U NITED S TATES S ECURITIES
      AND E XCHANGE C OMMISSION


Washington,
      D.C. 20549




FORM
      10-QSB




Quarterly
      Report of Small Business Issuers under Section 13 or 15(d) of the Securities
      Exchange Act of


1934
      for
      the quarterly period ended December 31, 2006




Commission
      File No. 000-14247




**I** **SO** **R** **AY** **,
      I** **NC.**


(Exact
      name of registrant as specified in its charter)




Minnesota
              (State
                or other jurisdiction of incorporation or
              organization)
            41-1458152
              (I.R.S.
                Employer Identification No.)350
                Hills St., Suite 106
              Richland,
                Washington
              (Address
                of principal executive offices)
            99354
              (Zip
                Code)Issuer's
                telephone number, including area code:(509)
                375-1202Check
                whether the issuer has (1) filed all reports required to be filed
                by
                Section 13 or 15(d) of the Exchange Act during the past 12 months
                (or for
                such shorter period the Company was required to file such reports),
                and
                (2) has been subject to such filing requirements for the past 90
                days.
                YesxNoo
              
              Indicate
                by check mark whether the Registrant is a shell company (as defined
                in
                Rule 12b-2 of the Exchange Act):YesoNoxNumber
                of shares outstanding of each of the issuer's classes of common
                equity:Class
            Outstanding
                as of February 7, 2007Common
                stock, $0.001 par value
            16,815,360Transitional
                Small Business Disclosure Format : YesoNox









**ISORAY,
      INC.**




**Table
      of Contents**




PagePART
                I FINANCIAL INFORMATION
            
            
            1Item
                1. Consolidated Unaudited Financial Statements
            
            
            1Consolidated
                Balance Sheets
            
            
            1Consolidated
                Unaudited Statements of Operations
            
            
            2Consolidated
                Unaudited Statements of Cash Flows
            
            
            3Notes
                to Consolidated Unaudited Financial Statements
            
            
            4Item
                2. Management's Discussion and Analysis of Financial
                Conditionand
                Results of Operations
            
            
            9Item
                3. Controls and Procedures
            
            
            16PART
                II OTHER INFORMATION
            
            
            17Item
                6. Exhibits and Reports on Form 8-K
            
            
            17SIGNATURES
            
            
            18







**IsoRay,
                  Inc. and Subsidiary****Consolidated
                  Balance Sheets****December
                  31,****2006**
              
              **June
                  30,****(Unaudited)**
              
              **2006****ASSETS**Current
                  assets:Cash
                  and cash equivalents
              
              $
              3,700,108
              
              $
              2,207,452Accounts
                  receivable, net of allowance for doubtful accountsof
                  $49,306 and $85,183, respectively
              
              
              982,001
              
              
              596,447Inventory
              
              
              229,899
              
              
              161,381Prepaid
                  expenses
              
              
              212,606
              
              
              161,546Total
                  current assets
              
              
              5,124,614
              
              
              3,126,826Fixed
                  assets, net of accumulated depreciation
              
              
              1,945,239
              
              
              1,642,293Deferred
                  financing costs, net of accumulated amortization
              
              
              230,645
              
              
              274,358Licenses,
                  net of accumulated amortization
              
              
              263,363
              
              
              273,475Other
                  assets, net of accumulated amortization
              
              
              350,889
              
              
              338,987Total
                  assets
              
              $
              7,914,750
              
              $
              5,655,939**LIABILITIES
                  AND SHAREHOLDERS' EQUITY**Current
                  liabilities:Accounts
                  payable and accrued expenses
              
              $
              842,584
              
              $
              584,296Accrued
                  payroll and related taxes
              
              
              718,983
              
              
              614,645Accrued
                  interest payable
              
              
              11,206
              
              
              11,986Notes
                  payable, due within one year
              
              
              47,189
              
              
              51,351Capital
                  lease obligations, due within one year
              
              
              197,227
              
              
              183,554Convertible
                  debentures payable, due within one year
              
              
              455,000
              
              
              455,000Total
                  current liabilities
              
              
              2,272,189
              
              
              1,900,832Notes
                  payable, due after one year
              
              
              551,974
              
              
              581,557Capital
                  lease obligations, due after one year
              
              
              118,258
              
              
              220,415Asset
                  retirement obligation
              
              
              70,516
              
              
              67,425Total
                  liabilities
              
              
              3,012,937
              
              
              2,770,229Shareholders'
                  equity:Preferred
                  stock, $.001 par value; 6,000,000 shares authorized:Series
                  A: 1,000,000 shares allocated; no shares issued and outstanding
              
              
              -
              
              
              -Series
                  B: 5,000,000 shares allocated; 77,080 and 144,759 shares issued
                  andoutstanding
              
              
              77
              
              
              145Common
                  stock, $.001 par value; 100,000,000 shares authorized;16,296,045
                  and 15,157,901 shares issued and outstanding
              
              
              16,296
              
              
              15,158Subscriptions
                  receivable
              
              
              -
              
              
              (6,122,007
              )Additional
                  paid-in capital
              
              
              23,277,585
              
              
              22,538,675Accumulated
                  deficit
              
              
              (18,392,145
              )
              
              (13,546,261
              )Total
                  shareholders' equity
              
              
              4,901,813
              
              
              2,885,710Total
                  liabilities and shareholders' equity
              
              $
              7,914,750
              
              $
              5,655,939The
                  accompanying notes are an integral part of these financial
                  statements.
  1
 
 **IsoRay,
                  Inc. and Subsidiary****Consolidated
                  Statements of Operations****(Unaudited)****Three
                  months ended December 31,**
              
              **Six
                  months ended December 31,****2006**
              
              **2005**
              
              **2006**
              
              **2005**Product
                  sales
              
              $
              1,414,155
              
              $
              486,247
              
              $
              2,439,599
              
              $
              697,162Cost
                  of product sales
              
              
              1,387,394
              
              
              916,274
              
              
              2,675,539
              
              
              1,636,440Gross
                  margin / (loss)
              
              
              26,761
              
              
              (430,027
              )
              
              (235,940
              )
              
              (939,278
              )Operating
                  expenses:Research
                  and development
              
              
              216,254
              
              
              96,837
              
              
              461,852
              
              
              122,619Sales
                  and marketing expenses
              
              
              890,018
              
              
              340,532
              
              
              1,562,948
              
              
              655,571General
                  and administrative expenses
              
              
              821,529
              
              
              675,444
              
              
              2,554,661
              
              
              1,636,393Total
                  operating expenses
              
              
              1,927,801
              
              
              1,112,813
              
              
              4,579,461
              
              
              2,414,583Operating
                  loss
              
              
              (1,901,040
              )
              
              (1,542,840
              )
              
              (4,815,401
              )
              
              (3,353,861
              )Non-operating
                  income (expense):Interest
                  income
              
              
              50,004
              
              
              3,193
              
              
              90,187
              
              
              10,152Financing
                  expense
              
              
              (67,413
              )
              
              (195,480
              )
              
              (120,670
              )
              
              (351,108
              )Debt
                  conversion expense
              
              
              -
              
              
              (244,097
              )
              
              -
              
              
              (244,097
              )Non-operating
                  income (expense), net
              
              
              (17,409
              )
              
              (436,384
              )
              
              (30,483
              )
              
              (585,053
              )Net
                  loss
              
              $
              (1,918,449
              )
              $
              (1,979,224
              )
              $
              (4,845,884
              )
              $
              (3,938,914
              )Basic
                  and Diluted loss per share
              
              $
              (0.12
              )
              $
              (0.17
              )
              $
              (0.31
              )
              $
              (0.36
              )Shares
                  used in computing net loss per share:Basic
                  and Diluted
              
              
              15,919,236
              
              
              11,852,047
              
              
              15,609,992
              
              
              10,844,913The
                  accompanying notes are an integral part of these financial
                  statements.
  2
 
 **IsoRay,
                  Inc. and Subsidiary****Consolidated
                  Statements of Cash Flows****(Unaudited)****Six
                  months ended December 31,****2006**
              
