FORM 10-K

                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549

        (X)     ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                 SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)

                  For the fiscal year ended September 30, 1996
                                       OR
        ( )    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
               THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

                           Commission File No. 0-12194

                                ZITEL CORPORATION
             (Exact name of Registrant as specified in its charter)

             CALIFORNIA                                     94-2566313
    (State or other jurisdiction of                        (IRS Employer
     incorporation or organization)                      Identification No.)

47211 Bayside Parkway, Fremont, California                  94538-6517
 (Address of principal executive offices)                   (Zip Code)

                                 (510) 440-9600
              (Registrant's telephone number, including area code)

           Securities registered pursuant to Section 12(b) of the Act:
                                      None

           Securities registered pursuant to Section 12(g) of the Act:
                           Common Stock, no par value
                                (Title of Class)

Indicate by check mark whether the Registrant (1) has filed reports  required to
be filed by Section 13 or 15(d) of the  Securities  Exchange  Act of 1934 during
the preceding 12 months (or 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 _____.

The  aggregate   market  value  of  the   Registrant's   Common  Stock  held  by
nonaffiliates  on November  30, 1996 (based upon the closing sale price of stock
on such date) was  $339,257,112.00.  As of November 30, 1996,  14,906,678 of the
Registrant's Common Stock were outstanding.


                      Documents Incorporated by Reference:

Portions of the  Company's  1996 Notice of Annual  Meeting of  Shareholders  and
Proxy Statement are incorporated by reference into Part III hereof.

<PAGE>

                             PART I

Item 1:  BUSINESS

                            Business

Zitel  Corporation  ("Zitel"  or  the  "Company")  specializes  in  the  design,
manufacture  and  marketing  of   high-performance,   mission-critical   storage
subsystems for enterprise-wide  applications which include relational  database,
batch and on-line  transaction  processing.  Its primary  products  include CASD
(Cached Actuator Storage Device)  subsystems for Unisys A and V mainframes,  and
CASD-II/Enterprise,  CASD technology  architected for UNIX, NT and NETWARE based
open  systems.   The  Company  also  develops  and  markets   single-system  and
multi-system  performance measurement and modeling software used on a variety of
UNIX  and   proprietary   platforms  to  measure  the   performance  of  complex
client/server  environments.  These  products are marketed  worldwide  through a
variety of channels  including systems  integrators,  value-added  resellers and
distributors,  sales representatives,  Original Equipment  Manufacturers (OEMs),
and directly to end users. Additionally,  the Company is a reseller of Year 2000
compliance  services.  The Company  conducts  its  business  within one industry
segment.

Zitel was  organized  in 1979 to  provide  semiconductor  memory  systems to OEM
customers. The Company's first end user product was the solid state RAMdisk sold
to users of Unisys  Corporation  mainframe  computer  systems.  The Company then
introduced  its  line  of  rotating  memory  systems   incorporating   its  CASD
technology, enhanced with caching solid state memory and proprietary algorithms,
also  for  Unisys  computer   systems.   In  1995,  the  Company  announced  the
availability  of the CASD products for the open systems and relational  database
markets.  In late fiscal  1995,  the second  generation  of CASD  (CASD-II)  was
announced for general availability into the Unisys market.  CASD-II for the open
systems and  relational  database  markets were  announced in December 1995. The
Company  also  sells  Value  Analysis   Modeling   (VAM)/Capacity   Planner  and
NetArchitect  software  products  which  enables  customers to plan their future
information  technology  systems by balancing service levels required to support
business  applications with the costs of building and maintaining those systems.
In 1996,  the Company  became a reseller of  MatriDigm  Corporation's  Year 2000
compliance  services.  The Company  operates  with little  backlog.  Most of its
orders are shipped in the quarter received.

