acquisition of Norland Corp. on September 11, 1997, the
Distribution Agreement with Norland Corp. and Stratec was terminated, and the
Company entered into a new Distribution Agreement with Stratec. The Company's
Distribution Agreement with Stratec grants the Company exclusive distribution
rights for all devices currently produced by Stratec. The distribution rights
are worldwide, except that Germany is currently excluded. The Company has the
option to become the exclusive distributor for Stratec in Germany at any time on
90 days' notice to Stratec. The term of the Distribution Agreement extends until
December 31, 2015. At the end of such term or any renewal term, either party may
renew the Distribution Agreement for an additional term of five years, provided
that the party electing to renew is not in material breach of the Distribution
Agreement at the time of renewal. Stratec has the right to terminate the
Company's distribution rights with respect to all Stratec devices other than the
pDEXA upon a change in control of the Company (defined as either (i) majority
ownership of the Company by a single person or entity


                                       8
<PAGE>

other than Reynald G. Bonmati, Hans Schiessl or an entity controlled by them or
(ii) Mr. Bonmati no longer being the chief executive officer of the Company).

      The pDEXA was developed jointly by Norland Corp. and Stratec. The Stratec
Distribution Agreement gives the Company the right to manufacture pDEXA systems
to be sold in North America and Latin America, while Stratec has the right to
manufacture the pDEXA for sale outside North America and Latin America. The
Company has the right to purchase from Stratec components and parts (other than
computer components) used to manufacture the pDEXA. It may also purchase such
components and parts from other sources. The Company is also the exclusive
manufacturer of all pQCT systems (other than research systems) to be sold in
North America, and the Company purchases components and parts (other than
computer components) for such systems from Stratec.

      The general pricing provisions of the Stratec Distribution Agreement are
as follows. The price at which the Company purchases a system from Stratec for
immediate resale is Stratec's Device Cost as defined in the Distribution
Agreement plus 50% of the difference between the amount for which the Company
sells such system and the Stratec Device Cost. Thus, the gross margin between
the Company's selling price and the Stratec Device Cost is allocated 50% to the
Company and 50% to Stratec. The Company has certain programs in which certain
customers are offered short-term rentals of systems or the ability to use
systems on a pay-per-scan basis, in each case with an option to purchase the
system. Systems subject to these programs, as well as demonstration systems, are
purchased by the Company from Stratec for 150% of Stratec Device Cost. The
Stratec Device Cost of a system is the aggregate of the standard costs of the
components and parts used in such system plus an allowance for other direct
manufacturing costs.

      During December of 1996 and for all of 1997, special pricing provisions
were in effect under the Stratec Distribution Agreement and the predecessor
Distribution Agreement. The Company paid Stratec an amount equal to the
Distributor's Device Cost as defined in the Distribution Agreement. The
Distributor's Device Cost of a system is the aggregate of the standard costs of
the components and parts used in the system plus the actual labor costs incurred
by Stratec in producing the system (subject to a cap) plus an agreed upon markup
on the standard costs of all non-computer components used in the system. Stratec
was also entitled to receive royalties equal to 5% of the price for which the
Company sold any pQCT system manufactured by Stratec. Stratec had the right to
terminate these special pricing provisions and reinstate the general pricing
provisions described above effective December 31, 1997. Stratec exercised this
termination right, and as a result, the general pricing provisions became
effective again as of January 1, 1998. The Company has been negotiating with
Stratec with respect to possible alternative pricing provisions. However, no new
agreement has been reached, and there can be no assurance that the general
pricing provisions now in effect will be changed.

Competition

      The bone densitometry systems market is highly competitive. Several
companies have developed or are developing bone densitometers or other devices
that compete or will compete with products marketed by the Company. Many of the
Company's existing and potential competitors have substantially greater
financial, marketing and technological resources, as well as established
reputations for success in developing, selling and servicing products. The
Company expects existing and new competitors will continue to introduce products
that are directly or indirectly competitive with those marketed by the Company,
including alternatives to absorptiometry such as ultrasound and in vitro
diagnostics. Such competitors may succeed in developing products that are more
functional or less costly than those sold by


                                       9
<PAGE>

the Company and may be more successful in marketing such products. There can be
no assurance that the Company will be able to continue to compete successfully
in this market.

      The Company's primary competitors for the sale of bone densitometry
systems are Hologic, Inc., Lunar Corporation and Schick Technologies, Inc. These
companies have products that compete directly with the products marketed by the
Company. There can be no assurance that the Company's competitors will not
succeed in developing and marketing lower priced or better performing devices
comparable to the Company's lines.

      The ultrasound market is particularly competitive. There are approximately
20 other companies, including Hologic and Lunar, that are marketing ultrasound
bone assessment systems outside the United States. In addition, Hologic, Lunar
and Myriad Ultrasound Systems, Ltd. have received FDA approval to market their
ultrasound systems in the United States, and one or more of the other companies
may also receive FDA approval before the Company receives FDA approval for an
ultrasound system.

      The Company believes the products it markets compete primarily on the
basis of price/performance characteristics, accuracy and precision of results,
ease and convenience of use, features and functions, quality of service and
price. In the small clinic and physician's office market, price, ease of use and
convenience are of particular importance. In the hospital and large clinic
market, traditional DXA systems are predominant and price is the primary
competitive factor among products that provide similar basic capabilities. The
Company believes that its DXA-based systems are competitive. In the research
market, the range, accuracy and precision of measurements are the principal
competitive factors. The Company believes the pQCT-based products it markets
provide measurement capabilities, such as three-dimensional measurements and
separate measurement of cortical and trabecular bone, not available with
traditional DXA-based technology, at prices competitive with systems using that
technology.

Third Party Reimbursement

      The products marketed by the Company are purchased principally by
hospitals, managed care organizations, including independent practice
associations and physician practice organizations or independent physicians or
physician groups, who are regulated in the United States by federal and state
authorities and who typically bill and are dependent upon various third party
payors, such as federal and state governmental programs (e.g., Medicare and
Medicaid), private insurance plans and managed care plans, for reimbursement for
use of the Company's products. The Health Care Financing Administration ("HCFA")
established new reimbursement codes and recommended reimbursement rates
effective January 1, 1998. The average recommended reimbursement rates
established by HCFA and currently in effect for central and peripheral DXA bone
density examinations are approximately $131 and $41, respectively. Currently,
there is an interim reimbursement code for ultrasound bone density examinations
and a reimbursement rate of approximately $41. On several occasions, HCFA has
effected increases and decreases in its recommended reimbursement rates for bone
densitometry examinations and has made changes in the types of examinations
eligible for reimbursement. There can be no assurance that HCFA will not
continue to make changes from time to time. The Company could be materially and
adversely affected by such changes.

      In August 1997, President Clinton signed into law the Medicare Bone Mass
Measurement Coverage Standardization Act as a provision in the Balanced Budget
Act. The provision sets forth a national mandate that requires Medicare, under
certain specified conditions, to cover bone density diagnostic tests utilizing


                                       10
<PAGE>

radiologic, radioisotopic, or other procedures approved by the FDA for the
purpose of identifying bone mass or detecting bone loss deterioration. This
mandate became effective July 1, 1998.

      In a number of European countries, Japan and several other countries,
third party payors provide reimbursement for bone densitometry scans.

Government Regulation

      The development, testing, manufacturing and marketing of the products
marketed by the Company are regulated by the FDA in the United States and by
various foreign regulatory agencies. The testing for, preparation of, and
subsequent FDA review of required applications is expensive, lengthy and
uncertain. Moreover, regulatory approval or clearance, if granted, can include
significant limitations on the indicated uses for which a product may be
marketed. Failure to comply with applicable regulations can result in warning
letters, civil penalties, refusal to approve or clear new applications or
notifications, withdrawal of existing product approvals or clearances, product
seizures, injunctions, recalls, operating restrictions, and criminal
prosecutions. Delays in receipt of or failure to receive clearances or approvals
for new products would adversely affect the marketing of such products and the
results of future operations.

      Before any new medical device may be introduced in the United States
market, the manufacturer must obtain either premarket clearance through the
Section 510(k) premarket notification process or premarket approval through the
lengthier premarket approval application ("PMA") process. All products for human
use currently marketed commercially by the Company in the United States are
considered Class II medical devices subject to FDA clearance pursuant to the
Section 510(k) premarket notification process. Section 510(k) submissions may be
filed only for those devices that are "substantially equivalent" to a legally
marketed Class I or Class II device or to a Class III device for which the FDA
has not called for PMAs. A Section 510(k) submission generally requires less
data than a PMA. The FDA must make a determination whether or not to clear a
Section 510(k) submission within 90 days of its receipt. The FDA may extend this
time period, however, if additional data or information are needed to
demonstrate substantial equivalence. If a device is not "substantially
equivalent" to a legally marketed Class I or Class II device or to a Class III
device for which the FDA has not called for PMAs, a PMA is required. The
premarket approval procedure involves a more complex and lengthy testing and FDA
review process than the Section 510(k) premarket notification process. There can
be no assurances that clearances or approvals will be obtained on a timely
basis, if at all. Modifications or enhancements to products that are either
cleared through the Section 510(k) process or approved through the PMA process
that could effect a major change in the intended use, or affect the safety or
effectiveness, of the device may require further FDA review and clearance or
approval through new Section 510(k) or PMA submissions.

      All establishments, whether foreign or domestic, manufacturing medical
devices for sale in the United States are subject to periodic inspections by or
under authority of the FDA to determine whether the manufacturing establishment
is operating in compliance with QSR requirements. Manufacturers must continue to
expend time, money and effort to ensure compliance with QSR requirements. The
FDA also requires that medical device manufacturers undertake postmarket
reporting for serious injuries, deaths, or malfunctions associated with their
products. If safety or efficacy problems occur after the product reaches the
market, the FDA may take steps to prevent or limit further marketing of the
product. Additionally, the FDA actively enforces regulations prohibiting
marketing of devices for indications or uses that have not been cleared or
approved by the FDA, unless such promotion is undertaken pursuant to the
recently enacted provisions of the Food and Drug Administration Modernization
Act of 1997.


                                       11
<PAGE>

      The Company's products also are subject to regulatory requirements for
electronic products under the Radiation Control for Health and Safety Act of
1968. The FDA requires that manufacturers of diagnostic x-ray systems comply
with certain performance standards, and recordkeeping, reporting, and labeling
requirements.

      The Company may export a medical device not approved in the United States
to any country without obtaining FDA approval, provided that the device (i)
complies with the laws of that country and (ii) has valid marketing
authorization or the equivalent from the appropriate authority in a "listed
country." The listed countries are Australia, Canada, Israel, Japan, New
Zealand, Switzerland, South Africa and countries in the European Union and the
European Economic Area. Export of unapproved devices that would be subject to
PMA requirements if marketed in the United States and that do not have marketing
authorization in a listed country generally continue to require prior FDA export
approval.

      Whether or not FDA approval has been obtained, in some foreign countries
marketing authorization must be obtained from regulatory authorities (or third
parties authorized by such regulatory authorities) prior to the commencement of
marketing of the product in each such country. Requirements governing the
conduct of clinical trials and product approvals may vary significantly from
country to country. The time required for approval may be longer or shorter than
that required for FDA approval. The Company generally relies on its local
distributors to obtain any required clearances or undergo any conformity
assessment procedures in the countries in which they sell products marketed by
the Company. There can be no assurance that the Company will not be required to
incur significant costs in the future with respect to compliance with laws and
regulations of such countries.

      Effective in June of 1998, bone densitometry systems imported into the
European Community must be manufactured in ISO-9001 certified facilities. The
Company is in the process of taking the steps required to obtain such
certification for its Fort Atkinson facility.

      In addition to the regulatory framework for product approvals, the Company
is, and may be subject to, regulation under local, state, federal and foreign
law, including requirements regarding occupational safety, clinical and
laboratory practices, the use, handling and disposition of radiological
materials, environmental protection and hazardous substance control, and may be
subject to other present and possible future local, state, federal and foreign
regulation. There can be no assurance that the Company will not be required to
incur significant costs in the future with respect to compliance with such laws
and regulations.

Proprietary Rights

      The Company believes that its sales are dependent in part on certain
proprietary features of the products it manufactures and/or markets. The Company
relies primarily on know-how, trade secrets and trademarks to protect those
intellectual property rights and has not sought patent protection for such
products. There can be no assurance that these measures will be adequate to
protect the rights of the Company. To the extent that intellectual property
rights are not adequately protected, the Company may be vulnerable to
competitors who attempt to copy the Company's products or gain access to the
trade secrets and know-how related to such products. Further, there can be no
assurance that the Company's competitors will not independently develop
substantially equivalent or superior technology. The Company is not the subject
of any litigation regarding proprietary rights, and the Company believes that
the technologies used in its products were developed independently. An action
brought against the Company by Lunar Corporation in 1998 alleging patent
infringement has been settled. In addition, the Company's business depends on


                                       12
<PAGE>

proprietary information regarding customers and marketing, and there can be no
assurance that the Company will be able to protect such information.

Backlog

      Backlog consists of signed purchase orders received by the Company from
its customers. Backlog as of December 31, 1998 and 1997 totaled approximately
$845,000 and $3,689,000, respectively. The Company's ability to ship products
depends on its production capacity and that of the other manufacturers whose
products are distributed by the Company. Purchase orders are generally
cancelable. The Company believes that its backlog as of any date is not a
meaningful indicator of future operations or net revenues for any future period.

Product Liability Insurance

      The Company's business involves the inherent risk of product liability
claims. If such claims arise in the future they could have a material adverse
impact on the Company. The Company maintains product liability insurance on a
"claims made" basis with respect to its products in the aggregate amount of $4.0
million, subject to certain deductibles and exclusions. The Company's agreements
with the manufacturers of other products distributed by the Company require that
such manufacturers maintain product liability insurance that covers the Company
as an additional named insured. There is no assurance that existing coverage
will be sufficient to protect the Company from risks to which it may be subject,
including product liability claims, or that product liability insurance will be
available to the Company at a reasonable cost, if at all, in the future or that
insurance maintained by the other manufacturers will cover the Company.

Employees

      At March 22, 1999, the Company had 97 employees, of whom 20 were engaged
in direct sales and marketing activities and 22 were engaged in manufacturing
activities. The remaining employees are in finance, administration, product
development and customer service. No employees of the Company are covered by any
collective bargaining agreements, and management considers its employee
relations to be excellent.


ITEM 2. PROPERTIES.

      The Company leases its principal executive offices, which are located at
106 Corporate Park Drive, Suite 106, White Plains, New York 10604. The lease
expires on August 31, 2000. The Company also leases approximately 28,500 square
feet of space in Fort Atkinson, Wisconsin. One lease with respect to 18,000
square feet expires on August 31, 2006, and the second lease with respect to the
remaining 10,500 square feet expires on June 30, 2002. The Company uses this
space for manufacturing, research and development, sales and marketing, customer
services, administration and warehousing. The Company is in the process of
leasing approximately 4,000 additional square feet of space in its Fort Atkinson
facility.