              **2005****CASH
                  FLOWS FROM OPERATING ACTIVITIES:**Net
                  loss
              
              $
              (4,845,884
              )
              $
              (3,938,914
              )Adjustments
                  to reconcile net loss to net cash used by operating activities:Depreciation
                  and amortization of fixed assets
              
              
              184,510
              
              
              95,432Amortization
                  of deferred financing costs and other assets
              
              
              69,580
              
              
              103,546Accretion
                  of asset retirement obligation
              
              
              3,091
              
              
              -Noncash
                  share-based compensation
              
              
              897,887
              
              
              -Merger
                  consulting fees paid by issuance of common stock
              
              
              -
              
              
              330,000Rent
                  expense paid by issuance of common stock
              
              
              -
              
              
              30,009Repair
                  and maintenance expense paid by issuance of common stock
              
              
              -
              
              
              14,752Debt
                  conversion expense
              
              
              -
              
              
              244,097Changes
                  in operating assets and liabilities:Accounts
                  receivable, net
              
              
              (385,554
              )
              
              (417,647
              )Inventory
              
              
              (68,518
              )
              
              (74,093
              )Prepaid
                  expenses
              
              
              (51,060
              )
              
              62,350Accounts
                  payable and accrued expenses
              
              
              258,288
              
              
              (291,895
              )Accrued
                  payroll and related taxes
              
              
              154,338
              
              
              65,032Accrued
                  interest payable
              
              
              (780
              )
              
              42,065Net
                  cash used by operating activities
              
              
              (3,784,102
              )
              
              (3,735,266
              )**CASH
                  FLOWS FROM INVESTING ACTIVITIES:**Purchases
                  of fixed assets
              
              
              (487,456
              )
              
              (347,357
              )Additions
                  to licenses and other assets
              
              
              (27,657
              )
              
              (64,096
              )Net
                  cash used by investing activities
              
              
              (515,113
              )
              
              (411,453
              )**CASH
                  FLOWS FROM FINANCING ACTIVITIES:**Net
                  advances on bank line of credit
              
              
              **-**
              
              
              200,000Proceeds
                  from issuance of notes payable
              
              
              **-**
              
              
              250,000Proceeds
                  from sales of convertible debentures payable
              
              
              -
              
              
              550,000Principal
                  payments on notes payable
              
              
              (33,745
              )
              
              (279,926
              )Principal
                  payments on capital lease obligations
              
              
              (88,484
              )
              
              (66,329
              )Proceeds
                  from cash sales of common stock, net of offering costs
              
              
              4,702,931
              
              
              2,324,168Proceeds
                  from cash sales of preferred stock, pursuant to exercise of warrants
              
              
              8,709
              
              
              -Proceeds
                  from cash sales of common stock, pursuant to exercise of warrants
              
              
              611,997
              
              
              59,565Proceeds
                  from cash sales of common stock, pursuant to exercise of options
              
              
              590,463
              
              
              72,928Payments
                  to common shareholders in lieu of issuing fractional shares
              
              
              -
              
              
              (734
              )Net
                  cash provided by financing activities
              
              
              5,791,871
              
              
              3,109,672Net
                  increase in cash and cash equivalents
              
              
              1,492,656
              
              
              (1,037,047
              )Cash
                  and cash equivalents, beginning of period
              
              
              2,207,452
              
              
              1,685,731**CASH
                  AND CASH EQUIVALENTS, END OF PERIOD**
              
              $
              3,700,108
              
              $
              648,684Non-cash
                  investing and financing activities:Cashless
                  exercise of common stock options
              
              $
              50,000
              
              $
              -Exchange
                  of convertible debentures payable for shares of common stock
              
              
              -
              
              
              3,607,875Fixed
                  assets acquired by capital lease obligations
              
              
              -
              
              
              507,947Prepaid
                  rent paid by issuance of common stock
              
              
              -
              
              
              90,026The
                  accompanying notes are an integral part of these financial
                  statements.


3




**IsoRay,
      Inc.**


**Notes
      to the Unaudited Consolidated Financial Statements**


**For
      the three and six month periods ended December 31, 2006 and
      2005**








**1.**
            **Basis
                of Presentation**





The
      accompanying consolidated financial statements are those of IsoRay, Inc., and
      its wholly-owned subsidiary (“IsoRay” or the “Company”). All significant
      intercompany accounts and transactions have been eliminated in
      consolidation.





The
      accompanying interim consolidated financial statements have been prepared in
      conformity with U.S. generally accepted accounting principles, consistent in
      all
      material respects with those applied in the Company’s Annual Report on Form
      10-KSB for the fiscal year ended June 30, 2006, except for the July 1, 2006
      adoption of Statement of Financial Accounting Standards No. 123R,
“Share-Based Payment” (“SFAS No. 123R”) — See Note 2. The financial information
      is unaudited but reflects all adjustments, consisting only of normal recurring
      accruals, which are, in the opinion of the Company’s management, necessary for a
      fair statement of the results for the interim periods presented. Interim results
      are not necessarily indicative of results for a full year. The information
      included in this Form 10-QSB should be read in conjunction with the Company’s
      Annual Report on Form 10-KSB for the fiscal year ended June 30,
      2006.





**2.**  **Share-Based
      Compensation**





Effective
      July 1, 2006, the Company adopted SFAS No. 123R using the modified-prospective
      method. Prior to July 1, 2006, the Company accounted for share-based
      employee compensation, including stock options, using the method prescribed
      in
      Accounting Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* and
      related interpretations (“APB 25”). No share-based employee compensation cost
      was reflected in the statement of operations prior to the adoption of SFAS
      No.
      123R. Results for prior periods have not been restated.





The
      following table presents the share-based compensation expense recognized in
      accordance with SFAS No. 123R during the three and six months ended December
      31,
      2006 and in accordance with APB 25 during the three and six months ended
      December 31, 2005:




Three
                  months
              
              Six
                  monthsended
                  December 31,
              
              ended
                  December 31,2006
              
              2005
              
              2006
              
              2005Cost
                  of product sales
              
              $
              20,492
              
              $
              -
              
              $
              71,325
              
              $
              -Research
                  and development
              
              
              7,879
              
              
              -
              
              
              19,714
              
              
              -Sales
                  and marketing
              
              
              52,456
              
              
              -
              
              
              99,237
              
              
              -General
                  and administrative
              
              
              35,617
              
              
              -
              
              
              707,611
              
              
              -Total
                  share-based compensation
              
              $
              116,444
              
              $
              -
              
              $
              897,887
              
              $
              -




The
      adoption of SFAS No. 123R increased net loss for the three and six months ended
      December 31, 2006 by $116,444 and $897,887, respectively. Basic loss per common
      share for the three and six months ended December 31, 2006 would have been
      $0.11
      and $0.25, respectively, if the Company had not adopted SFAS No. 123R, compared
      to reported basic loss per common share of $0.12 and $0.31, respectively. The
      total value of the stock option awards is expensed ratably over the service
      period of the employees receiving the awards. As of December 31, 2006, total
      unrecognized compensation cost related to stock-based options and awards was
      $1,041,962 and the related weighted-average period over which it is expected
      to
      be recognized is approximately 1.16 years.




4




The
      Company currently provides stock-based compensation under three equity incentive
      plans approved by the Board of Directors: the Amended and Restated 2005 Employee
      Stock Option Plan, the Amended and Restated 2005 Stock Option Plan, and the
      2006
      Director Stock Option Plan. Stock option awards granted from these plans are
      granted at the fair market value on the date of grant, and vest over a period
      determined at the time the options are granted, generally ranging from zero
      to
      three years, and generally have a maximum term of ten years. For stock options
      with graded vesting terms, the Company recognizes compensation cost on a
      straight-line basis over the requisite service period for each separately
      vesting portion of the award as if the award was, in substance, multiple
      awards.