In 1992, the Company entered into a joint development agreement

                                     Page 2
<PAGE>

with International Business Machines (IBM) Corporation. In September and October
of 1994, IBM announced general availability of RAMAC products, which incorporate
Zitel  technology,  and upon which the Company is receiving  royalties  based on
RAMAC  products  sold.  In October 1995 and  September  1996,  IBM announced the
general availability of RAMAC 2 and RAMAC 3, respectively,  its second and third
generation of RAMAC,  which continue to include Zitel  technology and upon which
Zitel will receive royalties. Royalties from RAMAC products constituted 38%, 65%
and 63% of total  revenue in fiscal 1994,  1995 and 1996,  respectively.  In the
event that IBM should  replace its current RAMAC  products with products that do
not incorporate the Company's technology or if sales of royalty bearing products
were to produce  significantly lower royalty payments and the Company were to be
unable to generate  profitable revenue from other sources,  the Company could be
unable to continue operations as currently conducted.

The Company has historically,  during certain quarters, made material sales to a
single customer which have had significant  impact on net sales and on operating
margins.  Operating  margins can also  fluctuate  from quarter to quarter due to
product  mix and other  cost of sales,  which do not vary  directly  with  sales
volume.  As a result of these and other  factors,  the Company  has  experienced
fluctuations in its quarterly operating results in the past and anticipates such
fluctuations in the future.

                    Research and Development and New Products

During fiscal 1996,  the Company  invested in a number of  development  programs
including the enhancement of CASD-II,  the current generation of rotating memory
systems  incorporating  its CASD  technology;  other  CASD  programs  for future
generations of CASD; and the development of NetArchitect, a software package for
client/server  network  design and  simulation.  Expenditures  for  research and
development activities were approximately $6,551,000,  $5,754,000 and $7,071,000
in fiscal 1996, 1995 and 1994, respectively.

The computer industry,  in general,  and the markets for the Company's products,
in particular,  are subject to extreme price  competition,  rapid  technological
change and evolving standards, resulting in relatively short product life cycles
and continuous  erosion of average selling prices. As a result, the Company must
continually enhance its existing products and develop and introduce new products
in an effort to maintain  and increase  net sales.  The Company has  experienced
delays in completing the

                                     Page 3
<PAGE>

development of new products and may well encounter difficulties that could delay
the products  currently  under  development.  There can be no assurance that the
Company will be  successful in its  enhancement  and  development  efforts or in
achieving market acceptance of products developed.

                                    Products

The  Company  offers a family of  rotating  memory  systems  utilizing  the CASD
technology  for use with Unisys A and V mainframe  computers and with most UNIX,
NT, Open VMS and NETWARE server  platforms.  The Company also offers a family of
software planning tools that help Information  Technology managers architect and
evaluate client/server environments.

CASD-II, the second generation of the Company's CASD products, was introduced in
September,  1995. CASD products integrate a high-capacity solid state cache with
multiple  rotating  disk  drives and  utilize  interactive  caching  algorithms.
Modules  utilizing the technology are available with cache sizes ranging from 64
to 512  megabytes and with one to four disk drives with  capacities  from 4.3 to
17.2  gigabytes,  depending  on the market  the  products  are sold into.  These
modules can be sold on an  individual  module basis or are  available in cabinet
configurations  ranging  from one to six  modules  and up to 103  gigabytes  per
cabinet.  Pricing  for a single  module  ranges  from  approximately  $16,500 to
$27,900.  Subsystems  incorporating CASD technology are available in prices from
$74,000 to $175,400,  depending on the number of modules utilized, the amount of
cache utilized, optional equipment, and other factors.

Performance and Modeling,  Inc., Zitel's wholly-owned  subsidiary,  designed and
developed the Value  Analysis  Modeling (VAM) family of system  planning  tools,
VAM/Capacity  Planner and NetArchitect.  VAM/Capacity Planner is a Windows-based
system  modeling  tool that  reduces  analyses  and  planning  costs by enabling
companies  to  correctly  identify  current  system  utilization  and  undertake
sophisticated  "what-if?"  analyses of  modifications  in system  deployment  or
design. VAM/Capacity Planner's embedded expertise allows easy examination of the
effects of various  configuration  changes  and  determines  the best  equipment
enhancements.  VAM/Capacity  Planner  measures and simulates  performance of IBM
MVS,  Digital  VMS,  Unisys  proprietary,  and a wide  variety  of open  systems
platforms.  This software tool aids system  administrators to anticipate,  track
and correct system performance bottlenecks and I/O problems.