                                       13
<PAGE>

ITEM 3. LEGAL PROCEEDINGS.

      Irwin I. Miller v. Reynald G. Bonmati et al., Defendants, and Norland
Medical Systems, Inc., Nominal Defendant. This shareholder's class action and
derivative complaint was filed in the Court of Chancery of the State of
Delaware, New Castle County, on August 1, 1997, against four members of the
Company's Board of Directors, Reynald G. Bonmati, Albert S. Waxman, James J.
Baker and Michael W. Huber (the "Individual Defendants"), NMS BV and the
Company. The action relates to the acquisition of Norland Corp. by the Company
from NMS BV. The complaint alleged that the Individual Defendants breached their
fiduciary duties of loyalty, candor and care in connection with the pending
acquisition, and that the Company's proxy statement relating to the
stockholders' meeting to vote on the acquisition did not contain full and fair
disclosure. Plaintiff sought among other things: to enjoin the consummation of
the acquisition; to require that the Company make additional disclosures to its
stockholders in connection with the acquisition; damages in unspecified amounts;
and costs, disbursements and counsel and expert fees. An agreement in principle
was reached to settle the action. The Company delayed its 1997 Annual Meeting of
Stockholders and supplemented its proxy statement with respect to the
acquisition and the plaintiff withdrew his application for a preliminary
injunction against the acquisition. The acquisition was approved by the
Company's stockholders at the Annual Meeting of Stockholders held on September
8, 1997, and the acquisition was consummated on September 11, 1997. A definitive
Stipulation of Settlement was executed, subject to the approval by the Court of
Chancery. As a result of the restatement of the Company's financial statements
for the fourth quarter of 1996 and the first three quarters of 1997, the
plaintiff withdrew his support for the Stipulation of Settlement and moved for
leave to file an amended and supplemental complaint that sought, among other
things, to rescind the Acquisition; recover compensation or injuries allegedly
suffered by the Company and the members of the stockholder class; and recover
costs, disbursements, and counsel and expert fees. Defendants consented to the
filing of such amended and supplemental complaint. All defendants filed answers
to the amended and restated complaint. A new Stipulation of Settlement was
agreed to on December 31, 1998, subject to approval by the Court of Chancery.
The new Stipulation of Settlement provides for, among other things: (1) a
reduction in the purchase price for Norland Corp. from $17,500,000 to $8,700,000
by reducing the principal amount of the Company's promissory note issued as part
of the purchase price for the acquisition of Norland Corp. from $16,250,000 to
$7,450,000; (2) the payment of $1,890,000 of the reduced principal amount of
such promissory note by the delivery to NMS BV of 7,000,000 shares of the
Company's Common Stock, valued at $0.27 per share; (3) the reduction in the
annual interest rate on such promissory note from 7% to 6 1/2%; and (4) the
payment by the Company of any award of fees and expenses of plaintiff's counsel
up to $1,000,000. The Court of Chancery approved this Stipulation of Settlement
at a hearing held on March 18, 1999.

      Wesley D. Johnson and Pamela S. T. Johnson v. Reynald G. Bonmati, Kurt W.
Streams and Norland Medical Systems, Inc. This shareholder's class action was
filed in the United States District Court for the Southern District of New York
on April 12, 1998 against the Company, Reynald G. Bonmati, its Chief Executive
Officer, and Kurt W. Streams, its Chief Financial Officer. The complaint made
claims under Sections 10(b) and 20 of the Securities Exchange Act of 1934,
arising from the Company's announcement on March 16, 1998 that it would be
restating its financial statements with respect to the fourth quarter of 1996,
and the first three quarters of 1997. The claims were made on behalf of a
purported class of certain persons who purchased the Company's Common Stock from
February 25, 1997 through March 16, 1998. Plaintiffs seek compensatory damages
in an unspecified amount, together with prejudgement interest, costs and
expenses (including attorneys' fees and disbursements). On August 10, 1998,
prior to the expiration of the defendants time to respond to the complaint, the
lead plaintiff filed an amended complaint purporting


                                       14
<PAGE>

to expand the class period through March 31, 1998. The defendants filed a motion
to dismiss the amended complaint. The motion is pending before the Court.

      In addition, in the normal course of business, the Company is named as
defendant in lawsuits in which claims are asserted against the Company. In the
opinion of management, the liabilities, if any, which may ultimately result from
such lawsuits are not expected to have a material adverse effect on the
financial position, results of operations or cash flows of the Company.

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

      No matters were submitted to a vote to the Company's security holders
during the fourth quarter of the fiscal year ended December 31, 1998.

                      EXECUTIVE OFFICERS OF THE REGISTRANT

            The Company's current executive officers are as follows:

      Name            Age                     Position
      ----            ---                     --------
Reynald G. Bonmati    51     Chairman of the Board; President; and Treasurer

Kurt W. Streams       37     Vice President, Finance; and Secretary

Lewis N. Harrold      51     Vice President, Product Development; and
                             Assistant Secretary

Ralph J. Cozzolino    53     Vice President, Sales

      Mr. Bonmati has served as a Director of the Company since its formation in
December 1993 and has served as Chairman of the Board, President and Treasurer
of the Company since January 1994. Mr. Bonmati has served since January 1992 as
a Managing Director of NMS BV, the holding company that owns Stratec. He has
also served as President of Novatech Resource Corporation, a private investment
firm, since 1981, and as President of Novatech Management Corporation, a private
investment firm, since 1990. Mr. Bonmati was also President and Chairman of the
Board of Directors of SBP Technologies, Inc. from 1993 to 1998. Mr. Bonmati
received BS and MS degrees from the Institut National Superieur de Chimie
Industrielle, an MS degree from the Ecole Nationale Superieure du Petrole et des
Moteurs and an MBA from the University of Paris.

      Mr. Streams joined the Company in September 1995 and has served as Vice
President, Finance and Secretary of the Company since February 1996. From 1988
to 1995, Mr. Streams was an Audit Manager and a Senior Audit Manager with
Deloitte & Touche LLP in the United States and Deloitte & Touche
Registeraccountants in the Netherlands. Mr. Streams holds a BA degree in
economics from the University of Massachusetts.

      Mr. Harrold joined the Company in November 1995 and has served as Vice
President, Product Development since May 1996. From 1976 to 1995, Mr. Harrold
held various positions with Waters Medical Systems, serving most recently as
Vice President of Engineering and General Manager from 1992 through 1995. He
holds a BSEE from Carnegie Mellon University.


                                       15
<PAGE>

      Mr. Cozzolino has served as Vice President, Sales since October 1998. From
May 1996 to September 1998, Mr. Cozzolino was the Company's Regional Sales
Manager for the eastern United States and Canada. From January 1995 to April
1996, Mr. Cozzolino was Vice President, Operations and Sales, of World
Technologies, Inc., a manufacturer of PC-based imaging equipment. Prior to 1995,
he was National Sales Manager of Luxor Corporation, a manufacturer of surgical
lasers.

                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
        STOCKHOLDER MATTERS.

      The Company's Common Stock is traded on the Over-The-Counter Bulletin
Board under the symbol "NRLD". Prior to September 23, 1998, the Company's Common
Stock was traded on the NASDAQ National Market. The following table sets forth,
for the periods indicated, the high and low sales prices per share of Common
Stock, as reported by the Over-The-Counter Bulletin Board and the NASDAQ
National Market for the respective periods.

PERIOD FROM JANUARY 1, 1997 THROUGH DECEMBER 31, 1997:

                                             High             Low
                                             ----             ---

First Quarter                               $  8.75          $5.00
Second Quarter                                11.00           5.50
Third Quarter                                 12.38           8.75
Fourth Quarter                                 9.25           4.50

PERIOD FROM JANUARY 1, 1998 THROUGH DECEMBER 31, 1998:

                                             High             Low
                                             ----             ---

First Quarter                               $ 9.88           $3.25
Second Quarter                                3.63            1.00
Third Quarter                                 1.81            0.41
Fourth Quarter                                0.80            0.19

      As of March 22, 1999, there were approximately 46 outstanding stockholders
of record of the Company's Common Stock. This number excludes persons whose
shares were held of record by a bank, broker or clearing agency.

      The Company has not paid any cash dividends on its shares of Common Stock
and does not expect to pay any cash dividends in the foreseeable future. The
Company's policy has been to reinvest any earnings in the continued development
and operations of its business.

ITEM 6. SELECTED FINANCIAL DATA.

      The Company began operations in January 1994 as the exclusive distributor
throughout much of the world for the bone densitometry products developed and
manufactured by Norland Corp. and Stratec. The Company acquired Norland Corp.
from NMS BV on September 11, 1997. Stratec is a subsidiary of NMS BV. Certain of
the Company's stockholders control NMS BV. The Company has no ownership interest
in NMS BV.


                                       16
<PAGE>

      The financial data as of December 31, 1998 and 1997 and for the periods
ended December 31, 1998, 1997 and 1996 has been derived from the consolidated
financial statements of the Company for the periods indicated and should be read
in conjunction with such financial statements and notes thereto, which are
included at Item 8 of this Report, and with "Management's Discussion and
Analysis of Financial Condition and Results of Operations", included at Item 7
of this Report.

<TABLE>
<CAPTION>
                                                                          Norland Medical Systems, Inc.
                                                                         For the Years Ended December 31,
                                                ----------------------------------------------------------------------------------- 
                                                    1994              1995             1996(2)          1997(3)            1998
                                                ------------      ------------     ------------     ------------       ------------ 
<S>                                             <C>               <C>              <C>              <C>                <C>         
Statement of Operations Data:
Revenue .....................................   $ 10,041,548      $ 18,243,808     $ 24,326,134     $ 20,530,376       $ 14,384,491
Cost of revenue .............................      6,517,701        12,508,809       15,709,420       15,568,876          8,888,947
One-time distribution agreement costs .......      1,922,247                 0                0                0                  0
                                                ------------      ------------     ------------     ------------       ------------ 
  Gross profit ..............................      1,601,600         5,734,999        8,616,714        4,961,500          5,495,544

Sales and marketing expense .................        973,208         1,651,125        3,756,391        5,635,469          6,711,653
General and administrative expense ..........        526,364           960,368        1,900,598        4,688,132          5,690,071
Research and development expense ............              0                 0          271,917          749,847          1,889,583
In-process research and development charge ..              0                 0                0        7,900,000                  0
Non-recurring charges .......................              0                 0          397,697        7,228,287            400,000
                                                ------------      ------------     ------------     ------------       ------------ 
  Income (loss) from operations .............        102,028         3,123,506        2,290,111      (21,240,235)        (9,195,763)

Loss on investment in Vitel, Inc. ...........              0                 0                0                0           (260,000)
Interest expense ............................         (6,984)                0                0         (383,962)        (1,289,665)
Interest income .............................              0           412,983          703,744          345,745             86,168
                                                ------------      ------------     ------------     ------------       ------------ 
  Income (loss) before income taxes (benefit)         95,044         3,536,489        2,993,855      (21,278,452)       (10,659,260)
Income taxes (benefit) ......................         27,000         1,436,000        1,216,000       (2,694,447)          (946,000)
                                                ------------      ------------     ------------     ------------       ------------ 
  Net income (loss) .........................   $     68,044      $  2,100,489     $  1,777,855     $(18,584,005)      $ (9,713,260)
                                                ============      ============     ============     ============       ============ 

Earnings (loss) per share(1)
  Basic .....................................   $       0.02      $      0. 43     $       0.26     $      (2.60)      $      (1.35)
  Diluted ...................................           0.02              0.40             0.25            (2.60)             (1.35)

Weighted average number of
  common shares outstanding(1):
   Basic ....................................      3,000,000         4,832,877        6,824,590        7,145,465          7,183,032
   Diluted ..................................      4,002,000         5,248,184        7,168,871        7,145,465          7,183,032
</TABLE>

<TABLE>
<CAPTION>
                                                                                 As of December 31,
                                                ----------------------------------------------------------------------------------- 
                                                    1994              1995             1996             1997               1998
                                                ------------      ------------     ------------     ------------       ------------ 
<S>                                             <C>               <C>              <C>              <C>                <C>         
Balance Sheet Data:
Working capital .............................   $   68,044        $20,326,055      $17,522,404      $11,624,860        $ 2,407,993
Total assets ................................    2,751,929         24,706,377       30,115,136       29,378,525         19,057,907
Long-term debt ..............................            0                  0                0       14,439,756          4,685,690
Stockholders' equity ........................       68,044         20,520,846       26,107,346        7,610,985          8,791,883
</TABLE>

(1)   Reflects the 2,000-for-1 split of the Common Stock in June 1995, the
      three-for-two split of the Common Stock in June 1996, and restatements for
      the adoption of SFAS No. 128, "Earnings per Share" (see Note 2 to the
      consolidated financial statements).

(2)   The results of operations of Dove Medical Systems, Inc. have been included
      from the April 2, 1996 date of acquisition.

(3)   The results of operations of Norland Corp. have been included from the
      September 11, 1997 date of acquisition.


                                       17
<PAGE>

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

      The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the Consolidated
Financial Statements and the related Notes thereto included in Item 8 of this
Report. The following discussion contains forward-looking statements which
involve risks and uncertainties, some of which are described in the Introduction
to this Report. The Company's actual results could differ materially from those
anticipated in these forward-looking statements as a result of certain factors,
including those discussed in the Introduction.

General

      Revenues and costs of revenues for systems and spare parts are generally
recognized at the time products are shipped and title passes to the customer.
Service revenue is recognized at the time the service is performed. Sales to
customers are generally made in U.S. dollars.

      Prior to September 11, 1997, the Company had exclusive worldwide
distribution rights to all products developed and manufactured by Norland Corp.
and Stratec. Under the arrangements with Norland Corp. and Stratec, the margins
between their costs of manufacturing the products and the amounts for which the
Company sold the products was divided between the Company and the manufacturers
as provided in the Company's Distribution Agreement with Norland Corp. and
Stratec. On September 11, 1997, the Company acquired Norland Corp. from NMS BV.
The $17,500,000 purchase price was paid at closing, $1,250,000 in cash and
$16,250,000 by the Company's 7% promissory note issued to NMS BV (the "Purchase
Note"). A $1,250,000 principal payment on the Purchase Note was originally
payable on March 11, 1998. The Purchase Note was amended to provide that such
payment would not be due until such time as the Company receives at least
$2,000,000 in proceeds from a debt or equity financing. The balance was payable
on September 11, 2002 with a right on the part of the Company to extend the
maturity for up to an additional two years. If the maturity was so extended, the
applicable interest rate would be subject to increases during the extension
period. The Purchase Note provided that the Company could repay at any time and
that, except for the $1,250,000 payment referred to above, the Company could
make payments of principal by delivering shares of its Common Stock, valued at
the average closing price for the five trading days preceding the delivery.