A
      summary
      of stock option activity within the Company’s share-based compensation plans and
      charges for the six months ended December 31, 2006 is as follows:




Shares
            
            Price
                (a)
            
            Life
                (b)
            
            Value
                (c)Outstanding
                at June 30, 2006
            
            
            3,129,692
            
            $
            2.05Granted
                (d)
            
            
            727,900
            
            
            3.14Cancelled
            
            
            (129,454
            )
            
            1.19Exercised
            
            
            (543,499
            )
            
            1.18Outstanding
                at December 31, 2006
            
            
            3,184,639
            
            $
            2.49
            
            
            8.84
            
            $
            8,029,758Expected
                to vest at December 31, 2006
            
            
            3,149,762
            
            $
            2.47
            
            
            8.84
            
            $
            7,997,372Vested
                and exercisable at December 31, 2006
            
            
            2,543,997
            
            $
            2.16
            
            
            8.71
            
            $
            7,223,876




(a)
            Weighted
                average price per share.


(b)
            Weighted
                average remaining contractual life.


(c)
            Aggregate
                intrinsic value.


(d)
            All
                options granted had exercise prices equal to the ending market price
                of
                the Company’s common stock on the grant
                date.





The
      aggregate intrinsic value of options exercised during the six months ended
      December 31, 2006 was $1,557,600.





The
      weighted average fair value of stock option awards granted and the key
      assumptions used in the Black-Scholes valuation model to calculate the fair
      value are as follows for the three and six months ended December 31, 2006 and
      2005:


Three
                  months
              
              Six
                  monthsended
                  December 31,
              
              ended
                  December 31,2006
              
              2005
              
              2006
              
              2005Weighted
                  average fair value of options granted
              
              $
              2.14
              
              $
              1.55
              
              $
              2.11
              
              $
              0.91Key
                  assumptions used in determining fair value:Weighted
                  average risk-free interest rate
              
              
              4.74
              %
              
              4.34
              %
              
              4.88
              %
              
              4.53
              %Expected
                  life of the option (in years)
              
              
              6.00
              
              
              5.00
              
              
              5.58
              
              
              7.59Expected
                  stock price volatility
              
              
              75.00
              %
              
              30.69
              %
              
              75.00
              %
              
              30.18
              %Expected
                  dividend yield
              
              
              0.00
              %
              
              0.00
              %
              
              0.00
              %
              
              0.00
              %


The
      Black-Scholes option valuation model was developed for use in estimating the
      fair value of traded options which have no vesting restrictions and are fully
      transferable. In addition, option valuation models require the input of highly
      subjective assumptions, including the expected stock price volatility. Because
      changes in the subjective input assumptions can materially affect the fair
      value
      estimate, in management’s opinion, the existing models do not necessarily
      provide a reliable single measure of the fair value of its employee stock
      options. The risk-free interest rate is based on the U.S. treasury security
      rate
      in effect as of the date of grant. The expected lives of options and the
      volatility are based on historical data of the Company.




5




The
      following table illustrates the effect on net loss and net loss per common
      share
      for the three and six months ended December 31, 2005 as if the Company had
      applied the fair value recognition provisions of SFAS No. 123 to all outstanding
      stock option awards for periods presented prior to the Company’s adoption of
      SFAS No. 123R:




Three
                  months
              
              Six
                  monthsended
              
              endedDecember
                  31,
              
              December
                  31,2005
              
              2005Net
                  loss, as reported
              
              $
              1,979,224
              
              $
              3,938,914Stock-based
                  compensation expense determined under fair value methods for all
                  stock
                  options
              
              
              3,254
              
              
              159,254Proforma
                  net loss
              
              $
              1,982,478
              
              $
              4,098,168Net
                  loss per share:Basic,
                  as reported
              
              $
              0.17
              
              $
              0.36Basic,
                  pro forma
              
              $
              0.17
              
              $
              0.38




**3.**  **Loss
      per Share**





The
      Company accounts for its income (loss) per common share according to SFAS No.
      128, *Earnings
      Per Share* .
      Under
      the provisions of SFAS No. 128, primary and fully diluted earnings per share
      are
      replaced with basic and diluted earnings per share. Basic earnings per share
      is
      calculated by dividing net income (loss) available to common shareholders by
      the
      weighted average number of common shares outstanding, and does not include
      the
      impact of any potentially dilutive common stock equivalents. Common stock
      equivalents, including warrants to purchase the Company's common stock and
      common stock issuable upon the conversion of notes payable, are excluded from
      the calculations when their effect is antidilutive. Basic weighted average
      shares outstanding for the year ended June 30, 2005 have been adjusted to
      reflect the exchange ratio contained in the merger transaction dated July 28,
      2005. At June 30, 2006 and 2005, the calculation of diluted weighted average
      shares does not include preferred stock, options, or warrants that are
      potentially convertible into common stock as those would be antidilutive due
      to
      the Company’s net loss position.




6




Securities
      that could be dilutive in the future as of December 31, 2006 and 2005 are as
      follows:




December
                  31,2006
              
              2005Preferred
                  stock
              
              
              77,080
              
              
              292,328Preferred
                  stock warrants
              
              
              28,614
              
              
              221,812Common
                  stock warrants
              
              
              4,707,131
              
              
              1,653,346Common
                  stock options
              
              
              3,184,639
              
              
              2,817,768Convertible
                  debentures
              
              
              109,639
              
              
              127,711Total
                  potential dilutive securities
              
              
              8,107,103
              
              
              5,112,965




**4.**  **Risks
      and Uncertainties**





The
      Company’s financial statements have been prepared on a going concern basis,
      which contemplates the realization of assets and settlement of liabilities
      and
      commitments in the normal course of business. However, our large operating
      losses and accumulated deficit, among other things, raise substantial doubt
      about our ability to continue as a going concern. Management plans to raise
      additional financing (including the sale of additional equity or borrowings)
      and
      grow the revenues of our core product while continually analyzing other market
      opportunities. However, no assurance can be given that such financing will
      be
      completed on terms acceptable to the Company or that the Company will be able
      to
      meet its revenue targets. If the Company is unable to obtain additional
      financing and grow revenues, we may have to curtail our business or cease
      operations. The financial statements do not include any adjustments relating
      to
      the recoverability of assets and classification of liabilities that might be
      necessary should the Company be unable to continue as a going
      concern.





**5.**  **Supply
      Contract**





On
      October 6, 2006, IsoRay Medical, Inc., the wholly owned subsidiary of the
      Company, entered into a Contract with FSUE "SSE - Research Institute of Atomic
      Reactors" ("RIAR") in Russia. The Contract provides for delivery to IsoRay
      Medical of purified Cs-131 isotope, which is used by IsoRay Medical to produce
      its proprietary Cs-131 brachytherapy seed used in cancer therapy. The total
      value of the Contract over its term, which expires on May 1, 2014, is
      $6,300,000. Delivery of the isotope is scheduled to commence in about October
      2007 and continue through December 2013, upon submission of written orders
      by
      IsoRay Medical forty-five days in advance of the planned date of delivery.





IsoRay
      Medical also entered into an Agreement for Exclusive Right to Buy on October
      6,
      2006 with RIAR. This Agreement gives IsoRay Medical the exclusive right to
      purchase the Cs-131 isotope produced by RIAR for a period of seven years, or
      through October 6, 2013.





**6.**  **Subsequent
      Events**





Warrant
      Exercises


During
      January 2007, two warrant holders exercised warrants issued in connection with
      the August 2006 Stock Purchase Agreement. The Company received $1,218,900 in
      cash and issued 406,300 common shares pursuant to these exercises.





Proxy
      Statement


On
      January 16, 2007, the Company filed a proxy statement and annual meeting notice
      with the SEC. The Board of Directors set January 5, 2007 as the record date
      for
      the annual meeting to be held on February 20, 2007. All shareholders of record
      on January 5, 2007 were mailed proxy materials. There are two proposals
      scheduled to be voted on at the annual meeting. The first is the election of
      seven directors to hold office until the 2008 annual meeting and the second
      is
      to ratify the selection of DeCoria, Maichel & Teague, P.S. as the Company’s
      independent registered public accounting firm for the fiscal year ending June
      30, 2007.