                                     Page 4
<PAGE>

NetArchitect  is a network  modeling  tool that has an  intuitive,  easy-to-use,
Windows-based Graphical User Interface. This package is designed for the Network
Administrator  who has the  responsibility  of  designing  and  installing a new
network,   or  maintaining  and  expanding  existing   structures.   As  network
requirements  become  increasingly  more complex,  computer-aided  tools will be
mandatory to sort through and evaluate the many issues and  possibilities  prior
to the investment and installation of significant  amounts of capital equipment.
With these capabilities in mind, NetArchitect also has practical applications as
a pre-sales tool for systems  integrators,  VARs, and other channels  selling or
consulting on network  management.  NetArchitect runs under Windows 3.X, Windows
95 and Windows NT.

                              MatriDigm Corporation

In November 1995,  Zitel invested  $3,350,000 in cash,  $66,000 in equipment and
$150,000 in future rent and  administrative  services in exchange for  preferred
stock  and  certain  technology  rights  of a  newly-formed  company,  MatriDigm
Corporation  ("MatriDigm"),  which  represented  37.5% of the  capital  stock of
MatriDigm on a  fully-converted  basis.  MatriDigm  was formed to provide  COBOL
maintenance  and  re-engineering  services.  As  of  December  15,  1996,  Zitel
beneficially  owned  approximately  33% of the  outstanding  capital  stock on a
fully-converted  basis.  Zitel's  percentage  ownership will change as MatriDigm
raises  additional  capital and as options under  MatriDigm's  stock option plan
vest and are exercised.

The initial  focus of MatriDigm has been  development  of technology to automate
the  conversion  of legacy  software  code which could not  recognize or utilize
dates after the year 1999 (the "Year 2000  Problem")  into code which is able to
recognize  and  utilize  dates  into the next  century.  MatriDigm  has  devoted
substantially  all of its resources to  development  of such  technology and has
stated  that it expects  to  announce  general  availability  of its  conversion
services early in 1997.

Substantially  all software programs written assume that the first two digits of
any date are "19" and cannot recognize or utilize dates commencing with the year
2000. Estimates of the cost and available market for conversion of existing code
to eliminate  this  problem are in the hundreds of billions of dollars.  A large
number of companies,  many of which have  substantially  greater  resources than
MatriDigm, are offering conversion services or are developing systems to provide
such services and  competition  is expected to be intense among the providers of
such services.
                                     Page 5
<PAGE>

MatriDigm  believes  that  the  software  systems  it is  developing  will  have
substantial  advantages over the currently  available systems.  However, as with
all development projects,  there are risks that the software in development will
not be  successfully  developed,  will take  longer to  develop  than  MatriDigm
currently  expects,  will not have the  functionality  currently planned or will
have "bugs" or other problems  rendering the commercial  provision of conversion
services more difficult or  impossible.  MatriDigm has stated that it expects to
announce  general  availability of its conversion  services in January 1997, but
general availability may differ materially from that expectation.

In August 1996,  Zitel was authorized to become a reseller of  MatriDigm's  year
2000  compliance  services on a commission  basis.  Zitel has  established a new
division to market those  services  and is in the process of staffing,  training
and  performing  preliminary  marketing  efforts.  The reseller  agreement  also
provides Zitel the exclusive right to create  portable,  on-site centers for the
performance of services  offered by the Company for certain  accounts in certain
circumstances. The Company's ability to generate sales and revenues is dependent
on the success of MatriDigm's  development effort and there is no assurance that
the Company will be  successful  in  generating  profitable  sales of conversion
services.