      On December 31, 1998, in connection with the settlement of the Miller v.
Bonmati litigation referred to in Item 3 of this Report, the terms of the
Norland Corp. acquisition were amended. Effective as of December 31, 1998, the
original $17,500,000 purchase price was reduced to $8,700,000 by reducing the
principal amount of the Purchase Note from $16,250,000 to $7,450,000. In
addition, $1,890,000 of principal of reduced Purchase Note was paid by
delivering 7,000,000 shares of the Company's Common Stock to NMS BV priced at
$0.27 per share, the average closing price for the five trading days prior to
December 31, 1998. The interest rate on the $5,560,000 balance of the Purchase
Note was reduced to 6 1/2%. The other payment terms, including those with
respect to maturity, prepayment and the ability to pay principal by delivering
shares of Common Stock, were not changed. The Purchase Note is collateralized by
a pledge to NMS BV of all of the stock of Norland Corp.

      As a result of the acquisition of Norland Corp., the Company receives the
entire margin between the cost of Norland Corp. products manufactured after the
date of acquisition and the amount for which the Company sells such products.
The Company entered into a new Distribution Agreement with Stratec which is
described in Item 1 of this Report.


                                       18
<PAGE>

Result of Operations

      The following table sets forth for the periods indicated certain items
from the Company's Statements of Operations as a percentage of revenue:

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

                                                    Years Ended December 31,
                                                    ------------------------
                                                 1998         1997         1996
                                                -----        -----        -----

Revenue ..................................      100.0%       100.0%       100.0%
Cost of revenue ..........................       61.8         75.8         64.6
                                                -----        -----        -----
  Gross profit ...........................       38.2         24.2         35.4

Sales and marketing expense ..............       46.7         27.4         15.4
General and administrative expense .......       39.5         22.8          7.8
Research and development expense .........       13.1          3.7          1.1
In-process research and development charge        0.0         38.5          0.0
Non-recurring charges ....................        2.8         35.2          1.6
                                                -----        -----        -----
  (Loss) income from operations ..........      (63.9)      (103.5)         9.5

Loss on investment in Vitel, Inc. ........        1.8          0.0          0.0
Interest income ..........................       (0.6)        (1.7)        (2.9)
Interest expense .........................        9.0          1.9          0.0
                                                -----        -----        -----
  (Loss) income before income taxes ......      (74.1)      (103.7)        12.4
  Income taxes (benefit) .................       (6.6)       (13.1)         5.0
                                                -----        -----        -----
  Net (loss) income ......................      (67.5)       (90.6)         7.4
                                                =====        =====        =====
--------------------------------------------------------------------------------

      The Company's Year Ended December 31, 1998 Compared to Its Year Ended
December 31, 1997.

      Revenue for 1998 decreased $6,145,885 (29.9%) to $14,384,491 from
$20,530,376 for 1997. The decrease was largely the result of lower sales of
densitometry systems, especially in the United States, and lower revenue from
sales of parts and services. The decrease in U.S. sales was partially offset by
a large third quarter single order sale of peripheral systems in the Pacific
Rim. Sales in the United States and Pacific Rim represented 66.7% and 14.3%,
respectively, of total revenue for 1998 and 71.5% and 1.1%, respectively, of
total revenue for 1997. A majority of the Company's revenue for 1998 and 1997
was derived from sales of the Eclipse and XR36 central systems. Sales of
complete bone densitometry systems represented 91.4% and 89.7% of total revenue
for 1998 and 1997, respectively. Sales of parts and services and rental income
comprised the balance of revenue for such periods.

      Sales in the United States have been affected by changes in the Medicare
reimbursement rates for bone densitometry tests. In November 1996 the Health
Care Financing Administration (HCFA) announced changes for 1997 that
significantly reduced the reimbursement rate for peripheral bone densitometry
tests. In June 1997 HCFA published proposed changes for 1998 that would have
increased the reimbursement rate for peripheral systems and significantly
reduced the rate for central systems. These proposed reimbursement rates for
1998 were not adopted by HCFA. Instead, the 1998 rates for both peripheral and
central systems, as finally adopted, were increased slightly over their
applicable rates for 1997. Such reimbursement rates are subject to further
changes. Several regional Medicare carriers did not allow any reimbursement for
peripheral bone densitometry tests. However, effective July 1, 1998, HCFA's
national policy mandates Medicare coverage of bone density diagnostic tests for
qualified individuals. Revenues and the mix of products sold are expected to
continue to be influenced by the relative degree of difference in reimbursement
rate levels for peripheral and central systems. They will also be influenced by
the Company's ability to bring


                                       19
<PAGE>

to the market systems that can be operated more profitably by end users at the
applicable reimbursement levels.

      Cost of revenue as a percentage of revenue was 61.8% and 75.8% for 1998
and 1997, respectively, resulting in a gross margin of 38.2% for 1998 compared
to 24.2% for 1997. The increase in gross margin for 1998 is primarily
attributable to the significantly greater inventory reserve charge taken in 1997
($4,161,953 in 1997 compared to $443,323 in 1998) and to the $712,000 third
quarter 1998 sale of certain systems that had been written off in prior periods.
Norland Corp. was a subsidiary of the Company for all of 1998. Because Norland
Corp. has certain fixed manufacturing costs, to the extent that revenues are
lower for any particular period, such fixed costs have a more negative impact on
gross margin.

      Sales and marketing expense increased $1,076,184 (19.1%) to $6,711,653 for
1998 from $5,635,469 for 1997, and increased as a percentage of revenue to 46.7%
from 27.4%. The dollar increase was primarily due to increased expenses of the
Company's customer service department required to support the expanding
installed base of systems in the United States, expenses of sales and marketing
personnel hired during the second half of 1997, and the continuing cost of
marketing efforts that were expanded during the second half of 1997.

      General and administrative expense increased $1,001,939 (21.4%) to
$5,690,071 for 1998 from $4,688,132 for 1997 and increased as a percentage of
revenue to 39.5% from 22.8%. The largest component of the increase was an
increase in professional fees of approximately $800,000 (primarily due to
litigations and to matters directly and indirectly related to the restatement of
the Company's financial statements for 1996 and the first three quarters of
1997). In addition, the inclusion of general and administrative expenses of
Norland Corp. for a full year, including an annual goodwill amortization expense
of $595,000 related to the Company's acquisition of Norland Corp. on September
11, 1997, contributed to the increase. The increased expenses were partially
offset by a lower allowance for doubtful accounts in 1998 and the elimination of
expenses for the Company's Dove Medical Systems subsidiary, whose Newbury Park,
California facility was closed in September 1997.

      Research and development expense increased $1,139,736 (152.0%) to
$1,889,583 for 1998 from $749,847 for 1997, and also increased as a percentage
of revenue to 13.1% from 3.7%. The dollar increase was primarily the result of
the inclusion of research and development expenses of Norland Corp. for a full
year, which expenses were partially offset by the elimination of expenses of
Dove Medical Systems.

      The increases in expense as a percentage of revenues referred to in the
three preceding paragraphs are also attributable to the Company's reduced
revenues for 1998.

      The Company recognized non-recurring charges of $400,000 and $15,128,287
in 1998 and 1997, respectively. In 1998 the Company settled certain patent
infringement litigation and, in connection with the settlement, agreed to pay
$400,000 in patent licensing fees, the timing of such payments to be based on
future sales of certain products through August 2004. A $50,000 advance payment
was made in 1998. The 1997 charge consisted of an in-process research and
development charge ($7,900,000) in connection with the acquisition of Norland
Corp., the closing of the Company's Dove Medical Systems subsidiary facility and
related asset write-offs ($7,126,782) and the acquisition of certain
distribution rights for an ultrasound product ($101,505). With respect to the
1997 in-process research and development charge and the two projects to which it
related, one such project was later completed and resulted in the May 1998
introduction of the Apollo DXA. The second project is ongoing and is not
expected to have a significant effect on the Company for the foreseeable future.

      Interest expense of $1,289,665 and $383,962 for 1998 and 1997,
respectively, represents interest on the $16,250,000 Purchase Note issued by the
Company in connection with the acquisition of Norland Corp.


                                       20
<PAGE>

The increase in expense reflects the fact that the Purchase Note was issued on
September 11, 1997 and was outstanding for all of 1998. Interest income in 1998
and 1997 consisted primarily of interest earned on the Company's cash balances,
reduced by other expenses consisting primarily of bank charges and other fees
related to bank transfers. The decrease in interest income in 1998 as compared
to 1997 reflects reduced interest income resulting from the Company's reduced
cash position. In 1998, the Company also wrote off its $260,000 minority
interest investment in Vitel, Inc.

      The income tax benefit as a percentage of loss before income taxes was
8.9% for the year ended December 31, 1998 as compared to a benefit percentage of
12.7% for 1997. The income tax benefit for 1998 was derived primarily from the
operating loss and was reduced to an effective rate of 8.9% by the valuation
allowance referred to below and the non-deductibility of goodwill amortization.
The 1997 income tax benefit also derived primarily from the 1997 operating loss
and was reduced to an effective rate of 12.7% by the non-deductibility of the
write-offs of both in-process research and development and goodwill.

      Net deferred tax assets increased $374,548 to $3,392,841 at December 31,
1998 from $3,018,293 at December 31, 1997, primarily as a result of an
additional asset recognized for 1998 net operating losses which was reduced by a
$2,421,338 valuation allowance. The deferred tax assets can be realized
primarily through future taxable income. Management believes that based on the
Company's history of operating earnings, exclusive of the nonrecurring and other
charges in 1998 and 1997, and its expected income, it is more likely than not
that future levels of income will be sufficient to realize the deferred tax
assets, as recorded.

      The Company had a net loss of $9,713,260 ($1.35 per share) for 1998
compared to net loss of $18,584,005 ($2.60 per share) for 1997. The
non-recurring charges of $400,000 ($0.06 per share) and $15,128,287 ($2.12 per
share) recognized in 1998 and 1997, respectively, increased the net losses for
such years on an after-tax basis by $364,400 and $13,439,907 respectively.
Excluding the after tax effect of these charges, the net losses for 1998 and
1997 would be $9,475,660 ($1.32 per share) and $5,144,098 ($0.72 per share),
respectively.

      The Company's Year Ended December 31, 1997 Compared to Its Year Ended
December 31, 1996.

      Revenue for 1997 decreased $3,795,758 (15.6%) to $20,530,376 from
$24,326,134 for 1996. The decrease was largely the result of significantly
decreased sales in the Pacific Rim and Japan in particular, offset by increased
sales in Europe, Latin America and the United States. Sales in Japan continued
to decline due in part to increased competition from ultrasound and other
systems and to reductions in reimbursement for certain densitometry tests in
Japan. Sales in the United States and Japan represented 71.5% and 1.1%,
respectively, of total revenue for 1997 and 52.0% and 22.4% respectively, of
total revenue for 1996. Sales of complete bone densitometry systems represented
89.7% and 93.8% of total revenue for 1997 and 1996, respectively. Sales of parts
and services and rental income comprised the balance of revenues for both years.

      Cost of revenue as a percentage of revenue was 75.8% and 64.6% for 1997
and 1996, respectively, resulting in a gross margin of 24.2% for 1997 compared
to 35.4% for 1996. The decrease in gross margin is primarily attributed to the
impact of the significantly greater inventory reserve charge taken in 1997
($4,161,953 in 1997 compared to $30,000 in 1996). The 1997 inventory charge
consisted of the write-off of demonstration systems with no future value, excess
quantities of certain DXA-based inventory and Dove inventory. Partially
offsetting the decrease in 1997 was the positive effect on gross margin of
reductions in the prices at which the Company purchased systems from Norland
Corp. and Stratec which became effective during the fourth quarter of 1996.

      Sales and marketing expense increased $1,879,078 (50.0%) to $5,635,469 for
1997 from $3,756,391 for 1996, and increased as a percentage of revenue to 27.4%
from 15.4%. The increases were primarily due


                                       21
<PAGE>

to increased expenses of new sales and marketing personnel, the cost of expanded
marketing efforts, and increased expenses related to customer service. The
infrastructure required for the Company's sales efforts in the United States
carries with it a relatively higher expense level than that which has been
applicable to the Company's sales efforts in the Pacific Rim, Europe and Latin
America.

      General and administrative expense increased $2,787,534 (146.7%) to
$4,688,132 for 1997 from $1,900,598 for 1996 and increased as a percentage of
revenue to 22.8% from 7.8%. The largest component of the increase was a
$1,850,000 charge for doubtful accounts receivable. This charge related
primarily to receivables of the Company's Dove subsidiary, whose facility was
closed in 1997, and of two customers of the Company with significant receivables
for which collection had become highly questionable. Other factors contributing
to the increases included expenses of new personnel, increased expenses of
existing personnel and professional fees, and general and administrative
expenses of Norland Corp. following the Company's acquisition of Norland Corp.
on September 11, 1997.

      Research and development expense increased $477,930 (175.8%) to $749,847
for 1997 from $271,917 for 1996, and also increased as a percentage of revenue
to 3.7% from 1.1%. The increases are primarily the result of the inclusion of
the research and development expenses of Norland Corp. following the September
11, 1997 acquisition of Norland Corp.

      The increases in expense as a percentage of 1997 revenues referred to in
the three preceding paragraphs are also attributable to the Company's reduced
revenues in 1997.

      The Company recognized non-recurring charges of $15,128,287 in 1997. At
the time of the acquisition of Norland Corp., certain research and development
projects acquired were not at a stage in which technological feasibility had
been achieved and were determined to have no alternative future use.
Accordingly, $7,900,000 of the purchase price was allocated to this in-process
research and development and expensed. In response to the increasing dominance
of the peripheral bone densitometry market by DXA technology, the Company closed
the Newbury Park facility of its Dove subsidiary and recorded a $7,126,782
write-off related to the value of fixed assets, goodwill, a patent and other
intangible assets, having concluded that expected cash flows will not enable the
Company to recover any of the remaining carrying value of such assets. In August
1997, the Company acquired distribution rights to an ultrasound product and
recorded a $101,505 non-recurring charge for costs incurred in connection with
the selection of an ultrasound product.

      Interest expense of $383,962 for 1997 represents interest on the Purchase
Note issued by the Company in connection with the acquisition of Norland Corp.
on September 11, 1997. Interest income in 1997 and 1996 consisted primarily of
interest earned on the Company's cash and loan balances, reduced by other
expenses consisting primarily of bank charges and other fees related to bank
transfers. The decrease in interest income in 1997 as compared to 1996 reflects
reduced interest income resulting from the Company's reduced cash position.

      The income tax benefit as a percentage of loss before income taxes was
12.7% for the year ended December 31, 1997, as compared to a provision for
income taxes of 40.6% for the same period in 1996. The effective rate of 12.7%
for 1997 was principally a result of the nondeductibility of both the write-off
of in-process research and development as part of the acquisition of Norland
Corp. and the write-off of goodwill in connection with the closing of the Dove
facility.