7




Form
      S-3


On
      January 26, 2007, the Company filed a Form S-3 registration statement using
      a
“shelf” registration process. Under this shelf registration process, we may
      offer from time to time up to $20,000,000 in the aggregate, inclusive of any
      exercise price thereof, of the following securities: (1) shares of our common
      stock; (2) warrants to purchase shares of our common stock; or (3) any
      combination of the foregoing.





Preferred
      Dividends


On
      February 1, 2007, the Board of Directors declared a dividend on the Series
      B
      Preferred Stock of all outstanding and cumulative dividends through December
      31,
      2006. The total dividend of $38,458 will be paid on February 15,
      2007.





Share
      Rights Plan


On
      February 1, 2007, the Board of Directors adopted a share rights plan. The plan
      grants to the Company’s common shareholders a right to purchase a fractional
      share of preferred stock for each outstanding common share held of record at
      the
      close of business on February 16, 2007, or alternatively (in lieu of purchasing
      preferred stock) entitles its registered holder to purchase $50 of the Company
      common stock at a price of $25 per share, subject to adjustment. This purchase
      right generally cannot be exercised by the Company’s common shareholders to
      purchase stock until after a person or group acquires beneficial ownership
      of
      15% or more of the Company's voting stock. However, the purchase rights held
      by
      the person or group that acquires 15% voting power will automatically become
      void and they will be unable to exercise their rights to purchase any shares
      of
      stock of the Company.




In
      addition, upon a merger or similar transaction resulting in an acquisition
      of
      the Company, each exercisable purchase right can be exercised by its holder
      to
      purchase common stock of the acquiring company with a market value of twice
      the
      right's exercise price. The purchase rights will expire on February 16, 2017.






Until
      a
      person or group acquires 15% or more of the Company's voting stock, the Board
      of
      Directors may redeem the rights for $.001 per right (subject to adjustment).
      In
      certain events, the Board of Directors may also exchange the rights for shares
      of the Company common stock, delay or temporarily suspend the exercisability
      of
      the rights or reduce the 15 percent stock ownership threshold to not less than
      10 percent.




By-Law
      Amendments


On
      February 1, 2007, the Board of Directors adopted by-law amendments requiring
      advance notice to the Company of shareholder business proposals and director
      nominations. These amendments will take effect for the 2008 Annual Shareholder
      Meeting.




8




**ITEM
      2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF
      OPERATION**





***Caution
      Regarding Forward-Looking Information***





*All
      statements contained in this Form 10-QSB, other than statements of historical
      facts, that address future activities, events or developments are
      forward-looking statements, including, but not limited to, statements containing
      the words "believe," "expect," "anticipate," "intends," "estimate," "forecast,"
      "project," and similar expressions . All statements other than statements of
      historical fact are statements that could be deemed forward-looking statements,
      including any statements of the plans, strategies and objectives of management
      for future operations; any statements concerning proposed new products,
      services, developments or industry rankings; any statements regarding future
      economic conditions or performance; any statements of belief; and any statements
      of assumptions underlying any of the foregoing. These statements are based
      on
      certain assumptions and analyses made by us in light of our experience and
      our
      assessment of historical trends, current conditions and expected future
      developments as well as other factors we believe are appropriate under the
      circumstances. However, whether actual results will conform to the expectations
      and predictions of management is subject to a number of risks and uncertainties
      described under “Risk Factors” beginning on page 17 below and in the “Risk
      Factors” sections of our Form 10-KSB for the fiscal year ended June 30, 2006 and
      our amended Registration Statement on Form SB-2 initially filed on November
      10,
      2005 and amended on December 1, 2006 that may cause actual results to differ
      materially.*





*Consequently,
      all of the forward-looking statements made in this Form 10-QSB are qualified
      by
      these cautionary statements and there can be no assurance that the actual
      results anticipated by management will be realized or, even if substantially
      realized, that they will have the expected consequences to or effects on our
      business operations. Readers are cautioned not to place undue reliance on such
      forward-looking statements as they speak only of the Company's views as of
      the
      date the statement was made. The Company undertakes no obligation to publicly
      update or revise any forward-looking statements, whether as a result of new
      information, future events or otherwise.*





**Critical
      Accounting Policies and Estimates**





The
      discussion and analysis of the Company’s financial condition and results of
      operations are based upon its consolidated financial statements, which have
      been
      prepared in accordance with accounting principles generally accepted in the
      United States of America. The preparation of these financial statements requires
      management to make estimates and judgments that affect the reported amounts
      of
      assets, liabilities, revenues and expenses, and related disclosure of contingent
      liabilities. On an on-going basis, management evaluates past judgments and
      estimates, including those related to bad debts, inventories, accrued
      liabilities, and contingencies. Management bases its estimates on historical
      experience and on various other assumptions that are believed to be reasonable
      under the circumstances, the results of which form the basis for making
      judgments about the carrying values of assets and liabilities that are not
      readily apparent from other sources. Actual results may differ from these
      estimates under different assumptions or conditions. The accounting policies
      and
      related risks described in the Company’s annual report on Form 10-KSB as filed
      with the Securities and Exchange Commission on September 28, 2006 are those
      that
      depend most heavily on these judgments and estimates. As of December 31,
      2006, there have been no material changes to any of the critical accounting
      policies contained therein except for the adoption of SFAS No. 123R as noted
      below.





**Share-Based
      Compensation**





As
      part
      of our adoption of SFAS No. 123R as of July 1, 2006, we were required
      to recognize the fair value of share-based compensation awards as an expense.
      We
      apply the Black-Scholes option-pricing model in order to determine the fair
      value of stock options on the date of grant, and we apply judgment in estimating
      key assumptions that are important elements in the model such as the expected
      stock-price volatility, expected stock option life and expected forfeiture
      ratios. Our estimates of these important assumptions are based on historical
      data and judgment regarding market trends and factors. If actual results are
      not
      consistent with our assumptions and judgments used in estimating these factors,
      we may be required to record additional share-based compensation expense, which
      could be material to our results of operations.




9




**Adoption
      of SFAS No. 123R**





During
      December 2004, the Financial Accounting Standards Board (“FASB”) issued
      SFAS No. 123R, which requires companies to measure and recognize compensation
      expense for all share-based payments at fair value. Share-based payments include
      stock option and nonvested share grants. We grant options to purchase common
      stock to some of our employees and directors under various plans at prices
      equal
      to the market value of the stock on the dates the options were granted. We
      historically have accounted for stock options using the method prescribed in
      APB
      25 whereby if stock options are granted at market price then no compensation
      cost is recognized, and disclosed the pro forma effect on net earnings assuming
      compensation cost had been recognized in accordance with SFAS No. 123. SFAS
      No.
      123R, which was effective for us beginning on July 1, 2006, eliminates the
      ability to account for share-based compensation transactions using APB 25,
      and
      generally requires that such transactions be accounted for using prescribed
      fair-value-based methods. SFAS No. 123R permits public companies to adopt its
      requirements using one of two methods: (a) a “modified prospective” method
      in which compensation costs are recognized beginning with the effective date
      based on the requirements of SFAS No. 123R for all share-based payments granted
      or modified after the effective date, and based on the requirements of SFAS
      No.
      123 for all awards granted to employees prior to the effective date of SFAS
      No.
      123R that remain unvested on the effective date or (b) a “modified
      retrospective” method which includes the requirements of the modified
      prospective method described above, but also permits companies to restate based
      on the amounts previously recognized under SFAS No. 123 for purposes of pro
      forma disclosures either for all periods presented or for prior interim periods
      of the year of adoption. We have decided to adopt SFAS No. 123R using the
      modified prospective method.