                             Marketing and Customers

Zitel offers its products through system integrators,  value-added resellers and
distributors,  OEMs, and directly to end users. Zitel's direct sales and service
staff  consists of employees  who operate  from  Arizona,  California,  Florida,
Kansas, Massachusetts, New Jersey, New York, Pennsylvania,  Tennessee, Virginia,
and Europe.

In fiscal 1996,  Proven  Technology and Banamex accounted for 13.0% and 11.8% of
net sales,  respectively.  In fiscal 1995,  Lockheed  Martin  Missiles and Space
Company  accounted  for  14.3% of net  sales.  In  fiscal  1994,  Unisys  Mexico
accounted for 14.5% of net sales

During fiscal 1996, Zitel sold to approximately 113 customers, both domestically
and internationally. Foreign and export sales were approximately $4.3 million in
fiscal 1996, up from approximately $3.1 million in fiscal 1995.



                                     Page 6
<PAGE>

Zitel  does not  maintain a field  service  organization.  Typically,  customers
contract with a third party to maintain products.  The end-user  organization is
staffed with experienced  technical  support  personnel to make or assist in the
initial  installations;  assist the service organization with problem resolution
and  field  upgrades;  assist  customers  in  determining  whether  or not Zitel
products can improve system reliability, performance and cost effectiveness; and
in helping customers determine how best to deploy Zitel products in their system
to achieve the maximum benefit.

                                  Competition

During  fiscal  1996,  the Company  generated a majority of its net sales in the
Unisys end user market.  Unisys Corporation offers alternative products by which
a computer user can achieve enhanced performance. Zitel products compete against
these alternatives in providing the customer with the best performance solution.
Zitel also  competes  with  other  independent  manufacturers  of devices in the
Unisys market and several system  integrators.  During fiscal 1996,  competition
remained  at a high  level  and  average  sales  prices  continued  to  decline.
Depending on the other markets served, the Company may compete with the computer
manufacturer and/or third party companies.

                                     Patents

Management   believes  that   technical   expertise,   responsiveness   to  user
requirements and implementation of technological  advances are mandatory factors
in Zitel's markets.  Zitel applied for additional  patent  protection on certain
elements of its CASD products,  VAM software  products and other products in the
development  stage.  During the year, the Company  received one patent on one of
its other products, bringing the total patents currently held to five. There can
be no assurance that any of the other patents  applied for will be issued or, if
issued, provide any meaningful protection.

                           Manufacturing and Suppliers

Zitel  manufactures  a large  percentage of its hardware  products from standard
component parts and subassemblies purchased from others. Certain of these parts,
including  printed circuit boards and  subassemblies,  are produced from Zitel's
design and to its  specifications.  Use of such standard  items  simplifies  the
manufacturing process, reduces the number of items carried in

                                     Page 7
<PAGE>

inventory  and permits  Zitel to expand its product  line while  minimizing  the
expense of designing and developing new assemblies.

The Company  utilizes  various  subcontractors  to assemble  and solder  printed
circuit  boards using  material  purchased by the Company or to produce  surface
mount ASICs to Zitel's  workmanship  standards.  Completed  assemblies  are then
inspected  by Zitel's  receiving  inspection  department  and  submitted  to its
manufacturing  test  operation.  This test operation  provides  board-level  and
system-level testing under stressed operating conditions.

The  Company's  hardware  products  use a large  number of  components  that are
generally  available from several sources and the Company believes that the loss
of one or more of its suppliers will not have a material effect on operations.

                                    Employees

At the end of fiscal  1996,  the  Company  employed  105  persons on a full time
basis,  36 in research and  development,  16 in  manufacturing,  29 in sales and
marketing, and 24 in general management and administration.

The Company  believes  that its further  success  will depend,  in part,  on its
ability to attract and retain qualified employees, who are in great demand. None
of Zitel's  employees are represented by a labor union and the Company  believes
that its employee relations are good.

Item 2:  PROPERTIES

Zitel leases its primary manufacturing and office facility under a noncancelable
operating  lease,  which expires in March 1998,  with an average  annual rent of
approximately $502,000 per annum.