      Net deferred tax assets were $3,018,293 at December 31, 1997, an increase
of $2,736,293 from deferred tax assets at December 31, 1996, primarily as a
result of the write off of demonstration inventory and increases in excess
inventory reserves, allowance for doubtful accounts and net operating loss
carryforwards. A portion of the deferred tax assets can be realized through
carryback and reversals of


                                       22
<PAGE>

existing taxable temporary differences with the remainder dependent on future
income. Management believes that based on the Company's history of operating
earnings, exclusive of the nonrecurring charges in 1997, and its expected
income, it is more likely than not that future levels of income will be
sufficient to realize the deferred tax assets, as recorded.

      The Company had a net loss of $18,584,005 for 1997 compared to net income
of $1,777,855 for 1996. The decrease was due primarily to the factors discussed
above.

      Liquidity and Capital Resources

      At December 31, 1997, the Company had cash of $3,082,202. At December 31,
1998, the Company had cash of $1,105,140. The decrease in cash was primarily
attributed to the net use of cash in operating activities as a result of the net
operating loss and investments in demonstration systems and tooling needed for
the new Apollo DXA product.

      The Company's accounts receivable decreased $4,288,196 (69.6%) to
$1,877,271 at December 31, 1998 from $6,165,467 at December 31, 1997, primarily
reflecting lower revenues for the year and more prompt payments by customers.

      Property and equipment as of December 31, 1998 consisted of computer and
telephone equipment, a management information system, demonstration systems,
office furniture, leasehold improvements, and tooling for the products
manufactured by the Company. At the present time, capital expenditures for 1999
are estimated to be $250,000, and include additional demonstration systems,
tooling and continued upgrading of the Company's management information system.

      In connection with the settlement of the litigation relating to the
Company's acquisition of Norland Corp. (see Item 3), the Purchase Note issued to
NMS BV as part of the purchase price for Norland Corp. was amended on December
31, 1998 to, among other things, reduce the principal amount by $8,800,000 and
reduce the interest rate from 7% to 6 1/2%. An additional $1,890,000 of
principal was paid by delivering 7,000,000 shares of the Company's common stock
to NMS BV. The Company may, at its sole option and discretion, pay up to
$4,310,000 of the remaining $5,560,000 of principal with shares of Company
common stock valued at the time of payment. Interest payments on the $5,560,000
principal of the Purchase Note will be approximately $90,000 per quarter.
Interest on the original $16,250,000 of principal for the period from July 1,
1998 through December 31, 1998 ($577,184) was outstanding on December 31, 1998.
$287,500 was paid on January 4, 1999, and the Company and NMS BV have agreed
that the balance will be paid in installments during 1999.

      The Company believes that its current cash position, together with cash
flow from operations, will be adequate to fund the Company's operations at least
through December 31, 1999. In order to increase its cash flow, the Company is
continuing its efforts to stimulate sales and reduce inventory levels. The
Company will be required to use working capital to manufacture the recently
introduced Apollo DXA and Excell. The Company is also continuing to focus its
efforts on improving the aging of its accounts receivable. To do so, the Company
has implemented higher credit standards for its customers and is emphasizing the
receipt of down payments from customers at the time their purchase orders are
received. The Company is also continuing to be more aggressive in seeking to
collect outstanding receivables.

      The Company has been seeking equity and debt financing. The Company does
not have a commitment for such financing, and there can be no guarantee that the
Company will be able to obtain such financing. The failure to do so could
materially adversely affect the Company and its operations. In addition, the
nature of the Company's business is such that it is subject to changes in
technology, government approval and regulation, and changes in third-party
reimbursement in the United States and numerous foreign


                                       23
<PAGE>

markets. Significant changes in one or more of these factors in a major market
for the Company's products could significantly affect the Company's cash needs.

Year 2000 Readiness

      The year 2000 (Y2K) problem stems from the fact that many existing
computer programs use only the last two digits to refer to a year. As a result,
such programs do not recognize a year that begins with "20" instead of "19", and
may recognize a date using "00" as the year 1900 rather than the year 2000. If
not corrected, many computer applications could fail or produce erroneous
results, such as a temporary inability to process transactions, send invoices or
engage in many ordinary business activities.

      The Company is evaluating the Y2K problem with respect to the Y2K
readiness of its internal management information and non-financial systems and
the Company's product lines and suppliers. At this point in time, the Company is
not aware of any Y2K problems that are reasonably likely to have a material
effect on the Company's business, results of operations or financial condition.

      The Company is completing its review of its internal management systems
for Y2K compliance. The Company believes that, with the following exceptions,
its information systems are Y2K compliant. The Norland Corp. management
information systems, as was planned following the Company's September 1997
acquisition of Norland Corp., are being replaced with systems that are
compatible with the Company's Y2K compliant management information systems. The
Company also uses certain other application hardware and software which may not
be Y2K compliant. Upgrades for most of these systems are available as part of an
annual maintenance program. The Company believes that it already has obtained
and installed most of the necessary upgrades for these programs and that the
remaining upgrades will be available during 1999 without material expense to the
Company. The Company anticipates that it will be able to complete, test and
implement all software upgrades that may be material to its business on a timely
basis. There is always a risk that, if the Company has not properly identified
all Y2K compliance issues with respect to its internal systems, the Company may
not be able to implement all necessary changes to these systems on a timely
basis and within budget. This in turn could cause a material disruption to the
Company's business, including the inability to process orders on a timely basis,
which could have a material adverse effect on its business, results of
operations and financial condition.

      The Company has evaluated the product lines currently offered by the
Company for Y2K compliance. The Company believes that its peripheral and
traditional DXA-based products are Y2K compliant. With respect to its pQCT and
ultrasound products, certain Y2K compliance issues exist. The Company plans to
make software upgrades for these products available to its customers before
January 1, 2000. The costs to the Company, if any, are not expected to be
material, as such upgrades to products still under warranty should be provided
by the product manufacturers at no charge. Upgrades of non-warranty products
will be provided at the customer's expense. The Company has also identified
certain older DXA, SXA and pQCT products that will also require computer
hardware and/or software upgrades to become Y2K compliant. The Company plans to
offer users of these products the opportunity to purchase upgrade options.

      The Company's ability to manufacture and sell systems on a timely basis
could be adversely affected by Y2K compliance problems that may be experienced
by its suppliers and customers. The Company has made inquiries of its major
suppliers in an effort to determine their year 2000 readiness. The Company
cannot presently estimate the nature or extent of any potential adverse impact
resulting from the failure of these third parties to achieve Y2K compliance.
Even if such third parties are themselves Y2K compliant, they may be adversely
affected by Y2K problems of third parties with whom they deal.

      Other than the actions described above, at the present time the Company
does not have a contingency plan to address the Y2K problem. The Company has
begun the process of developing a contingency plan to address potential Y2K
problems affecting it and third parties with whom it deals. The Company
presently anticipates completing such plan over the next six months. Should any
significant Y2K


                                       24
<PAGE>

problems arise that are not adequately dealt with in such plan, the Company and
its business, financial condition and results of operations could be materially
adversely affected.

      If the Company does not identify and effectively deal with material Y2K
problems affecting the Company or third parties, the most reasonably likely
worst case scenario would be a systemic failure beyond the control of the
Company, such as a prolonged telecommunications or electrical failure, or a
general disruption of business activities that triggers a significant economic
downturn. The Company believes that the primary business risks to the Company in
such event would include, but not be limited to, loss of orders, increased
operating costs, inability to obtain inventory on a timely basis, disruptions in
product shipments, or other business interruptions of a material nature, as well
as claims of mismanagement, misrepresentation, or breach of contract, any of
which could have a material adverse effect on the Company and its business,
results of operations and financial condition.

Forward-looking Statements

      As indicated in the Introduction to this Report, forward-looking
statements, including those contained in this Management's Discussion and
Analysis section, are subject to risks and uncertainties. This section includes
forward-looking statements with respect to the effect of reimbursement rates on
future sales and product mix, the Company's ability to realize deferred tax
assets as recorded, future capital expenditures, Year 2000 readiness and the
Company's plans for funding its ongoing operations. Such forward-looking
statements are subject to the factors cited in the Introduction.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS.

The table below provides information about the Company's market sensitive
financial instruments and constitutes a "forward-looking statement". The
Company's major financial market risk exposure is changing interest rates,
primarily in the United States. The Company's policy has been to manage its
interest rate risks through use of a fixed rate debt. See Note 8 for a
description of the Note Payable. All items described are non-trading and are
stated in U.S. dollars.

<TABLE>
<CAPTION>
                                                         Expected Maturity Dates
                                     ---------------------------------------------------------------                 Fair Value
                                        1999      2000      2001      2002      2003      Thereafter     Total     December 31, 1998
                                        ----      ----      ----      ----      ----      ----------     -----     -----------------
<S>                                  <C>                            <C>                                <C>           <C>
CASH AND CASH EQUIVALENTS

Bank deposits--non interest bearing  $  123,942                                                        $  123,942    $  123,942

Money Market Mutual Fund Shares         981,198                                                           981,198       981,198

   Average interest rate - 4.82%

NOTE PAYABLE

  Fixed interest rate - 6.50%                                       $5,560,000                          5,560,000     4,685,690
  Market interest rate - 10.75%
</TABLE>


                                       25
<PAGE>

ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

                        CONSOLIDATED FINANCIAL STATEMENTS

                                      INDEX

                                                                            Page
                                                                            ----

Independent Auditors' Reports                                                 27

Financial Statements:

       Consolidated Balance Sheets as of December 31, 1998 and 1997           29

       Consolidated Statements of Operations for the years ended
              December 31, 1998, 1997 and 1996                                30

       Consolidated Statements of Changes in Stockholders' Equity
              for the years ended December 31, 1998, 1997 and 1996            31

       Consolidated Statements of Cash Flows for the years ended
              December 31, 1998, 1997 and 1996                                32

       Notes to Consolidated Financial Statements                             34

Financial Statement Schedule:

       Valuation and Qualifying Accounts                                      51


                                       26
<PAGE>

                          INDEPENDENT AUDITORS' REPORT

To the Stockholders and Board of Directors of
  Norland Medical Systems, Inc.:

We have audited the accompanying consolidated financial statements and the
financial statement schedule of Norland Medical Systems, Inc. and subsidiaries
(the "Company") as of December 31, 1998 and for the year then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these 1998 financial statements based
on our audit.

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

In our opinion, the 1998 financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Norland Medical
Systems, Inc. and subsidiaries as of December 31, 1998, and the consolidated
results of their operations and their cash flows for the year then ended in
conformity with generally accepted accounting principles. In addition, in our
opinion, the 1998 financial statement schedule referred to above, when
considered in relation to the basic 1998 consolidated financial statements taken
as a whole, presents fairly, in all material respects, the information required
to be included therein.


DELOITTE & TOUCHE LLP

Hartford, Connecticut
March 19, 1999


                                       27
<PAGE>

                        REPORT OF INDEPENDENT ACCOUNTANTS

To the Stockholders and Board of Directors of
  Norland Medical Systems, Inc.:

We have audited the accompanying consolidated financial statements and the
financial statement schedule of Norland Medical Systems, Inc., listed in the
index on page 26 of this Form 10-K, as of December 31, 1997 and for the years
ended December 31, 1997 and 1996. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

The Company, as disclosed in the financial statements, has extensive
transactions and relationships with related parties. Because of these
relationships, it is possible that the terms of these transactions are not the
same as those that would result from transactions among wholly unrelated
parties.

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Norland Medical
Systems, Inc. as of December 31, 1997, and the consolidated results of its
operations and its cash flows for the years ended December 31, 1997 and 1996 in
conformity with generally accepted accounting principles. In addition, in our
opinion, the financial statement schedule referred to above, when considered in
relation to the basic financial statements taken as a whole, presents fairly, in
all material respects, the information required to be included therein.


COOPERS & LYBRAND L.L.P.

New York, New York
March 31, 1998


                                       28
<PAGE>

                          NORLAND MEDICAL SYSTEMS, INC.
                           CONSOLIDATED BALANCE SHEETS

                        as of December 31, 1998 and 1997

<TABLE>
<CAPTION>
                                     ASSETS

                                                                                1998               1997
                                                                            ------------       ------------
<S>                                                                         <C>                <C>         
Current assets:
  Cash and cash equivalents                                                 $  1,105,140       $  3,082,202
  Accounts receivable - trade, less allowance for doubtful accounts of
    $300,000 and $2,200,000 at December 31, 1998 and 1997,
    respectively                                                               1,877,271          6,165,467
  Income taxes receivable                                                        340,000          1,774,314
  Inventories, net                                                             2,521,345          5,163,682
  Prepaid expenses and other current assets                                      187,354            207,221
  Deferred income taxes                                                        1,817,217          2,559,758
                                                                            ------------       ------------
      Total current assets                                                     7,848,327         18,952,644
                                                                            ------------       ------------

Officer's loan receivable                                                         91,304             86,504
Property and equipment, net                                                    1,392,032            875,166
Investment in Vitel, Inc.                                                             --            260,000
Deferred income taxes, net                                                     1,575,624            458,535
Intangible assets,  net                                                        8,150,620          8,745,676
                                                                            ------------       ------------
      Total assets                                                          $ 19,057,907       $ 29,378,525
                                                                            ============       ============

                      LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
  Current portion of note payable                                           $         --       $  1,122,788
  Accounts payable - related parties                                             292,315            584,779
  Accounts payable - trade                                                     1,435,616          2,021,904
  Accrued expenses                                                             2,215,219          1,923,938
  Accrued warranty expense                                                       920,000            890,000
  Accrued interest expense                                                       577,184            284,375
  Customer deposits                                                                   --            500,000
                                                                            ------------       ------------
      Total current liabilities                                                5,440,334          7,327,784
                                                                            ------------       ------------

Note payable, net of discount                                                  4,685,690         14,439,756
Other                                                                            140,000                 --
Commitments and contingencies (Note 12)                                               --                 --

Stockholders' equity:
Common stock, par value of $0.0005 per share -
  20,000,000 shares authorized 14,164,031 and 7,162,531 shares
  issued and outstanding at December 31, 1998 and 1997,
  respectively                                                                     7,081              3,580
Additional paid-in capital                                                    33,136,343         22,245,686
Accumulated deficit                                                          (24,351,541)       (14,638,281)
                                                                            ------------       ------------
  Total stockholders' equity                                                   8,791,883          7,610,985
                                                                            ------------       ------------

  Total liabilities and stockholders' equity                                $ 19,057,907       $ 29,378,525
                                                                            ============       ============
</TABLE>

              See notes to the consolidated financial statements.