The
      following table presents the share-based compensation expense recognized in
      accordance with SFAS No. 123R during the three and six months ended December
      31,
      2006 and in accordance with APB 25 during the three and six months ended
      December 31, 2005:




Three
                    months
                
                Six
                    monthsended
                    December 31,
                
                ended
                    December 31,2006
                
                2005
                
                2006
                
                2005Cost
                    of product sales
                
                $
                20,492
                
                $
                -
                
                $
                71,325
                
                $
                -Research
                    and development
                
                
                7,879
                
                
                -
                
                
                19,714
                
                
                -Sales
                    and marketing
                
                
                52,456
                
                
                -
                
                
                99,237
                
                
                -General
                    and administrative
                
                
                35,617
                
                
                -
                
                
                707,611
                
                
                -Total
                    share-based compensation
                
                $
                116,444
                
                $
                -
                
                $
                897,887
                
                $
                -




As
      of
      December 31, 2006, total unrecognized compensation cost related to stock-based
      options and awards was $1,041,962 and the related weighted-average period over
      which it is expected to be recognized is approximately
      1.16 years.





10


**Results
      of Operations**





**Three
      months ended December 31, 2006 and 2005**





***Revenues.***  The
      Company generated sales of $1,414,155 during the three months ended December
      31,
      2006, compared to sales of $486,247 during the three months ended December
      31,
      2005. The increase of $927,908 or 191% is due to increased sales volume of
      the
      Company’s 131 Cs
      seed.
      During the three months ended December 31, 2006, the Company sold its 131 Cs
      seed
      to 33 different medical centers as compared to 15 centers during the
      corresponding period of 2005.





***Cost
      of product sales.*** Cost of
      product sales was $1,387,394 for the three months ended December 31, 2006
      compared to cost of product sales of $916,274 during the three months ended
      December 31, 2005. The increase of $471,120 or 51% was due to the higher
      production levels during the three months ended December 31, 2006 which were
      related to the increase in sales volume over the corresponding period from
      2005.
      The major components of the increase were wages, benefits and related taxes,
      materials, depreciation, preload expenses, and share-based compensation. Wages,
      benefits, and related taxes increased about $211,000 to approximately $412,000
      for the three months ended December 31, 2006 due to the hiring of additional
      production employees to support the higher production levels. Materials costs
      increased about $137,000 to approximately $478,000 in 2006, due to increased
      sales volumes. Material costs in 2005 included payments to Pacific Northwest
      National Laboratory (“PNNL”) for facilities and personnel to manufacture the
      seeds. The Company no longer uses PNNL to produce the seeds but continues to
      use
      PNNL for certain analytical support functions. During the three months ended
      December 31, 2006, the Company expensed payments of about $55,000 to PNNL for
      these support functions. Depreciation expense increased about $69,000 to
      approximately $87,000 in 2006 due to the addition of equipment that was placed
      in service during the second half of the fiscal year ended June 30, 2006.
      Preload expenses also increased by about $52,000 to approximately $98,000 for
      the three months ended December 31, 2006 due to the higher volume of sales.
      Share-based compensation expense was approximately $20,000 and $0 for the three
      months ended December 31, 2006 and 2005, respectively, as the Company
      implemented SFAS No. 123R on July 1, 2006. These increases were offset by a
      decrease in small tools expense of about $90,000 to approximately $16,000 as
      the
      prior year expense included start-up costs of the Company’s production
      facility.





***Gross
      margin / loss.***  Gross
      margin was $26,761 for the three month period ended December 31, 2006. This
      represents an improvement of $456,788 or 106% over the corresponding period
      of
      2005’s gross loss of $430,027. The improvement in gross margin is due to higher
      revenues and greater production efficiency.





***Research
      and development.*** **** Research
      and development expenses for the three month period ended December 31, 2006
      were
      $216,254 which represents an increase of $119,417 or 123% over the research
      and
      development expenses of $96,837 for the corresponding period of 2005. The major
      components of the increase were wages, benefits and related taxes, patent legal
      expenses, consulting, and share-based compensation. Wages, benefits and related
      taxes were approximately $79,000 and $0 for the three months ended December
      31,
      2006 and 2005, respectively, as the Company hired research scientists. During
      the three months ended December 31, 2006, the Company incurred about $19,000
      of
      legal expenses related to patents and trademarks that were expensed. Consulting
      expenses increased about $65,000 to approximately $80,000 as the Company
      continues to increase the efficiency of production. Share-based compensation
      expense was approximately $8,000 and $0 for the three months ended December
      31,
      2006 and 2005, respectively, as the Company implemented SFAS No. 123R on July
      1,
      2006. Clinical study protocol expenses decreased about $69,000 to approximately
      $14,000 for the three months ended December 31, 2006 as the Company is near
      the
      end of its initial protocol study.




11




***Sales
      and marketing expenses.*** **** Sales
      and
      marketing expenses were $890,018 for the three months ended December 31, 2006.
      This represents an increase of $549,486 or 161% compared to the three months
      ended December 31, 2005’s expenditures of $340,532 for sales and marketing.
      Wages, including payroll-related taxes, travel, office and other support
      expenses on behalf of our sales and marketing and customer service staff
      increased by approximately $270,000 to approximately $509,000 for the three
      months ended December 31, 2006 due to hiring additional sales and marketing
      personnel as the Company continues to expand market share. Conventions and
      tradeshows increased by approximately $169,000 to approximately $254,000 due
      to
      the Company’s continued efforts to expand its market share. Consulting expenses
      increased by $34,000 to approximately $38,000 for consultants hired to increase
      brand and market awareness. Also included in sales and marketing expenses is
      share-based compensation expense of approximately $52,000 due to the Company’s
      implementation of SFAS No. 123R on July 1, 2006.




***General
      and administrative expenses.*** General
      and administrative expenses for the three months ended December 31, 2006 were
      $821,529 compared to general and administrative expenses of $675,444 for the
      corresponding period of 2005. The increase of $146,085 or 22% is primarily
      due
      to approximately $36,000 of share-based compensation expense related to the
      implementation of SFAS No. 123R on July 1, 2006, approximately $145,000 of
      increased payroll costs due to a higher headcount, and approximately $64,000
      relating to investor relations and other public company expenses. These
      increased expenses were partially offset by a reduction in consulting fees
      of
      approximately $19,000 as the Company has hired more internal staff, a decrease
      in audit related fees of $24,000 as the Company had more regulatory and other
      filings in 2005 following the merger, and a reduction in the bad debt expense
      of
      $14,000 as the Company reduced its allowance for doubtful accounts during the
      three months ended December 31, 2006.





***Operating
      loss.*** Due to
      our rapid structural growth, significant research and development expenditures,
      and additional responsibilities as a reporting company, we have not been
      profitable, and have generated operating losses since our inception. In the
      three months ended December 31, 2006, the Company had an operating loss of
      $1,901,040 which is an increase of $358,200 or 23% over the operating loss
      of
      $1,542,840 for the three months ended December 31, 2005. Included in the
      operating loss for the three months ended December 31, 2006 is share-based
      compensation expense of $116,444 due to the implementation of SFAS No. 123R
      on
      July 1, 2006.





***Interest
      income.*** Interest
      income increased by $46,811 or 1,466% to $50,004 for the three months ended
      December 31, 2006. Interest income is mainly derived from excess funds held
      in
      certain near-liquid accounts.





***Financing
      expense.*** Financing expense for the three months ended December 31, 2006 was $67,413
      or a
      decrease of $128,067 or 66% from financing expense of $195,480 for the
      corresponding period in 2005. Included in financing expense is interest expense
      of approximately $46,000 and $144,000 for the three months ended December 31,
      2006 and 2005, respectively. The decrease in interest expense is due to the
      conversion of debentures to common stock during the fiscal year ended June
      30,
      2006 partially offset by interest expense related to the Hanford Area Economic
      Investment Fund Committee (HAEIFC) loan that was entered into in June 2006.
      The
      remaining balance of financing expense represents the amortization of deferred
      financing costs which decreased due to the write-off in fiscal year 2006 of
      the
      deferred financing costs relating to the debentures that were converted to
      common stock partially offset by the amortization of the HAEIFC deferred
      financing costs.