Item 3:  LEGAL PROCEEDINGS

         None.

Item 4:  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

The Company did not submit any matters to a vote of security  holders during the
fourth quarter of the fiscal year ended September 30, 1996.

                                     Page 8
<PAGE>

Executive Officers of the Registrant

Set forth below is information  regarding  executive officers of the Company who
are not directors.

Name                     Age       Position                            
Richard F. Harapat        61       Vice President, International Sales
Henry C. Harris           48       Vice President, Finance and
                                     Administration; Chief Financial
                                     Officer; Chief Accounting Officer;
                                     Secretary
Jesse I. Stamness         50       Vice President, Engineering
Frank J. Vukmanic         50       Vice President, Domestic Sales
                              
Richard F. Harapat joined Zitel as Director of  International  Sales in March of
1986.  In October of 1987,  he was promoted to Vice  President of End User Sales
and, in mid-1992,  to Vice President of  International  Sales.  Prior to joining
Zitel, he spent over 30 years in the computer  industry in the sales  management
area, 15 of which were with Burroughs Corporation.

Henry  C.  Harris,   CPA,   joined  Zitel  as  Vice  President  of  Finance  and
Administration, Chief Financial Officer and Chief Accounting Officer in December
1986. He has served as Secretary of the Company since  November  1987.  Prior to
joining  Zitel,  he was  employed by Dynamic  Disk,  Inc. as Vice  President  of
Finance and  Administration  and Chief Financial Officer from October 1983 until
November  1986.  Prior to  Dynamic  Disk,  he spent  over 10 years in  financial
management and public accounting positions.

Jesse I. Stamness  joined Zitel in May 1991. He has over 26 years of development
experience in data storage and storage  controller  products for various markets
including  IBM and Unisys.  Mr.  Stamness  has been granted many patents in disk
storage  controller  and caching  technology  and currently has several  patents
pending  on  technology  recently  released.  He  has  held  senior  engineering
management  positions at Unisys  Corporation,  Memorex Corporation and Burroughs
Corporation.

Frank J.  Vukmanic  joined Zitel in June 1994 as Vice  President  of  Marketing,
which he  relinquished  in February  1996 to become Vice  President  of Domestic
Sales. Prior to joining Zitel, Mr. Vukmanic was CEO of Edgetech International, a
consulting  firm,  from  October  1993 until  joining  Zitel.  From June 1989 to
September  1993,  Mr.  Vukmanic was Sr. Vice  President  of Amperif  Corporation
responsible for worldwide sales, marketing, customer

                                     Page 9
<PAGE>

support, and customer engineering for mass storage products.  For 19 years prior
to joining  Amperif,  Mr.  Vukmanic held various sales and marketing  management
positions  with Unisys  Corporation.  His  experience  includes over 25 years in
sales, marketing,  product management,  customer service and support management,
and program management.



























Zitel,  CASD  and  RAMdisk  are  registered  trademarks  of  Zitel  Corporation.
NetArchitect and VAM are trademarks of Zitel Corporation. Digital is a trademark
of Digital Equipment  Corporation.  IBM, MVS and RAMAC are registered trademarks
of IBM Corporation.  MatriDigm is a trademark of MatriDigm Corporation.  Windows
NT is a trademark of Microsoft Corporation.  Unisys is a registered trademark of
Unisys Corporation. Unisys A and V are trademarks of Unisys Corporation. UNIX is
a registered trademark of UNIX Systems Laboratories,  Inc., in the United States
and other  countries.  All other  product  names are  trademarks  or  registered
trademarks of their respective holders.



                                     Page 10
<PAGE>

PART II

Item 5:  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
         STOCKHOLDER MATTERS

Zitel Corporation's common stock is traded in the over-the-counter market and is
listed on the Nasdaq National Market System under the symbol ZITL.