                                       29
<PAGE>

                          NORLAND MEDICAL SYSTEMS, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS

                  Years ended December 31, 1998, 1997 and 1996

<TABLE>
<CAPTION>
                                                                    1998               1997               1996
                                                                ------------       ------------       ------------
<S>                                                             <C>                <C>                <C>         
Revenue (including sales to affiliates of $9,803, $349,483
  and $562,108 in 1998, 1997 and 1996, respectively)            $ 14,384,491       $ 20,530,376       $ 24,326,134
Cost of revenue                                                    8,888,947         15,568,876         15,709,420
                                                                ------------       ------------       ------------
  Gross profit                                                     5,495,544          4,961,500          8,616,714

Sales and marketing expense                                        6,711,653          5,635,469          3,756,391
General and administrative expense (including an
  overhead charge from an affiliate of $0, $7,800 and
  $33,136 in 1998, 1997 and 1996, respectively)                    5,690,071          4,688,132          1,900,598
Research and development expense                                   1,889,583            749,847            271,917
In-process research and development charge                                --          7,900,000                 --
Non-recurring charges                                                400,000          7,228,287            397,697
                                                                ------------       ------------       ------------

Operating (loss) income                                           (9,195,763)       (21,240,235)         2,290,111

Other income (expense):
  Loss on investment in Vitel, Inc.                                 (260,000)                --                 --
  Interest income                                                     86,168            345,745            703,744
  Interest expense                                                (1,289,665)          (383,962)                --
                                                                ------------       ------------       ------------

(Loss) income before income taxes (benefit)                      (10,659,260)       (21,278,452)         2,993,855
Income taxes (benefit)                                              (946,000)        (2,694,447)         1,216,000
                                                                ------------       ------------       ------------

Net (loss) income                                               $ (9,713,260)      $(18,584,005)      $  1,777,855
                                                                ============       ============       ============

Weighted average number of shares:
  Basic                                                            7,183,032          7,145,465          6,824,590
  Diluted                                                          7,183,032          7,145,465          7,168,871

(Loss) earnings per share:
  Basic                                                               $(1.35)            $(2.60)             $0.26
  Diluted                                                              (1.35)            $(2.60)              0.25
</TABLE>

              See notes to the consolidated financial statements.


                                       30
<PAGE>

                          NORLAND MEDICAL SYSTEMS, INC.
           CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY

                  Years ended December 31, 1998, 1997 and 1996

<TABLE>
<CAPTION>
                                                                                                                       Retained
                                                                                                      Additional       Earnings
                                                                                        Common         Paid-In       (Accumulated)
                                                            Total          Shares        Stock         Capital          Deficit
                                                        ------------     ---------   ------------    ------------    ------------
<S>                                                     <C>              <C>         <C>             <C>             <C>         
Balance as of December 31, 1995                         $ 20,520,846     6,000,000   $      3,000    $ 18,349,813    $  2,168,033

Issuance of shares for stock options exercised                   292       743,250            371             (79)             --
Issuance of shares to acquire Dove Medical
  Systems                                                  3,311,519       161,538             81       3,311,438              --
Cost and expenses directly related to stock
  offering                                                    (3,002)           --             --          (3,002)             --
Cash paid in lieu of fractional shares on 3-for-2
  split on June 14, 1996                                        (164)           (7)            --              --            (164)
Tax benefit related to stock options                         500,000            --             --         500,000              --
Net income                                                 1,777,855            --             --              --       1,777,855
                                                        ------------     ---------   ------------    ------------    ------------
Balance as of December 31, 1996                           26,107,346     6,904,781          3,452      22,158,170       3,945,724

Issuance of shares for stock options exercised                37,644       257,750            128          37,516              --
Tax benefit related to stock options                          50,000            --             --          50,000              --
Net loss                                                 (18,584,005            --             --              --     (18,584,005)
                                                        ------------     ---------   ------------    ------------    ------------
Balance as of December 31, 1997                            7,610,985     7,162,531          3,580      22,245,686     (14,638,281)

Issuance of shares of stock options exercised                      1         1,500              1              --              --
Reduction in Norland Corp. acquisition price
  by reduction of principal of Note Payable,
  net of discount                                          9,004,157            --             --       9,004,157              --
Issuance of shares in partial payment of Note Payable      1,890,000     7,000,000          3,500       1,886,500              --
Net loss                                                  (9,713,260            --             --              --      (9,713,260)
                                                        ------------     ---------   ------------    ------------    ------------
Balance as of December 31, 1998                         $  8,791,883    14,164,031   $      7,081    $ 33,136,343    $(24,351,541)
                                                        ============    ==========   ============    ============    ============ 
</TABLE>

              See notes to the consolidated financial statements.


                                       31
<PAGE>

                          NORLAND MEDICAL SYSTEMS, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                  Years ended December 31, 1998, 1997 and 1996

<TABLE>
<CAPTION>
                                                                            1998              1997               1996
                                                                        ------------      ------------       ------------
<S>                                                                     <C>               <C>                <C>         
Cash flows from operating activities:
  Net (loss) income                                                     $ (9,713,260)     $(18,584,005)      $  1,777,855
                                                                        ------------      ------------       ------------
  Adjustments to reconcile net income (loss) to net cash used
  in operating activities:
    Non-recurring charges                                                    350,000         7,228,287            397,697
    Provision for doubtful accounts                                        1,357,769         1,979,000             70,000
    Deferred income taxes                                                   (496,000)       (2,136,878)          (282,000)
    Amortization expense                                                     733,811           654,449            343,666
    Depreciation expense                                                     408,535           158,307             59,276
    Gain on sale of investment                                                    --           (47,365)                --
    Loss on investment in Vitel, Inc.                                        260,000                --                 --
    Inventory write-off                                                      443,323         4,161,593             30,000
    In-process research and development charge                                    --         7,900,000                 --
    Changes in assets and liabilities, net of businesses acquired:
      Accounts receivable                                                  2,930,427            42,630         (3,551,403)
      Inventories                                                          2,199,014        (3,215,564)        (1,561,237)
      Prepaid expenses and other current assets                               19,867           182,443           (673,396)
      Accounts payable                                                      (878,752)       (1,416,163)           373,589
      Accrued expenses                                                       404,090           339,556            434,245
      Income taxes                                                         1,434,314          (663,593)        (1,599,322)
      Customer deposits                                                     (500,000)          452,150             (6,314)
                                                                        ------------      ------------       ------------
        Total adjustments                                                  8,666,398        15,618,852         (5,965,199)
                                                                        ------------      ------------       ------------

        Net cash used in operating activities                             (1,046,862)       (2,965,153)        (4,187,344)
                                                                        ------------      ------------       ------------

Cash flows from investing activities:
  Purchases of property and equipment                                       (925,401)         (284,917)          (430,233)
  Loans to officers                                                           (4,800)       (1,909,573)        (1,099,211)
  Repayment of loans to officers                                                  --         2,404,773            517,507
  Purchase of Norland Corporation, net of cash acquired                           --        (1,852,510)                --
  Payment for purchase of stock and certain intangible assets
    of Dove Medical Systems, net of cash acquired                                 --                --         (3,432,937)
  Investment in Vitel, Inc.                                                       --                --           (260,000)
  Purchase of investment available for sale                                       --                --         (1,949,039)
  Sale of investment available for sale                                           --         1,996,403                 --
  Loans and advances to affiliate                                                 --        (2,509,979)          (241,266)
  Repayment of loan to affiliate                                                  --            32,046                 --
                                                                        ------------      ------------       ------------
        Net cash used in investing activities                               (930,201)       (2,123,757)        (6,895,179)
                                                                        ------------      ------------       ------------

Cash flows from financing activities:
  Proceeds from stock options exercised                                            1            37,644                292
  Costs and expenses of issuing common stock                                      --                --             (3,002)
  Cash paid for fractional shares                                                 --                --               (164)
                                                                        ------------      ------------       ------------
        Net cash provided by (used in) financing activities                        1            37,644             (2,874)
                                                                        ------------      ------------       ------------

Net decrease in cash and cash equivalents                                 (1,977,062)       (5,051,266)       (11,085,397)

Cash and cash equivalents at beginning of year                             3,082,202         8,133,468         19,218,865
                                                                        ------------      ------------       ------------
Cash and cash equivalents at end of year                                $  1,105,140      $  3,082,202       $  8,133,468
                                                                        ============      ============       ============
</TABLE>

              See notes to the consolidated financial statements.


                                       32
<PAGE>

                          NORLAND MEDICAL SYSTEMS, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS

                  Years ended December 31, 1998, 1997 and 1996

Noncash investing and financing activities:

On April 2, 1996, the Company purchased all of the outstanding shares of Dove
Medical Systems and certain intangible assets for $3,600,000 in cash and 161,538
shares of Company common stock valued at $3,311,529. In conjunction with the
acquisition, the Company assumed $325,774 in liabilities (see Note 8).

In the years ended December 31, 1997 and 1996, the Company's tax benefits
related to stock options increased additional paid-in capital by $50,000 and
$500,000, respectively.

On September 11, 1997, the Company issued a $15,522,461 Note Payable (net of
discount) as part of the purchase price for Norland Corporation (see Note 8).

On December 31, 1998, the Company issued 7,000,000 shares of common stock in
satisfaction of a portion of the Note Payable. In addition, the principal amount
of the Note Payable was reduced by $8,800,000 in connection with the reduction
of the purchase price for Norland Corporation.

Cash paid for:

                                       1998             1997             1996
                                       ----             ----             ----
      Income taxes                  $   23,915       $  201,830       $3,097,332
                                    ==========       ==========       ==========
      Interest expense              $  858,102       $   90,880       $        0
                                    ==========       ==========       ==========

              See notes to the consolidated financial statements.


                                       33
<PAGE>

                          NORLAND MEDICAL SYSTEMS, INC.

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                  Years ended December 31, 1998, 1997 and 1996

1.    The Company:

Norland Medical Systems, Inc. ("NMS" or the "Company") develops, manufactures,
markets, sells, distributes and services bone densitometry systems which aid in
the detection and monitoring of bone diseases, and in the assessment of the
effect of existing and potential therapies for the treatment of such diseases
throughout the world to individual practitioners, hospitals, clinics, research
institutions and pharmaceutical companies. NMS is the exclusive marketer and
distributor of certain medical products and technologies of Norland Corporation
(U.S.) ("Norland Corp.") and Stratec Medizintechnik GmbH (Germany) ("Stratec").
Stratec is a wholly-owned subsidiary of Norland Medical Systems B.V.
(Netherlands) ("NMS BV"). Certain shareholders of NMS are direct or indirect
shareholders of NMS BV and own more than 90% of that company.

On September 11, 1997, the Company acquired Norland Corp. from NMS BV. On April
2, 1996, the Company acquired Dove Medical Systems (U.S.) ("Dove"), a
manufacturer of low-cost bone densitometry systems. The Company's other
subsidiary, IMRO Medical Systems, Inc. (U.S.) ("IMRO"), holds certain
manufacturing and worldwide distribution rights with respect to certain
ultrasound devices for bone applications.

      The Company believes that its current cash position, together with cash
flow from operations, will be adequate to fund the Company's operations at least
through December 31, 1999. In order to increase its cash flow, the Company is
continuing its efforts to stimulate sales and reduce inventory levels. The
Company will be required to use working capital to manufacture the recently
introduced Apollo DXA and Excell. The Company is also continuing to focus its
efforts on improving the aging of its accounts receivable. To do so, the Company
has implemented higher credit standards for its customers and is emphasizing the
receipt of down payments from customers at the time their purchase orders are
received. The Company is also continuing to be more aggressive in seeking to
collect outstanding receivables. The Company has been seeking equity and debt
financing. The Company does not have a commitment for such financing, and there
can be no guarantee that the Company will be able to obtain such financing.

2.    Summary of Significant Accounting Policies:

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries. Intercompany transactions and balances are
eliminated in consolidation.


                                       34
<PAGE>

Revenue and Cost Recognition

The Company primarily sells its products through third party dealers and
distributors. Revenue is generally recognized at the time products are shipped
and title passes to the customer. The Company estimates and records provisions
for product installation and user training in the period that the sale is
recorded.

Prior to the acquisition of Norland Corp., NMS purchased products from Norland
Corp. and Stratec (the "manufacturers") on the basis of sales orders in hand.
NMS was invoiced by the manufacturers when the product was shipped. After the
acquisition, these arrangements have been continued with respect to Stratec.
Management believes the gross profit recognized by NMS on products purchased
from the manufacturers materially approximates that which would have been
realized had the Company used unaffiliated suppliers.

The Company offers one-year warranties on both hardware and software. The
provision for product warranties represents an estimate for future claims
arising under the terms of the Company's various product warranties. The
estimated future claims are accrued at the time of sale. Stratec offers the same
warranties with respect to its products. The Company provides warranty services
on behalf of Stratec. The Company invoices Stratec for the costs of performing
such warranty services.

The Company has no obligations to provide any other services to any of its third
party dealers or distributors or their customers.

Cash and Cash Equivalents

Cash and cash equivalents include highly liquid short-term investments purchased
with initial maturities of three months or less.

Stock-based Compensation

Stock-based compensation related to employees is accounted for in accordance
with the intrinsic method.

Investments

The Company also has a minority interest in Vitel, Inc. (U.S.) that was
accounted for as a long-term investment according to the cost method. In 1998
the investment was written off reflecting management's estimate that its
carrying value was other than temporarily impaired.


                                       35
<PAGE>

Inventory

Inventories are stated at the lower of cost or market; cost is determined
principally by the first-in, first-out method.

Systems used in the Company's short-term rental program are carried in inventory
at the lower of cost or net realizable value until the time of sale.

Property and Equipment

Machinery, equipment, furniture and fixtures are recorded at cost and are
depreciated using the straight-line method over three to seven years. Leasehold
improvements are amortized over the lesser of the remaining life of the lease or
ten years.

The Company's demonstration systems used for marketing and customer service
purposes are carried at the lower of cost or net realizable value until the time
of sale. From time to time, the Company may judge it desirable for marketing
purposes to provide a device to a prominent scientist or research institution
specializing in the study of bone disease. In such cases, the Company will carry
the device at cost less amortization expense calculated on a straight-line basis
over thirty-six months.

Goodwill

Goodwill was $8,150,620 and $8,745,676 at December 31, 1998 and 1997,
respectively, and is being amortized on a straight-line basis over 15 years.
Accumulated amortization of goodwill was $775,225 and $180,169 at December 31,
1998 and 1997, respectively.

Long-lived Assets

Management evaluates on an ongoing basis whether events or changes in
circumstances exist that would indicate the carrying value of the Company's
long-lived assets may not be recoverable. Should there be an indication of
impairment in the value of its long-lived assets, management would estimate the
future cash flows expected to result from the use of the assets and their
eventual disposition and recognize a specific provision against such assets if
the aggregate nominal estimated future undiscounted cash flows are less than the
carrying value of the assets. In considering whether events or changes in
circumstances exist, management assesses several factors, including a
significant change in the extent or manner in which the assets are used, a
significant adverse change in legal factors or in the business climate that
could affect the value of the assets, an adverse action or assessment of a
regulator, and a current period operating or cash flow loss combined with a
history of operating or cash flow losses or a projection or forecast that
demonstrates continuing losses associated with such assets.