12




***Debt
      conversion expense.*** Debt
      conversion expense for the three months ended December 31, 2005 relates to
      the
      one-time recognition of $244,097 expense in short-term inducement to convert
      debentures.





**Six
      months ended December 31, 2006 and 2005**





***Revenues.***  Sales
      for
      the six months ended December 31, 2006 were $2,439,599 compared to sales of
      $697,162 for the six months ended December 31, 2005. The increase of $1,742,437
      or 250% is due to increased sales volume of the Company’s 131 Cs
      seed.
      During the six months ended December 31, 2006 the Company sold its 131 Cs
      seed
      to 35 different medical centers as compared to 15 centers during the
      corresponding period of 2005.





***Cost
      of product sales.*** Cost of
      product sales was $2,675,539 for the six months ended December 31, 2006 compared
      to cost of product sales of $1,636,440 during the six months ended December
      31,
      2005. The increase of $1,039,099 or 63% was due to the higher production levels
      during the six months ended December 31, 2006 which were related to the increase
      in sales volume over the corresponding period from 2005. The major components
      of
      the increase were wages, benefits and related taxes, materials, depreciation,
      preload expenses, share-based compensation, and rent and occupancy
      expenses.  Wages, benefits, and related taxes increased about $412,000 to
      approximately $786,000 for the six months ended December 31, 2006 due to the
      hiring of additional production employees to support the higher production
      levels. Materials costs increased about $263,000 to approximately $879,000
      in
      2006, due to increased sales volumes. Material costs in 2005 included payments
      to Pacific Northwest National Laboratory (“PNNL”) for facilities and personnel
      to manufacture the seeds. The Company no longer uses PNNL to produce the seeds
      but continues to use PNNL for certain analytical support functions. During
      the
      six months ended December 31, 2006, the Company expensed payments of about
      $135,000 to PNNL for these support functions. Depreciation and amortization
      expense increased about $110,000 to approximately $169,000 in 2006 due to the
      addition of equipment that was placed in service during the second half of
      the
      fiscal year ended June 30, 2006. Preload expenses also increased by about
      $129,000 to approximately $192,000 for the six months ended December 31, 2006
      due to the higher volume of sales. Share-based compensation expense was
      approximately $71,000 and $0 for the six months ended December 31, 2006 and
      2005, respectively, as the Company implemented SFAS No. 123R on July 1, 2006.
      Rent and occupancy expenses were approximately $73,000 and $40,000 for the
      six
      months ended December 31, 2006 and 2005, respectively, as the Company moved
      into
      its independent production facility during the second quarter of fiscal year
      2005. These increases were offset by a decrease in small tools expense of
      $172,000 to approximately $48,000 as the prior year expense included start-up
      costs of the Company’s production facility.





***Gross
      margin / loss.***  Gross
      loss was $235,940 for the six month period ended December 31, 2006. This
      represents an improvement of $703,338 or 75% over the corresponding period
      of
      2005’s gross loss of $939,278. The improvement in gross loss is due to higher
      revenues and greater production efficiency.





***Research
      and development.*** **** Research
      and development expenses for the six months ended December 31, 2006 were
      $461,852 which represents an increase of $339,233 or 277% over the research
      and
      development expenses of $122,619 for the corresponding period of 2005. The
      major
      components of the increase were wages, benefits and related taxes, consulting,
      and share-based compensation. Wages, benefits and related taxes were
      approximately $143,000 and $0 for the six months ended December 31, 2006 and
      2005, respectively, as the Company hired research scientists. Consulting
      expenses increased about $130,000 to approximately $168,000 as the Company
      continues to increase the efficiency of production. Share-based compensation
      expense was approximately $20,000 and $0 for the six months ended December
      31,
      2006 and 2005, respectively, as the Company implemented SFAS No. 123R on July
      1,
      2006.




13




***Sales
      and marketing expenses.*** **** Sales
      and
      marketing expenses were $1,562,948 for the six months ended December 31, 2006.
      This represents an increase of $907,377 or 138% compared to the six months
      ended
      December 31, 2005’s expenditures of $655,571 for sales and marketing. Wages,
      including payroll-related taxes, travel, office and other support expenses
      on
      behalf of our sales and marketing and customer service staff increased about
      $268,000 to approximately $353,000 due to the hiring of additional sales and
      marketing personnel as the Company continues to expand market share. Conventions
      and tradeshows increased by about $254,000 to approximately $441,000 due to
      the
      Company’s continued efforts to expand its market share. Consulting expenses
      increased by $54,000 to approximately $58,000 related to consultants hired
      to
      increase brand and market awareness. Also included in sales and marketing
      expenses is share-based compensation expense of about $99,000 due to the
      implementation of SFAS No. 123R on July 1, 2006.





***General
      and administrative expenses.*** General
      and administrative expenses for the six months ended December 31, 2006 were
      $2,554,661 compared to general and administrative expenses of $1,636,393 for
      the
      corresponding period of 2005. The increase of $918,268 or 56% is primarily
      due
      to approximately $708,000 of share-based compensation expense related to the
      implementation of SFAS No. 123R on July 1, 2006, a one-time severance accrual
      of
      $288,000, approximately $238,000 of increased payroll costs due to a higher
      headcount, and approximately $97,000 relating to investor relations and other
      public company expenses. These increased expenses were partially offset by
      a
      reduction in consulting fees of approximately $330,000 which represents merger
      consulting fees incurred in the three months ended September 30, 2005. Other
      consulting expenses also decreased approximately $25,000 as the Company hired
      more internal resources. In addition, audit related fees decreased approximately
      $24,000 as the Company had more regulatory and other filings in 2005 following
      the merger and bad debt expense was reduced by approximately $36,000 as the
      Company reduced its allowance for doubtful accounts during the six months ended
      December 31, 2006.





***Operating
      loss.*** Due to
      our rapid structural growth, product revenues not covering production costs,
      significant research and development expenditures, and additional
      responsibilities as a reporting company, we have not been profitable, and have
      generated operating losses since our inception. In the six months ended December
      31, 2006, the Company had an operating loss of $4,815,401 which is an increase
      of $1,461,540 or 44% over the operating loss of $3,353,861 for the six months
      ended December 31, 2005. Included in the operating loss for the six months
      ended
      December 31, 2006 is share-based compensation expense of $897,887 due to the
      implementation of SFAS No. 123R during the period and a one-time severance
      accrual of $288,000. Without these two expense items, our operating loss would
      have only increased by $275,653 or 8%.





***Interest
      income.*** Interest
      income increased by $80,035 or 788% to $90,187 for the six months ended December
      31, 2006. Interest income is mainly derived from excess funds held in certain
      near-liquid accounts.





***Financing
      expense.*** Financing expense for the six months ended December 31, 2006 was $120,670 or
      a
      decrease of $230,438 or 66% from financing expense of $351,108 for the
      corresponding period in 2005. Included in financing expense is interest expense
      of approximately $77,000 and $248,000 for the six months ended December 31,
      2006
      and 2005, respectively. The decrease in interest expense is due to the
      conversion of debentures to common stock during the fiscal year ended June
      30,
      2006 partially offset by interest expense related to the Hanford Area Economic
      Investment Fund Committee (HAEIFC) loan that was entered into in June 2006.
      The
      remaining balance of financing expense represents the amortization of deferred
      financing costs which decreased due to the write-off in fiscal year 2006 of
      the
      deferred financing costs relating to the debentures that were converted to
      common stock partially offset by the amortization of the HAEIFC deferred
      financing costs.




14




***Debt
      conversion expense.*** Debt
      conversion expense for the six months ended December 31, 2005 relates to the
      one-time recognition of $244,097 expense in short-term inducement to convert
      debentures.