The  following  table shows the  quarterly  high and low  closing  prices in the
Nasdaq National Market System after giving effect to the two-for-one stock split
on November 27, 1996:

          FISCAL              1996                  1995
                       -------------------   -------------------
                         High        Low       High        Low
                       --------   --------   --------   --------
     First Quarter      6 3/8     4 11/16     6 13/16   3 15/16
     Second Quarter     6 15/16   5 1/16     10 3/8     5 13/16
     Third Quarter     10         6 1/16      6 1/2     4 1/16
     Fourth Quarter    10 1/8     5 1/8       6 13/16   4 5/8

As of September 30, 1996, the Registrant had  approximately  251 shareholders of
record of its Common Stock.

The Company has paid no cash  dividends on its common stock and does not plan to
pay cash dividends to its shareholders in the foreseeable future.

Item 6:  SELECTED FINANCIAL DATA

Five-Year Financial Summary
(In thousands except per share data)

                                   1996     1995     1994      1993      1992

Total Revenue                    $23,066  $23,714  $17,452   $21,780   $47,771
  Net income (loss)                4,049    8,526   (6,961)   (8,277)      783

Net income (loss) per share          .26      .56     (.55)     (.67)      .06
Number of shares used in
  per share calculation           15,626   15,166   12,654    12,358    13,110

At year end:
Working capital                   20,445   19,969    7,202    15,668    18,374
Total assets                      30,699   26,206   13,678    24,230    32,442
Long-term liabilities                  -        -       13     4,355       305
Shareholders' equity              27,089   22,957   10,004    16,203    23,802


                                     Page 11
<PAGE>

Item 7:  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
         CONDITION AND RESULTS OF OPERATIONS

The  following  discussion  should  be read in  conjunction  with the  five-year
summary of selected  financial  data and the  Company's  consolidated  financial
statements and notes thereto.

Business

Zitel  Corporation  (the "Company")  specializes in the design,  manufacture and
marketing  of   high-performance,   mission-critical   storage   subsystems  for
relational database, batch and on-line transaction processing.  The Company also
develops and markets single-system and multi-system  performance  management and
modeling software used on a variety of UNIX and proprietary  platforms to manage
the  performance  of  client/server  environments.  These  products are marketed
worldwide  through a wide  variety of channels  including  systems  integrators,
value-added  resellers and  distributors,  OEMs, and directly to end users.  The
Company has recently been  appointed as an authorized  reseller of the Year 2000
services by an affiliated company. It has not completed  development of its Year
2000 services and no revenue has been generated from this activity.

1996 vs. 1995

Total revenue for 1996 was  $23,066,000  compared with revenue of $23,714,000 in
the prior year, a decrease of 3%. The decrease in total revenue is  attributable
to a decrease in royalty  revenue based upon the sale of products  incorporating
the Company's  technology by a third party from $15,421,000 to $14,473,000.  The
third  party  has  recently   commenced  shipping  a  third  generation  product
incorporating  the Company's  technology and management is not yet in a position
to express a view on the level of future royalty revenue.

Net sales were approximately  level year to year with increases in sales of CASD
products into the Unisys  Corporation  computer  systems  market  offsetting the
absence of sales of products discontinued or sold in fiscal 1995. Net sales into
the open system market were not a material  portion of the Company's sales until
the fourth  quarter of the year.  While  management  has been  encouraged by the
initial  reception  of these  products,  the  Company's  ability  to sell  these
products in quantities and at prices  resulting in profitable  operations is yet
to be established.

                                     Page 12
<PAGE>

Cost of goods sold as a  percentage  of net sales  decreased to 77% in 1996 from
82% of net sales in the prior year.  The  improvement  in cost of goods sold was
attributable  to lower  material and  production  costs of the newly  introduced
CASD-II.  The average  sales price per  megabyte  of product  sales  declined by
nearly 50% during the year.

Research and development  expenses were 28% of total revenue versus 24% of total
revenue in the prior year. Spending increased $797,000,  primarily  attributable
to  enhancements of existing  products and the development of new products.  The
increase was primarily related to increased salary and related costs, consulting
costs and costs associated with chip development.