Income Taxes

The Company accounts for deferred income taxes by recognizing the tax
consequences of "temporary differences" by applying enacted statutory tax rates
applicable to future years to differences between the financial statement
carrying amounts and the tax basis of existing assets and liabilities. The
effect of a


                                       36
<PAGE>

change in tax rates on deferred taxes is recognized in income in the period that
includes the enactment date. The Company realizes an income tax benefit from the
exercise of certain stock options or the early disposition of stock acquired
upon exercise of certain options. This benefit results in an increase in
additional paid in capital.

Research and Development

Research and development costs are charged to operations as incurred.

Earnings (Loss) per Share

Basic per share amounts are computed using the weighted average number of common
shares outstanding. Diluted per share amounts are computed using the weighted
average number of common shares outstanding, after giving effect to dilutive
options, using the treasury stock method.

The calculations of per share results for the years ended December 31 are as
follows:

<TABLE>
<CAPTION>
                                                            1998              1997               1996
                                                            ----              ----               ----
<S>                                                     <C>               <C>                <C>         
Net (loss) income available to common stockholders      $ (9,713,260)     $(18,584,005)      $  1,777,855

Basic weighted average shares outstanding                  7,183,032         7,145,465          6,824,590
Effect of dilutive stock options                                  --                --            344,281
                                                        ------------      ------------       ------------
Diluted weighted average shares outstanding                7,183,032         7,145,465          7,168,871
                                                        ============      ============       ============
Basic net (loss) earnings per share                           $(1.35)           $(2.60)             $0.26
Diluted net (loss) earnings per share                          (1.35)            (2.60)              0.25
</TABLE>

Options to purchase 867,500, 485,356 and 202,500 shares of common stock were
outstanding at December 31, 1998, 1997 and 1996, respectively, but were not
included in the computation of diluted loss per share because the options'
exercise prices were greater than the average market price of the common shares.

Concentration of Credit Risk

The Company generally sells on credit terms ranging from thirty to ninety days
or against irrevocable letters of credit. Any financing of the end user is the
decision of, and dependent on, the distributor in each territory. At December
31, 1998, no customer had outstanding trade receivables in excess of 10% of
total outstanding trade receivables. At December 31, 1997, two customers
represented 15% and 10%, respectively, of the total outstanding trade
receivables. The Company sells to customers in various geographic territories
worldwide (see Note 14).

Management Estimates

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and


                                       37
<PAGE>

disclosure of contingent assets and liabilities at the date of financial
statements and the reported amounts of revenue and expenses during the reporting
period. Estimates are used when accounting for the allowance for doubtful
accounts, potentially excess and obsolete inventory, depreciation and
amortization, warranty reserves, income tax valuation allowances and
contingencies, among others. Actual results could differ significantly from
those estimates.

Foreign Exchange Exposure

The Company's purchases and sales of products and services are made primarily in
U.S. dollars. As a result, the Company has minimal exposure to foreign exchange
risk in the short-term. However, a portion of the Company's products are
supplied by Stratec and sold along with the Company's products into foreign
markets. Any significant and lasting change in the exchange rates between the
U.S. dollar and the currencies of those countries could have a material effect
on both the costs and sales of those products and services.

Reclassification

Certain information in 1997 and 1996 has been reclassified to conform to the
current year presentation.

Accounting Pronouncements

SFAS No. 130, "Reporting Comprehensive Income," requires that comprehensive
income and its components be reported in the financial statements. Comprehensive
income represents the change in net assets of a business enterprise as a result
of non-owner transactions. The Company adopted this standard during the first
quarter of 1998 with no impact on the financial statements as there were no
other comprehensive income components.

SFAS No. 131, "Disclosures About Segments of an Enterprise and Related
Information," requires that publicly traded companies report financial and
descriptive information about its reporting operating segments. The Company
adopted this standard in the fourth quarter of 1998 with no impact on the
financial statements, as there was one operating segment.

SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activity,"
becomes effective for fiscal years beginning January 1, 2000. The Company does
not expect the adoption of this statement to have a material impact on the
Company's financial statements.

3.    Distribution Agreement:

Prior to the acquisition of Norland Corp., the Company was party to an exclusive
distribution agreement with Norland Corp. and Stratec which extended until
December 31, 2015. The original pricing formula in the agreement was such that
the margin retained by NMS was equal to one-half of the difference between the
price at which the product was sold to the distributor or end user and the
direct cost of material, parts and labor of Norland Corp. or Stratec. This
agreement was subject to renewal for an indefinite number of


                                       38
<PAGE>

successive five-year terms and contained no purchase obligation on the part of
NMS. Under this agreement, the Company could not distribute devices manufactured
by any non-affiliate of the Company which competed directly with the devices
obtained from the manufacturers (except for devices using ultrasound
technology).

The distribution agreement was amended in 1996 to change the pricing formula.
The amended pricing formula became effective as of October 1, 1996 with respect
to Norland Corp. products and as of December 1, 1996 with respect to Stratec
products. Under the amended pricing formula, NMS paid Norland Corp. and Stratec
an amount for each system equal to the aggregate costs of the components and
parts used in the system plus the actual labor costs plus an agreed upon markup
on the costs of all non-computer components. The manufacturers were also
entitled to receive royalties equal to 5% of the price for which NMS sold
certain devices. In the case of Norland Corp., the royalty applied to all new
systems manufactured by Norland Corp. (i.e., any system other than the pDEXA,
the Eclipse and the XR-36). In the case of Stratec, the royalty applied to any
system manufactured by Stratec which uses pQCT technology. If the aggregate
amount payable by NMS to the manufacturers for a year under the amended pricing
formula would exceed the aggregate amount payable under the original pricing
formula, then the original pricing formula would apply. The amended pricing
formula was to be in effect until December 31, 1997, subject to automatic
renewal with respect to each manufacturer for successive one year periods,
unless such manufacturer elected to terminate the amended pricing formula
effective on December 31 of any year by notice given to NMS not less than 90 nor
more than 180 days prior to the end of such year.

Upon the completion of the acquisition of Norland Corp. by NMS on September 11,
1997, the distribution agreement with Norland Corp. and Stratec was terminated,
and NMS entered into a new distribution agreement with Stratec containing
essentially the same provisions (including pricing and term of the agreement) as
the prior distribution agreement did with respect to Stratec and Stratec
products. Stratec has exercised its right to terminate the amended pricing
formula as of December 31, 1997 and reinstate the original pricing formula.

4.    Non-Recurring and Other Charges:

The Company recognized non-recurring charges of $400,000, $15,128,287 and
$397,697 in 1998, 1997 and 1996, respectively. In November 1998 the Company
settled certain patent infringement litigation and, in connection with the
settlement, agreed to pay $400,000 in patent licensing fees, the timing of such
payments to be based on future sales of certain products through August 2004. A
$50,000 advance payment was made in 1998.

At the time of the acquisition of Norland Corp. in September 1997, certain
research and development projects acquired were not at a stage in which
technological feasibility had been achieved and were determined to have no
alternative future use. Accordingly, $7,900,000 of the purchase price was
allocated to this in-process research and development and expensed (see Note 7).
Also in 1997, in response to the increasing dominance of the peripheral bone
densitometry market by DXA technology, the Company closed the Newbury Park
facility of its Dove subsidiary and recorded a $7,126,782 write-off related to
the value of fixed assets, goodwill, a patent and other intangible assets,
having concluded that expected cash flows will not enable the Company to recover
any of the remaining carrying value of such assets. In August 1997, the Company
acquired distribution rights to an ultrasound product and recorded a $101,505
non-recurring charge


                                       39
<PAGE>

for costs incurred in connection with the selection of an ultrasound product. In
addition to these 1997 non-recurring charges, the Company recognized (i)
additional provisions for doubtful accounts of $1,850,000, which is reflected in
general and administrative expense, related to its decision to close the Dove
facility ($400,000) and for certain other customers for which collection was no
longer expected ($1,450,000); and (ii) a $4,161,593 charge to cost of revenue
related to a write-off of demonstration systems ($2,165,375) and reserves for
excess inventory ($1,996,218, including $1,221,218 of inventory at its Dove
subsidiary).

During the year ended December 31, 1996, the Company recognized a $397,697
charge for expenses incurred in connection with the Company's stock offering
that was withdrawn in August 1996 as a result of the general stock market
decline and the decline in the price of the Company's common stock.

5.    Inventories:

Inventories consist of the following as of December 31:

                                                1998              1997
                                                ----              ----
      Raw materials, product kits,
        spare parts and sub-assemblies      $ 2,322,744       $ 2,201,268
      Work in progress                          380,835           191,069
      Finished goods                          1,151,302         4,014,094
      Rental systems                             66,464            32,251
      Inventory reserve                      (1,400,000)       (1,275,000)
                                            -----------       -----------
                                            $ 2,521,345       $ 5,163,682
                                            ===========       ===========

6.    Property and Equipment:

Property and equipment consisted of the following as of December 31:

                                        1998              1997
                                        ----              ----
      Machinery and equipment       $ 1,386,972       $ 1,271,309
      Demonstration systems             713,096            93,591
      Tooling                           641,202           467,284
      Furniture and fixtures            433,877           396,380
      Leasehold improvements            116,896           104,577
      Construction in progress           47,011            80,511
                                    -----------       -----------
                                      3,339,054         2,413,652
      Accumulated depreciation
        and amortization             (1,947,022)       (1,538,486)
                                    -----------       -----------
                                    $ 1,392,032       $   875,166
                                    ===========       ===========


                                       40
<PAGE>

7.    Acquisitions:

Norland Corp.

On September 11, 1997, the Company acquired Norland Corp. in a transaction
accounted for under the purchase method of accounting. The consolidated
financial statements reflect the acquisition of all of the issued and
outstanding stock of Norland Corp. for $17,500,000 from the date of acquisition.
The $17,500,000 consideration consisted of a $1,250,000 cash payment made on
September 11, 1997 and a $16,250,000 Purchase Note (the "Note") (see Note 8).

The cost of acquisition (including acquisition costs and a discount applied to
the Note to reflect a market rate of interest) has been allocated based on the
fair value of assets acquired and liabilities assumed as follows:

            Purchase price, net of Note discount of $728,000      $ 16,772,000
            Loans and advances to Norland Corp.                      2,757,000
            Current assets                                          (4,467,000)
            Noncurrent assets                                         (368,000)
            Deferred tax assets, net                                  (609,000)
            Current liabilities assumed                              2,739,000
            Noncurrent liabilities assumed                               2,000
            In-process research and development charge              (7,900,000)
                                                                  ------------
            Goodwill                                              $  8,926,000
                                                                  ============

Acquisition costs are primarily legal, accounting and investment banking fees,
all of which are directly related to the transaction. Certain research and
development projects acquired were not at a stage in which technological
feasibility had been achieved and were determined to have no alternative future
use. Accordingly, $7,900,000 of the purchase price was allocated to this
in-process research and development and expensed in 1997. The goodwill is being
amortized using the straight-line method over fifteen years. The purchase
agreement required an additional contingent payment if certain financial targets
were met for the year ended December 31, 1997. The targets were not met and no
additional payment was required.

On December 31, 1998, in connection with the settlement of the Miller v. Bonmati
litigation referred to in Note 12, the terms of the Norland Corp. acquisition
were amended. Effective as of December 31, 1998, the original $17,500,000
purchase price was reduced to $8,700,000 by reducing the principal amount of the
Note from $16,250,000 to $7,450,000 and the annual interest rate was reduced to
6 1/2% from 7%.


                                       41
<PAGE>

Dove Medical Systems

On April 2, 1996, the Company acquired all of the outstanding shares of Dove and
a patent and other intangible assets owned by the Dove majority shareholder and
certain other investors. The Company paid consideration of $6,911,529,
consisting of $3,600,000 in cash and 161,538 shares of the Company common stock
valued at $3,311,529. The operating results of Dove have been included in the
accompanying consolidated statements of operations from the date of acquisition.
The acquisition was accounted for using the purchase method of accounting, and,
accordingly, the purchase price was allocated to the assets purchased and the
liabilities assumed based on the fair values at the date of acquisition. The
amount allocated to the patent and other intangible assets was $3,391,735. The
excess purchase price over the fair values of the net assets was $3,308,011 and
was recorded as goodwill. In connection with the closing of the Dove facility,
the Company took a $8,348,000 non-recurring charge in 1997 (see Note 4).

Pro forma unaudited consolidated operating results and related per share amounts
of the Company for the years ended December 31, 1997 and 1996, assuming both
acquisitions had been made as of January 1, 1996, are summarized below:

                                                     1997              1996
                                                     ----              ----
                                                  (unaudited)       (unaudited)

      Net sales                                  $ 20,289,740       $23,974,811

      Net (loss) income                           (14,842,044)        2,361,476
      (Loss) earnings per share:
        Basic                                    $      (2.08)      $      0.35
        Diluted                                         (2.08)             0.33

These unaudited pro forma results have been prepared for comparative purposes
only and include certain adjustments to give effect to amortization of goodwill,
patent and other intangible assets and certain other adjustments, together with
related income tax effects. The unaudited pro forma information is not
necessarily indicative of either the results of operations that would have
occurred had the acquisition been made on January 1, 1996 or that may occur in
the future.

8.    Note Payable:

In connection with the acquisition of Norland Corp. (See Note 7), consideration
included a $16,250,000 Note bearing interest at the rate of 7% per annum
beginning September 30, 1997. A $1,250,000 portion of the Note was originally
payable in cash on March 11, 1998. The Note was amended to provide that such
payment is not due until such time as the Company receives at least $2,000,000
in proceeds from a debt or equity financing. The remaining principal was due and
payable on September 11, 2002. The Company could prepay the Note at any time,
pay the principal (except for the $1,250,000 payment referred to above) with
shares of Company common stock valued at the time of payment and extend the
September 11, 2002 maturity date by up to two years (at increasing interest
rates). The Note is collateralized by a pledge of the shares of Norland Corp.


                                       42
<PAGE>

Effective as of December 31,1998, in connection with the amendment of the terms
of the Norland Corp. acquisition, the Note principal was reduced from
$16,250,000 to $7,450,000 and the annual interest rate was reduced from 7% to 6
1/2%. The other payment terms, including those with respect to maturity,
prepayment and the ability to pay principal by delivering shares of Common
Stock, were not changed. Also on December 31, 1998, the Company paid $1,890,000
in Note principal by delivering 7,000,000 shares of Company's Common Stock to
NMS BV priced at $0.27 per share, the average closing price for the five trading
days prior to December 31, 1998.