**Liquidity
      and capital resources** .
      At
      December 31, 2006, cash and cash equivalents amounted to $3,700,108. During
      the
      six months ended December 31, 2006, the Company issued 2,063,000 shares of
      common stock at a price of $2.50 per share and 2,269,300 common stock warrants
      (including broker warrant commissions) with an exercise price of $3.00 per
      share
      pursuant to a round of institutional funding. This funding provided
      approximately $4.7 million, net of offering costs. Additionally, the Company
      issued 755,829 shares of common stock pursuant to the exercise of common stock
      options and warrants and preferred stock warrants, which were exchanged for
      common stock immediately upon exercise. The Company received approximately
      $1.2
      million in cash pursuant to these exercises.





During
      January 2007, two warrant holders exercised warrants issued in connection with
      the August 2006 Stock Purchase Agreement. The Company received $1,218,900 in
      cash and issued 406,300 common shares pursuant to these exercises. The Company
      had approximately $3.7 million cash on hand as of February 2, 2007 **.** As of
      that date management believes that the Company’s monthly required cash operating
      expenditures were approximately $630,000. Management believes that assuming
      expenditures continue at approximately the same monthly rate and that it is
      able
      to fund a portion of its equipment purchases with the HAEIFC loan, that the
      Company’s cash on hand will fund operating expenditures through the beginning of
      June 2007. This is based on the Company attaining its current revenue targets
      and the ability to continue to efficiently manufacture our product. If we should
      experience disruptions in our revenues then our monthly cash requirements would
      increase and necessitate that we obtain additional funding prior to May
      2007.





Our
      growth plans for fiscal 2007 include expanding sales to new customers, growing
      sales volume with existing customers, and developing additional therapies.
      Additional production capability, including new equipment and additional
      employees, will be needed to meet our anticipated growth. The Company has also
      begun a review of its current facilities and future needs based on current
      forecasts. The Company’s current production facility lease ends in October 2007.
      While the landlord has agreed to work with the Company to minimize production
      disruptions, the landlord has indicated that it does not intend to enter into
      a
      long-term leasing agreement with the Company. Management is in the final stages
      of negotiation to lease space for a new production facility. Once the new lease
      is signed, the Company will begin to obtain the necessary permits and licenses
      and to make the necessary leasehold improvements. Management believes that
      the
      Company will be able to obtain the necessary permits for the new facility in
      a
      timely manner that will not cause delays in the leasehold improvements
      construction schedule. This new facility is expected to be operational at the
      end of calendar year 2007. Management believes that the new production facility
      lease currently being negotiated will be able to accommodate the Company’s
      anticipated future growth for several years. The Company continues to use PNNL
      to provide third-party assay of its products, but has otherwise vacated PNNL
      facilities. Management believes that if the Company is unable to obtain the
      new
      lease, the necessary permits, or finish the leasehold improvements before having
      to vacate the present manufacturing facility, that a temporary manufacturing
      facility is available and could be used although production capacity and
      scheduling flexibility would be limited.





IsoRay
      has three loan facilities in place as of December 31, 2006. The first loan
      is
      from the Benton-Franklin Economic Development District (“BFEDD”) in an original
      principal amount of $230,000 and was funded in December 2004. It bears interest
      at eight percent and has a sixty month term with a final balloon payment. As
      of
      December 31, 2006, the principal balance owed was $193,720. This loan is secured
      by certain equipment, materials and inventory of IsoRay, and also required
      personal guarantees, for which the guarantors were issued approximately 70,455
      shares of common stock. The second loan is a line of credit from Columbia River
      Bank, which provides credit in the amount of $375,000. It bears interest at
      a
      floating prime plus two percent rate, and is secured by certain accounts
      receivable and inventory and personal guarantees, for which the guarantors
      were
      issued approximately 107,401 shares of common stock. As of December 31, 2006,
      no
      balance was outstanding on the line of credit. The line of credit expires on
      March 1, 2007. Management believes the line of credit will be renewed. The
      third
      loan is from the Hanford Area Economic Investment Fund Committee and was
      originated in June 2006. The loan has a total facility of $1,400,000 and bears
      interest at nine percent. As of December 31, 2006, the Company has taken only
      a
      partial draw of $418,670 on the facility and the remaining facility of $981,330
      is available to use to purchase equipment. The principal balance owed on the
      loan as of December 31, 2006 was $405,443. This loan is secured by receivables,
      equipment, materials and inventory of IsoRay, and certain life insurance
      policies.




15




The
      Company has certain capital leases for production and office equipment that
      expire at various times from March 2008 to April 2009. These leases currently
      call for total monthly payments of $19,361. The total of all capital lease
      obligations at December 31, 2006 was $315,485.





At
      December 31, 2006, the Company had outstanding $455,000 of convertible
      debentures. These debentures could be converted into 109,639 shares of common
      stock at a conversion rate of $4.15 per share. Each debenture bears interest
      at
      an annual rate of eight percent (not compounded) with accrued interest paid
      quarterly. The debentures mature at various times from February 2007 to June
      2007.





In
      February 2006, the Company signed a license agreement with International
      Brachytherapy s.a. (“IBt”) covering North America and providing the Company with
      access to IBt’s Ink Jet production process and its proprietary polymer seed
      technology for use in brachytherapy procedures using Cesium-131. The Company
      paid license fees of $275,000 during 2006 and another payment of $225,000 was
      to
      be made in August 2006 pursuant to the license agreement. Royalty payments
      based
      on net sales revenue are also required, with minimum quarterly royalties ranging
      from $100,000 to $200,000 and minimum annual royalties ranging from $400,000
      to
      $800,000 over the term of the agreement. Management is engaged in further
      negotiations with IBt and may ultimately terminate this agreement, although
      management has not yet decided on a course of action.





As
      of the
      date of this report, the payment due in August 2006 has not been made as the
      Company has been in continued negotiations with IBt concerning the amount and
      timing of future royalty payments due to the low market acceptance of the
      polymer seed technology.





In
      September 2006, the Company entered into a settlement agreement with a former
      executive. As part of the settlement the Company agreed to pay the former
      executive $100,000 in September 2006 and $215,000 in January 2007.





The
      Company finalized the settlement agreement with its former Chief Financial
      Officer in December 2006. An initial payment of $50,000 and the cashless
      exercise of 50,000 options at $1.00 per share in lieu of another cash payment
      of
      $50,000 were recorded in December 2006. A final payment of $93,000 and a
      cashless exercise of 95,000 options at $1.00 per share in lieu of an additional
      cash payment of $95,000 were recorded in January 2007.





The
      industry that the Company operates in is subject to product liability
      litigation. Through its production and quality assurance procedures, the Company
      works to mitigate the risk of any lawsuits concerning its product. The Company
      also carries product liability insurance to help protect it from this
      risk.




16




The
      Company expects to finance its future cash needs through the sale of equity
      securities, solicitation to warrant holders to exercise their warrants, and
      possibly strategic collaborations or debt financing or through other sources
      that may be dilutive to existing shareholders. If the Company needs to raise
      additional money to fund its operations, funding may not be available to it
      on
      acceptable terms, or at all. If the Company is unable to raise additional funds
      when needed, it may not be able to market its products as planned or continue
      development and regulatory approval of its future products. If the Company
      raises additional funds through equity sales, these sales may be dilutive to
      existing investors.





The
      Company has no off-balance sheet arrangements.





**Going
      Concern Issues**




Our
      financial statements have been prepared assuming we will continue as a going
      concern. We had net losses of $8,218,130 and $4,269,188 for the years ended
      June
      30, 2006 and 2005 and an accumulated deficit of $13,546,261 at June 30, 2006.
      Our accumulated deficit at December 31, 2006 was $18,392,145. These factors,
      among others, raise substantial doubt about our ability to continue as a going
      concern. Our financial statements do not include any adjustment that might
      result from the outcome of this uncertainty. Management plans to obtain the
      necessary financing and to continue to grow revenues in order to achieve
      profitability but no assurances can be given that management will be able to
      obtain additional financing or grow revenues to a profitable level.





If
      we are
      unable to generate profits and unable to obtain additional financing to meet
      our
      working capital requirements, we may have to curtail our business or cease
      operations. Our continuation as a going concern is dependent upon our ability
      to
      generate sufficient cash flow to meet our obligations on a timely basis, to
      obtain additional financing, and, ultimately, to attain profitability. Should
      any of these events not occur, the accompanying financial statements will be
      adversely effected and we may have to cease operations.




**Risk
      Factors**





**You
      should consider the following discussion of risks as well as other information
      regarding our operations. The risks and uncertainties described below are not
      the only ones. Additional risks and uncertainties not presently known to us
      or
      that we currently deem immaterial also may impair our business operations.
      For a
      more detailed discussion of the risks facing us, you should review the "Risk
      Factors" sections contained in our Form 10-KSB for the fiscal year ended June
      30, 2006, and our amended Registration Statement on Form SB-2 originally filed
      with the SEC on November 10, 2005 and amended on December 1,
      2006.**





·
            Our
                independent accountants have expressed uncertainty about our ability
                to
                continue as a going concern.




·
            Our
                revenues depend upon one product, our131Cs
                brachytherapy seed, which is used to treat only one type of cancer
                as of
                the date of this report, although it is approved to treat any malignant
                disease.




·
            The
                lease on our production facility ends in October 2007 and although
                management is negotiating a lease for a new production facility,
                there can
                be no assurance that any new facility will be licensed and the necessary
                leasehold improvements completed by the time our current lease
                expires.




·
            We
                have limited data on the clinical performance of the131Cs
                seed.




17




·
            We
                will need to raise additional capital to fund our operations until
                we
                reach profitability.




·
            The
                passage of Initiative 297, which may in the future impose restrictions
                on
                sites generating certain types of radioactive wastes in Washington,
                may
                result in the relocation of our manufacturing
                operations.




·
            We
                have limited manufacturing experience and may not be able to meet
                future
                demand without increasing our supply of the isotopes used to manufacture
                our product and also increasing our level of
                staffing.




·
            We
                are subject to the risk that certain third parties may mishandle
                our
                product.




·
            Our
                quarterly operating results will be subject to significant
                fluctuations.




·
            We
                rely heavily on a limited number of suppliers, particularly on our
                Russian
                suppliers of131Cs
                which amount to well over 50% of the raw materials needed for our
                production.




·
            Future
                production increases will depend on our ability to acquire larger
                quantities of131Cs
                and hire more employees.




·
            We
                are subject to uncertainties regarding reimbursement for use of our
                product.




·
            It
                is possible that other treatments may be deemed superior to brachytherapy
                for the treatment of cancer and if this were to occur, demand for
                our
                product could decline.




·
            Our
                industry is intensely competitive, and many of our competitors are
                larger
                than we are and possess greater
                resources.




·
            We
                may be unable to adequately protect or enforce our intellectual property
                rights or secure rights to third-party patents, the value of our
                granted
                patent and our patents pending is uncertain, and one of our licensed
                patents may be terminated under certain
                conditions.




·
            Failure
                to comply with government regulations, which are quite complex, could
                harm
                our business.




·
            Our
                business exposes us to product liability claims and also involves
                environmental risks.




·
            We
                rely heavily upon the expertise of our executive officers and key
                scientific personnel.




·
            Our
                ability to expand into foreign markets is
                uncertain.




·
            Our
                ability to expand operations and manage growth is
                uncertain.




·
            Our
                reporting obligations as a public company are
                costly.




·
            There
                is a limited market for our common stock, and our stock price is
                likely to
                be volatile.




·
            Our
                common stock may be subject to penny stock regulation.




·
            Future
                sales by shareholders of the shares available for sale in the public
                market, or the perception that such sales may occur, may depress
                the price
                of our common stock.







**ITEM
      3.**  **CONTROLS
      AND PROCEDURES**





***Evaluation
      of Disclosure Controls and Procedures***





Under
      the
      supervision and with the participation of our management, including our
      principal executive officer and principal financial officer, we conducted an
      evaluation of the design and operation of our disclosure controls and
      procedures, as such term is defined under Rules 13a-14(c) and 15d-14(c)
      promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange
      Act"), as of the end of the period covered by this report. Based on that
      evaluation, our principal executive officer and our principal financial officer
      concluded that the design and operation of our disclosure controls and
      procedures were effective in timely alerting them to material information
      required to be included in the Company's periodic reports filed with the SEC
      under the Exchange Act. The design of any system of controls is based in part
      upon certain assumptions about the likelihood of future events, and there can
      be
      no assurance that any design will succeed in achieving its stated goals under
      all potential future conditions, regardless of how remote. However, management
      believes that our system of disclosure controls and procedures is designed
      to
      provide a reasonable level of assurance that the objectives of the system will
      be met.




18




***Management’s
      Remediation Initiatives***





As
      previously reported, our independent registered public accounting firm, in
      connection with the review of our consolidated financial statements for the
      period ended September 30, 2005, advised the Board of Directors and management
      of certain significant internal control deficiencies that they considered to
      be,
      in the aggregate, a material weakness. In particular, our independent registered
      public accounting firm identified the following weaknesses in our internal
      control system: (1) a lack of segregation of duties and (2) a lack of formal
      procedures relating to all areas of financial reporting. The independent
      registered public accounting firm indicated that they considered these
      deficiencies to be reportable conditions as that term is defined under standards
      established by the American Institute of Certified Public Accountants. A
      material weakness is a significant deficiency in one or more of the internal
      control components that alone or in the aggregate precludes our internal
      controls from reducing to an appropriately low level of risk that material
      misstatements in our financial statements will not be prevented or detected
      on a
      timely basis. The Company considered these matters in connection with the period
      end closing of accounts and preparation of the related consolidated financial
      statements and determined that no prior period financial statements were
      materially affected by such matters.





During
      the second quarter of fiscal year 2007, the Company completed the implementation
      of the following control improvements to remediate the two material
      weaknesses:





***Lack
      of segregation of duties***


§
            Reviewed
                the duties of all accounting personnel and reassigned any conflicting
                duties to other personnel;


§
            Established
                daily management reviews of cash and account receivables activities
                and
                positions;


§
            Distributed
                monthly operating results for review by management in an appropriate
                time
                frame; and


§
            Established
                monthly reconciliation procedures including review by the appropriate
                supervisor.





***Financial
      reporting procedures***


§
            Established
                monthly reconciliation procedures including review by the appropriate
                supervisor;


§
            Established
                and implemented various accounting policies and procedures;
                and


§
            Distributed
                monthly operating results for review by management in an appropriate
                time
                frame.





Based
      on
      the evaluation completed in the second quarter of fiscal year 2007, the
      Company has concluded that these control improvements are properly designed
      and
      operating effectively as of December 31, 2006, and the two material
      weaknesses that previously existed have been substantially
      remediated.




19




**PART
      II - OTHER INFORMATION**




**ITEM
      6. EXHIBITS AND REPORTS ON FORM 8-K**




(a)
            Exhibits:




31.1  Rule
      13a-14(a)/15d-14(a) Certification of Principal Executive Officer




31.2  Rule
      13a-14(a)/15d-14(a) Certification of Principal Financial Officer




32  Section
      1350 Certifications




(b)
            Reports
                on Form 8-K:




On
      November 6, 2006, the Company filed a Current Report on Form 8-K announcing
      its
      subsidiary’s entry into two contracts for the supply of Cesium-131 with RIAR in
      Russia.





On
      February 7, 2007, the Company filed a Current Report on Form 8-K announcing
      the
      approval of a rights plan and the adoption of certain bylaw
      amendments.




20




SIGNATURES





In
      accordance with the requirements of the Exchange Act, the registrant caused
      this
      report to be signed on its behalf by the undersigned, thereunto duly
      authorized.




Dated:
                February 14, 2007ISORAY,
                INC., a Minnesota corporationBy
            /s/ Roger
                E. GirardRoger
                E. Girard, Chief Executive Officer





By
            /s/ Jonathan
                R. HuntJonathan
                R. Hunt, Chief Financial Officer





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