The Note has been fair valued as of the December 31, 1998 amendment date using a
market rate of interest of 10.75%, which resulted in the establishment of a
$874,310 note discount that is being amortized using the effective interest
method over the Note's remaining term.

The Note activity described above may be summarized as follows as of December
31, 1998:

      Note principal as of September 11, 1998 acquisition date     $ 16,250,000
      Reduction in Note principal from reduced purchase price        (8,800,000)
      Payment of Note principal by delivering 7,000,000 shares       (1,890,000)
      Note discount for market rate of interest                         874,310
                                                                   ------------
      Note payable, net of discount                                $  4,685,690
                                                                   ============

9.    Stockholders' Equity:

Effective June 14, 1996, the Board authorized a 3-for-2 stock split (in the
nature of a stock dividend), which increased the issued and outstanding shares
accordingly. The financial statements and net result per common share for all
periods presented reflect the stock split described above.

The Company has authorized 1,000,000 shares of preferred stock, par value
$0.0005 per share, issuable in series with such rights, powers and preferences
as may be fixed by the Board of Directors. At December 31, 1998 and 1997, there
was no preferred stock outstanding.

10.   Compensation Programs:

Stock Option Plan

The Company has a stock-based compensation plan whereby stock options may be
granted to officers, employees and non-employee consultants to purchase a
specified number of shares of common stock. All outstanding options granted have
an exercise price not less than 100% of the market value of the Company's common
stock at the date of grant, are for a term not to exceed 10 years, and vest over
a four year period at 25% per year.

The stockholders authorized on September 8, 1997 an amended and restated 1994
Stock Option Plan. The amended plan includes an increase of common stock
reserved for issuance to 2,250,000 shares and establishes an automatic option
grant. The automatic option grant program grants options to new non-employee
Board members to purchase 30,000 shares of common stock at an exercise price
equal to the fair


                                       43
<PAGE>

market value at the grant date for a maximum term of ten years and is subject to
25% vesting each year and early termination upon the optionee's leaving the
Board.

On October 6, 1998 and December 14, 1998, the Board of Directors approved the
repricing of certain employee stock options. Approximately 673,750 shares were
repriced to $0.67 per share on October 6, 1998 and December 14, 1998,
representing a price that was not less than the market value at such dates.

The following is a summary of options related to the plan as of December 31:

<TABLE>
<CAPTION>
                                                 Range of                         Range of                         Range of
                                               Option Prices                    Option Prices                    Option Prices
                                    1998         per Share             1997       per Share            1996        per Share
                                    ----       -------------           ----     -------------                    -------------
<S>                               <C>          <C>                 <C>          <C>                <C>           <C>
Options outstanding at
beginning of year                  751,750     $0.0005-15.00        674,250     $0.0005-22.17      1,117,500     $0.0005-13.83

Cancellations                     (115,500)     $6.38-20.00        (138,750)     $7.50-22.17              --           --

Granted                            232,750         $0.67            474,000      $6.38-11.50         300,000     $15.00-22.17

Exercised                           (1,500)       $0.0005          (257,750)     $0.0005-7.50       (743,250)   $0.0005-0.0006
                                  --------                         --------                        ---------
Options outstanding at end
of year                            867,500     $0.0005-15.00        751,750     $0.0005-15.00        674,250     $0.0005-22.17
                                  ========                         ========                        =========
Options exercisable at end
of year                            251,313                          114,188                           46,125
                                  ========                         ========                        =========
Options available for grant at
end of year                        380,000                          497,250                          382,500
                                  ========                         ========                        =========
</TABLE>

The following table summarizes information about significant groups of stock
options outstanding at December 31, 1998:

<TABLE>
<CAPTION>
                               Options Outstanding                                     Options Exercisable
                   -----------------------------------------------       -----------------------------------------------
                                                      Weighted                                              Weighted
                                        Weighted       Average                              Weighted         Average
                                        Average       Remaining                              Average        Remaining
Exercise             Options            Exercise      Contractual         Options            Exercise       Contractual
 Prices            Outstanding           Price       Life in Years       Exercisable          Price        Life in Years
 ------            -----------           -----       -------------       -----------          -----        -------------
<S>                  <C>                <C>               <C>             <C>                <C>               <C>
$0.0005                4,500            $0.0005           5                 4,500            $0.0005            5
$0.67                716,500            $  0.67           8               186,938            $  0.67            8
$6.38                 25,000            $  6.38           9                 6,250            $  6.38            9
$9.75                  1,500            $  9.75           7                 1,125            $  9.75            7
$11.50                30,000            $ 11.50           9                 7,500            $ 11.50            9
$15.00                90,000            $ 15.00           7                45,000            $ 15.00            7
                     -------                                              -------
                     867,500                                              251,313
                     =======                                              =======
</TABLE>


                                       44
<PAGE>

Had compensation expense for the Company's 1998, 1997 and 1996 grants for the
stock-based compensation plan been determined based on the fair value of the
options at their grant dates consistent with SFAS 123, the Company's net income
(loss) and earnings (loss) per common share for 1998, 1997 and 1996 would
approximate the pro forma amounts below:

<TABLE>
<CAPTION>
                                             1998                1997                  1996
                                             ----                ----                  ----
<S>                                      <C>                 <C>                    <C>       
      Net (loss) income:
        As reported                      $(9,713,260)        $(18,584,005)          $1,777,855
        Pro forma                        (10,168,139)         (19,734,360)             796,334

      (Loss) earnings per share:
        As reported:
          Basic                               $(1.35)              $(2.60)               $0.26
          Diluted                              (1.35)               (2.60)                0.25
        Pro forma:
          Basic                                (1.41)              $(2.76)               $0.12
          Diluted                              (1.41)               (2.76)                0.11
</TABLE>

The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following assumptions used for
grants during each of the applicable periods presented: dividend yield of 0%,
risk-free weighted average interest rate of 5%, expected volatility factor of
117%, and an expected option term of 4 years. The weighted average fair value at
date of grant for options granted during 1998, 1997 and 1996 was $0.49, $5.13
and $11.85 per option, respectively.

401(k) Plan

Pursuant to the Norland Medical Systems, Inc. and Norland Corporation Retirement
Savings Plans, eligible employees may elect to contribute a portion of their
salary on a pre-tax basis. With respect to employee contributions of up to 7% of
salary, the Company makes a contribution at the rate of 25 cents on the dollar.
Contributions are subject to applicable limitations contained in the Internal
Revenue Code. Employees are at all times vested in their own contributions;
Company matching contributions vest gradually over six years of service. The
Company's policy is to fund plan contributions as they accrue. Contribution
expense was $42,710, $14,570 and $13,342 for the years ended December 31, 1998,
1997 and 1996, respectively.


                                       45
<PAGE>

11.   Income Taxes:

The components of income taxes (benefit) for the years ended December 31 were as
follows:

                               1998              1997              1996
                               ----              ----              ----
            Current:
              Federal        $(463,000)      $  (557,569)       $1,254,387
              State             13,000                --           243,613
                             ---------       -----------        ----------
                              (450,000)         (557,569)        1,498,000
                             ---------       -----------        ----------
            Deferred:
              Federal         (452,000)       (2,030,830)         (282,000)
              State            (44,000)         (106,048)               --
                             ---------       -----------        ----------
                              (496,000)       (2,136,878)         (282,000)
                             ---------       -----------        ----------
                Total        $(946,000)      $(2,694,447)       $1,216,000
                             =========       ===========        ==========

Income taxes (benefit) differ from the statutory federal income tax rate of 34%
for the years ended December 31 as follows:

                                           1998            1997            1996
                                         ------          ------          ------

Statutory income tax rate                 (34.0%)         (34.0%)          34.0%
Valuation allowance                        23.0%             --              --
State income taxes, net of
  Federal benefit                          (0.3%)          (1.3%)           6.6%
Amortization of goodwill                    1.9%            1.5%             --
In-process research and
  development charge                         --            12.6%             --
Write-off of goodwill                        --             8.5%             --
Other                                       0.5%             --              --
                                         ------          ------          ------
Effective income tax rate                  (8.9%)         (12.7%)          40.6%
                                         ======          ======          ======

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial statement
purposes and the amounts used for income tax purposes and net operating loss
carryforwards. Significant components of the Company's deferred tax assets and
liabilities as of December 31 are summarized below.

                                                    1998                1997
                                                    ----                ----
Deferred tax assets and liabilities:

  Inventory                                      $ 1,440,759        $ 1,331,179
  Allowance for doubtful accounts                    111,900            820,600
  Accrued liabilities                                343,160            345,065
  Alternative minimum tax credits                         --             62,914
  Other                                              (78,602)                --
                                                 -----------        -----------
    Net current deferred tax assets                1,817,217          2,559,758
                                                 -----------        -----------
  Net operating loss carryforwards                 4,240,809            714,956
  Discount on note payable                          (244,518)          (256,421)
  Alternative minimum tax                             49,797                 --
  Other                                              (49,126)                --
  Valuation allowance                             (2,421,338)                --
                                                 -----------        -----------
    Net noncurrent deferred tax assets             1,575,624            458,535
                                                 -----------        -----------
      Total deferred tax assets                  $ 3,392,841        $ 3,018,293
                                                 ===========        ===========


                                       46
<PAGE>

The net deferred tax assets can be realized through future taxable income.
Management believes that based on the Company's history of operating earnings
and its expected income, that it is more likely than not that future levels of
income will be sufficient to realize the deferred tax assets, as recorded.

The Company has utilizable federal and state net operating loss carryforwards of
approximately $11,000,000 at December 31, 1998 for income tax purposes which
expire in 2012 through 2018.

12.   Commitments and Contingencies:

Legal Proceedings

Irwin I. Miller v. Reynald G. Bonmati et al., Defendants, and Norland Medical
Systems, Inc., Nominal Defendant. This shareholder's class action and derivative
complaint was filed in the Court of Chancery of the State of Delaware, New
Castle County, on August 1, 1997, against four members of the Company's Board of
Directors, Reynald G. Bonmati, Albert S. Waxman, James J. Baker and Michael W.
Huber (the "Individual Defendants"), NMS BV and the Company. The action relates
to the acquisition of Norland Corp. by the Company from NMS BV. The complaint
alleged that the Individual Defendants breached their fiduciary duties of
loyalty, candor and care in connection with the pending acquisition, and that
the Company's proxy statement relating to the stockholders' meeting to vote on
the acquisition did not contain full and fair disclosure. Plaintiff sought among
other things: to enjoin the consummation of the acquisition; to require that the
Company make additional disclosures to its stockholders in connection with the
acquisition; damages in unspecified amounts; and costs, disbursements and
counsel and expert fees. An agreement in principle was reached to settle the
action. The Company delayed its Annual Meeting of Stockholders and supplemented
its proxy statement with respect to the acquisition and the plaintiff withdrew
his application for a preliminary injunction against the acquisition. The
acquisition was approved by the Company's stockholders at the Annual Meeting of
Stockholders held on September 8, 1997, and the acquisition was consummated on
September 11, 1997. A definitive Stipulation of Settlement was executed, subject
to the approval by the Court of Chancery. As a result of the restatement of the
Company's financial statements for the fourth quarter of 1996 and the first
three quarters of 1997, the plaintiff withdrew his support for the Stipulation
of Settlement and moved for leave to file an amended and supplemental complaint
that sought, among other things, to rescind the Acquisition; recover
compensation or injuries allegedly suffered by the Company and the members of
the stockholder class; and recover costs, disbursements, and counsel and expert
fees. Defendants consented to the filing of such amended and supplemental
complaint. All defendants filed answers to the amended and restated complaint. A
new Stipulation of Settlement was agreed to on December 31, 1998, subject to
approval by the Court of Chancery. The new Stipulation of Settlement provides
for, among other things: (1) a reduction in the purchase price for Norland Corp.
from $17,500,000 to $8,700,000 by reducing the principal amount of the Company's
promissory note issued as part of the purchase price for the acquisition of
Norland Corp. from $16,250,000 to $7,450,000; (2) the payment of $1,890,000 of
the reduced principal amount of such promissory note by the delivery to NMS BV
of 7,000,000 shares of the Company's Common Stock, valued at $0.27 per share;
(3) the reduction in the annual interest rate on such promissory note from 7% to
6 1/2%; and (4) the payment by the Company of any award of fees and expenses of
plaintiff's counsel up to $1,000,000. The Court of Chancery approved this
Stipulation of Settlement at a hearing held on March 18, 1999.


                                       47
<PAGE>

Wesley D. Johnson and Pamela S. T. Johnson v. Reynald G. Bonmati, Kurt W.
Streams and Norland Medical Systems, Inc. This shareholder's class action was
filed in the United States District Court for the Southern District of New York
on April 12, 1998 against the Company, Reynald G. Bonmati, its Chief Executive
Officer, and Kurt W. Streams, its Chief Financial Officer. The complaint made
claims under Sections 10(b) and 20 of the Securities Exchange Act of 1934,
arising from the Company's announcement on March 16, 1998 that it would be
restating its financial statements with respect to the fourth quarter of 1996,
and the first three quarters of 1997. The claims were made on behalf of a
purported class of certain persons who purchased the Company's Common Stock from
February 25, 1997 through March 16, 1998. Plaintiffs seek compensatory damages
in an unspecified amount, together with prejudgement interest, costs and
expenses (including attorneys' fees and disbursements). On August 10, 1998,
prior to the expiration of the defendants time to respond to the complaint, the
lead plaintiff filed an amended complaint purporting to expand the class period
through March 31, 1998. The defendants filed a motion to dismiss the amended
complaint. The motion is pending before the Court.

The Company and Norland Corp. were named as defendants in an action entitled
Robert L. Piccioni, Ph.D. and Joan Piccioni v. Norland Medical Systems, Inc. and
Norland Corp., brought by Robert L. Piccioni, a former director of the Company,
and Joan Piccioni, the former President of the Company's Dove subsidiary. The
action related to the Company's acquisition of Dove in April of 1996. This
action was settled pursuant to a Settlement Agreement and Mutual General Release
dated August 11, 1998.

In addition, in the normal course of business, the Company is named in lawsuits
in which claims are asserted against the Company. In the opinion of management,
the liabilities, if any, which may ultimately result from such lawsuits are not
expected to have a material adverse effect on the financial position, results of
operations or cash flows of the Company.

Leases

In 1996, the Company entered into operating leases for its manufacturing and
office facilities and established subleases for portions of certain facilities
with Norland Corp. and another company in which certain stockholders of NMS are
also stockholders. Rent is prorated on a square footage basis. For the year
ended December 31, 1998, lease expense was $213,949 and sublease income was
$6,250 with respect to the other company. Rent expense for the years ended
December 31, 1997 and 1996 was $183,556 and $93,258, respectively. Sublease
income for the years ended December 31, 1997 and 1996 was $101,441 and $67,326,
respectively.

The following is a schedule of future minimum lease payments as of December 31,
1998:

            1999                      $  203,352
            2000                         174,638
            2001                         145,923
            2002                         126,962
            2003                         108,000
            Thereafter                   288,000
                                      ----------
                                      $1,046,875
                                      ==========


                                       48
<PAGE>

13.   Related Party Transactions:

Sales and Purchases

During 1998, 1997 and 1996, the Company sold $9,803, $108,845 and $210,785,
respectively, of products and services to Stratec. During 1997 and 1996, the
Company sold $240,638 and $351,323, respectively, of products and
services to Norland Corp. (through the acquisition date with respect to 1997).

During 1997 and 1996, the Company purchased $7,826,914 and $13,138,280,
respectively, of products and services from Norland Corp. (through the
acquisition date with respect to 1997). During 1998, 1997 and 1996, the Company
purchased $1,244,766, $1,424,474 and $3,163,964, respectively, from Stratec. The
amounts owed at December 31, 1998, 1997 and 1996 by NMS to Stratec for such
purchases were $292,315, $584,779 and $714,127, respectively. The amounts
payable to Stratec at December 31, 1998, 1997 and 1996 are net of receivables
from Stratec in the amounts of $23,803, $7,700 and $62,689, respectively. The
amount owed by the Company to Norland Corp. at December 31, 1996 was $2,220,816.

Other

The Company rented space in 1996 on a month to month basis, and purchased
administrative support services, from another company in which certain
beneficial stockholders of the Company are also beneficial stockholders. The
cost of the services and space to the Company for the years ended December 31,
1997 and 1996 was $7,800 and $33,136, respectively. As of December 31, 1997, no
amount was due by the Company for these costs.

Note Payable

In connection with the acquisition of Norland Corp. (see Note 7), consideration
included a Note Payable (see Note 8) issued to the seller, NMS BV.

Officer's Loan Receivable

The balance of an officer loan, including interest, was $91,304 and $86,504 at
December 31, 1998 and 1997, respectively. This loan is payable in March 2000
with interest at 6% per annum.

14.   Supplemental Sales and Customer Information:

For the years ended December 31, 1998 and 1997, no customer accounted for more
than 10% of revenues. The Company's largest customers are medical device
distributors. For the year ended December 31, 1996, two Pacific Rim distributors
accounted for 22% and 6% of revenues.


                                       49
<PAGE>

The Company's sales consisted of domestic sales to customers and export sales to
customers in the following geographic territories:

<TABLE>
<CAPTION>
                                 1998                                1997                                  1996
                        ------------------------            ----------------------              ------------------------ 
<S>                     <C>                 <C>             <C>               <C>               <C>                 <C>  
Pacific Rim             $   2,053,356       14.3%           $ 2,066,024       10.1%             $  10,338,350       42.5%
Europe/Middle East          1,688,945       11.7              2,224,178       10.8                    578,081        2.4
Latin America               1,043,031        7.3              1,556,441        7.6                    747,498        3.1
                        -------------      -----            -----------      -----              -------------      ----- 
Export Sales                4,785,332       33.3              5,846,643       28.5                 11,663,929       48.0
Domestic Sales              9,599,159       66.7             14,683,733       71.5                 12,662,205       52.0
                        -------------      -----            -----------      -----              -------------      ----- 
                        $  14,384,491      100.0%           $20,530,376      100.0%             $  24.326,134      100.0%
                        =============      =====            ===========      =====              =============      ===== 
</TABLE>

15.   Quarterly Financial Data (Unaudited):

<TABLE>
<CAPTION>
                                                                            1998 Quarters
                                       -------------------------------------------------------------------------------------
                                           First            Second             Third            Fourth             Total
                                           -----            ------             -----            ------             -----
<S>                                    <C>               <C>               <C>               <C>               <C>         
Revenue                                $  2,062,707      $  4,846,356      $  4,130,592      $  3,344,836      $ 14,384,491
Gross profit                                256,793         2,127,589         2,064,089         1,047,073         1,263,157
Operating loss                           (2,865,433)       (2,202,352)       (1,434,978)       (2,693,000)       (9,195,763)
Net loss                                 (1,889,582)       (1,504,721)       (2,006,272)       (4,312,685)       (9,713,260)

Weighted average shares:
  Basic and diluted                       7,163,314         7,164,031         7,163,531         7,240,118         7,183,032

 Basic and diluted loss per share      $      (0.26)     $      (0.21)     $      (0.28)     $      (0.60)     $      (1.35)
</TABLE>

<TABLE>
<CAPTION>
                                                                            1997 Quarters
                                       -------------------------------------------------------------------------------------
                                           First            Second             Third            Fourth             Total
                                           -----            ------             -----            ------             -----
<S>                                    <C>               <C>               <C>               <C>               <C>         
                                         First(1)          Second(1)         Third(1)           Fourth             Total
                                         --------          ---------         --------           ------             -----
Revenue                                $  4,337,203      $  5,132,024      $  5,338,508      $  5,722,641      $ 20,530,376
Gross profit (loss)                       1,854,329         2,310,318          (466,304)        1,263,157         4,961,500
Operating income (loss)                      37,722           214,179       (18,456,195)       (3,035,941)      (21,240,235)
Net income (loss)                           103,616           194,759       (16,103,818)       (2,778,562)      (18,584,005)

Weighted average number of                                                 
  common and common                                                        
  equivalent shares:                                                       
     Basic                                7,115,831         7,149,800         7,154,161         7,161,471         7,145,465
     Diluted                              7,166,878         7,188,847         7,154,161         7,161,471         7,145,465

Earnings (loss) per share:                                                 
  Basic and diluted                    $       0.01      $       0.03      $      (2.25)     $      (0.39)     $      (2.60)
</TABLE>

The per share figures for all periods presented reflect the application of
"Earnings (Loss) per Share" described in Note 2.


                                       50
<PAGE>

                          NORLAND MEDICAL SYSTEMS, INC.

                                   SCHEDULE II

                        VALUATION AND QUALIFYING ACCOUNTS
              for the years ended December 31, 1998, 1997 and 1996

<TABLE>
<CAPTION>
                                     Balance at      Charged to
                                      Beginning         Costs           Other                      Balances at End
                                      of Period      and Expenses    Accounts(A)   Deductions(B)      of Period
                                     -----------     ------------    -----------   -------------   ---------------
<S>                                  <C>             <C>             <C>           <C>               <C>        
1998
Allowance for Doubtful Accounts      $ 2,200,000     $ 1,357,769     $         0   $(3,257,769)      $   300,000
                                     ===========     ===========     ===========   ===========       ===========

Obsolescence Reserve                 $ 1,275,000     $   443,323     $         0   $  (318,323)      $ 1,400,000
                                     ===========     ===========     ===========   ===========       ===========

1997
Allowance for Doubtful Accounts      $   221,000     $ 1,979,000     $         0   $         0       $ 2,200,000
                                     ===========     ===========     ===========   ===========       ===========

Obsolescence Reserve                 $    41,895     $ 1,480,000     $   600,000   $  (846,895)      $ 1,275,000
                                     ===========     ===========     ===========   ===========       ===========

1996
Allowance for Doubtful Accounts      $   150,000     $    70,000     $     1,000   $         0       $   221,000
                                     ===========     ===========     ===========   ===========       ===========

Obsolescence Reserve                 $         0     $    30,000     $    50,000   $   (38,105)      $    41,895
                                     ===========     ===========     ===========   ===========       ===========
</TABLE>

(A)   Assumed in acquisition.
(B)   Amounts written off against the reserve.


                                       51
<PAGE>

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

None.

                                    PART III

ITEMS 10, 11, 12 AND 13.

The information required under these items is contained in the Company's Proxy
Statement relating to its 1999 Annual Meeting of Stockholders, which will be
filed with the Securities and Exchange Commission within 120 days after the
close of the Company's fiscal year end. This information is incorporated herein
by reference.


                                       52
<PAGE>

                                     PART IV

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

      (a)   Financial Statement and Financial Statement Schedules.

            See Index to Financial Statements at Item 8 of this Report.

      (b)   Exhibits.

            Exhibit
            Number                    Description

            2.1         Agreement and Plan of Merger by and among Dove Medical
                        Systems, DMS Acquisition Corp. and Norland Medical
                        Systems, Inc., (C)

            2.2         Purchase Agreement by and among Robert L. Piccioni and
                        Joan Piccioni, CHC, Inc., Mirella Monte Belshe and
                        Norland Medical Systems, Inc. (C)

            2.3         Stock Purchase Agreement between Norland Medical
                        Systems, Inc. and Norland Medical Systems B.V. (G)

            2.4         Amendment to Stock Purchase Agreement dated as of
                        December 31, 1998 between Norland Medical Systems, B.V.
                        and Norland Medical Systems, Inc.

            3.1         Restated Certificate of Incorporation of Norland Medical
                        Systems, Inc. (H)

            3.2         By-laws of Norland Medical Systems, Inc., as amended (A)

            +10.1       Distribution Agreement dated as of April 1, 1995 by and
                        among Norland Corporation, Stratec Medizintechnik GmbH
                        and Norland Medical Systems, Inc. (A)

            +10.2       Product Development Loan Agreement dated as of June 1,
                        1995 by and among Stratec Medizintechnik GmbH, Norland
                        Corporation and Norland Medical Systems, Inc. (A)

            10.3        Amended and Restated 1994 Stock Option and Incentive
                        Plan (G)

            10.4        Exclusive Distributor Agreement dated as of July 1, 1996
                        among Norland Medical Systems, Inc., Nissho Iwai
                        Corporation and Nissho Iwai American Corporation (E)

            10.5        Exclusive Distributor Agreement dated as of June 2, 1995
                        between Norland Medical Systems, Inc. and Meditec Co.,
                        Ltd. (A)

            10.6        Amendment No. 1 to Distribution Agreement by and among
                        Norland Corporation, Stratec Medizintechnik GmbH and
                        Norland Medical Systems, Inc. (B)

            10.7        Amendment No. 2 to Distribution Agreement by and among
                        Norland Corporation, Stratec Medizintechnik GmbH and
                        Norland Medical Systems, Inc. (D)


                                       53
<PAGE>

            +10.8       Amendment No. 3 to Distribution Agreement by and among
                        Norland Corporation, Stratec Medizintechnik GmbH and
                        Norland Medical Systems, Inc. (F)

            +10.9       Amended Distribution Agreement dated as of September 11,
                        1997 among Stratec Medizintechnik GmbH, Norland Medical
                        Systems, Inc. and Norland Corporation (G)

            10.10       Amendment No. 1 to Amended Distribution Agreement dated
                        as of December 7, 1998 by and among Stratec
                        Medizintechnik GmbH, Norland Medical Systems, Inc. and
                        Norland Corporation.

            21          Subsidiaries

            27.1        Financial Data Schedule

            (c)         Reports on Form 8-K.

                        The Company filed a Current Report on Form 8-K on
                        December 4, 1998 describing the settlement of litigation
                        with Lunar Corporation and Stanford University.

                        The Company filed a Current Report on Form 8-K on
                        January 5, 1999 describing the proposed settlement of
                        the Miller v. Bonmati litigation referred to in Item 3
                        of this Report and the reduction in the purchase price
                        for the acquisition of Norland Corp. and the related
                        debt reduction and stock issuance, all of which were
                        effected on December 31, 1998.

----------

+     Confidentiality requested as to certain provisions

(A)   This Exhibit was previously filed as an Exhibit to the Company's
      Registration Statement on Form S-1 (Registration No. 33-93220), effective
      August 1, 1995, and is incorporated herein by reference.

(B)   This Exhibit was previously filed as an Exhibit to the Company's Report on
      Form 10-K dated March 27, 1996 and is incorporated herein by reference.

(C)   This Exhibit was previously filed as an Exhibit to the Company's Report on
      Form 8-K dated April 15, 1996 and is incorporated herein by reference.

(D)   This Exhibit was previously filed as an Exhibit to the Company's
      Registration Statement on Form S-1 (Registration No. 333-05303) and is
      incorporated herein by reference.

(E)   This Exhibit was previously filed as an Exhibit to the Company's Report on
      Form 10-Q dated August 13, 1996 and is incorporated herein by reference.

(F)   This Exhibit was previously filed as an Exhibit to the Company's report on
      Form 10-K dated March 28, 1997 and is incorporated herein by reference.


                                       54
<PAGE>

(G)   This Exhibit was previously filed as an Exhibit to the Company's Proxy
      Statement dated July 25, 1997 and is incorporated herein by reference.

(H)   This Exhibit was previously filed as an Exhibit to the Company's report on
      Form 10-Q dated November 13, 1997 and is incorporated herein by reference.


                                       55
<PAGE>

                                   SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Annual Report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the City of White
Plains, New York, on the 30th day of March, 1999.

                                        NORLAND MEDICAL SYSTEMS, INC.


                                        By: /s/ Reynald G. Bonmati
                                           -------------------------------------
                                            Name: Reynald G. Bonmati
                                            Title: President

                                POWER OF ATTORNEY

Each person whose signature appears below hereby constitutes and appoints
Reynald G. Bonmati and Kurt W. Streams, or either of them, the true and lawful
attorney-in-fact and agent of the undersigned, with full power of substitution
and resubstitution, for and in the name, place and stead of the undersigned, in
any and all capacities, to sign any and all amendments to this Annual Report and
to file the same, with all exhibits thereto, and other documents in connection
therewith, with the Commission, and hereby grants to such attorneys-in-fact and
agents full power and authority to do and perform each and every act and thing
requisite or desirable to be done, as fully to all intents and purposes as the
undersigned might or could do in person, hereby ratifying and confirming all
that said attorneys-in-fact and agents, or their substitutes, may lawfully do or
cause to be done by virtue hereof.

Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual
Report has been signed below by the following persons on behalf of the
Registrant, Norland Medical Systems, Inc., in the capacities and on the dates
indicated.

         Signature                Capacity In Which Signed             Date
         ---------                ------------------------             ----

   /s/ Reynald G. Bonmati       Chairman of the Board and         March 30, 1999
-----------------------------   President (Principal Executive
       Reynald G. Bonmati       Officer); and-Director

   /s/ Kurt W. Streams          Vice President, Finance           March 30, 1999
-----------------------------   (Principal Financial Officer
       Kurt W. Streams          and Principal-Accounting
                                Officer)


                                       56
<PAGE>

         Signature                Capacity In Which Signed             Date
         ---------                ------------------------             ----

   /s/ Jeremy Allen             Director                          March 30, 1999
-----------------------------
       Jeremy Allen

   /s/ James J. Baker           Director                          March 30, 1999
-----------------------------
       James J. Baker

   /s/ Michael W. Huber         Director                          March 30, 1999
-----------------------------
       Michael W. Huber

   /s/ Andre-Jacques Neusy      Director                          March 30, 1999
-----------------------------
       Andre-Jacques Neusy

   /s/ Albert S. Waxman         Director                          March 30, 1999
-----------------------------
       Albert S. Waxman


                                       57