Selling,  general and  administrative  expenses were 35% of total revenue versus
29% of total revenue in the prior year.  Actual spending  increased  $1,058,000.
The  increase is  primarily  attributable  to an increase in bad debt expense of
$367,000  resulting  from a bad debt reversal in the prior year and increases in
expenses in a wide variety of expense categories.

Included  in  interest  and other  income  is a gain on  trading  securities  of
$4,177,000  of which  $2,136,000  has been  realized.  Also included is interest
income in fiscal  1996 of $482,000  versus  $399,000  in 1995.  The  increase is
primarily related to higher cash balances invested in fiscal 1996 versus 1995.

In 1996,  the Company  recorded a tax  provision of 38% of income  before income
taxes.  In 1995, the Company  recorded a tax provision of 33.2% of income before
income taxes,  which was offset by the  utilization of net operating  losses and
the  recognition  of  deferred  tax  assets in  accordance  with  SFAS No.  109,
"Accounting for Income Taxes," totaling $5,500,000.

On November 27, 1996,  the Company's  common stock was split  two-for-one in the
form of a stock  dividend to  shareholders  of record on November 18, 1996.  All
applicable  share and per-share  data in these  financial  statements  have been
restated to give effect to the stock split.

1995 vs. 1994

Total revenue for 1995 was $23,714,000  compared with revenues of $17,452,000 in
the prior year, an increase of 36%. The increase in revenue was  attributable to
an increase of $8,743,000 in

                                     Page 13
<PAGE>

royalties,  partially  offset by a decrease of $2,481,000  in net sales.  Fiscal
1995  represented  the first full year that  royalties  based on a third party's
sales of products incorporating the Company's technology were received.

In  1994,  royalties  represented  a  one-time   non-refundable   prepayment  of
$6,378,000  from this third party and $300,000  from product sales in the fourth
quarter of the fiscal year.

The  decrease  in  net  sales  continued  to  impact  operational  profitability
excluding royalty revenue. The decrease in net sales was primarily  attributable
to competitive  factors in the data storage market which have made the Company's
original  generation  of  CASD  products  a less  cost  effective  solution  for
end-users of Unisys  Corporation  computer  systems.  A new  generation  of CASD
products for the Unisys market was announced for general  availability  in early
October 1995.

Cost of goods sold as a  percentage  of net sales  decreased  to 82% during 1995
from 90% of net sales in the prior  year.  The  improvement  in gross  margin is
primarily  attributable  to a decrease  in other cost of sales which do not vary
directly with sales volume.

Research and development  expenses were 24% of total revenue versus 41% of total
revenue in the prior year. Spending decreased $1,317,000, primarily attributable
to  decreased  development  spending  as a result of the  completion  of a major
development  program,  and lower salary and related costs in  connection  with a
reduction in personnel.

Selling,  general and  administrative  expenses were 29% of total revenue versus
43% of total revenue in the prior year. Actual spending decreased $586,000.  The
decrease was primarily attributable to the reversal of a bad debt reserve for an
expected collection of a receivable ($350,000).

Interest  expense in fiscal 1995 was $57,000 versus  $310,000 in the prior year.
The decrease was primarily  attributable  to lower levels of debt in fiscal 1995
versus  1994.  Interest  income in fiscal 1995 was $399,000  versus  $174,000 in
1994.  The increase is  primarily  related to higher cash  balances  invested in
fiscal 1995 versus 1994.

In 1995,  the Company  recorded a tax provision of 33.2% of income before income
taxes. This provision was offset by the

                                     Page 14
<PAGE>

utilization of net operating  losses and the  recognition of deferred tax assets
in  accordance  with SFAS No.  109,  "Accounting  for  Income  Taxes,"  totaling
$5,500,000.

Liquidity and Capital Resources

The Company's principal sources of working capital are product sales and royalty
revenue.  Working capital  increased  $476,000 during fiscal 1996 and cash flows
provided by operations were $626,000.  Cash flows from operating activities were
generated  primarily from net income of  $4,049,000,  a decrease in deferred and
refundable taxes of $2,124,000,  an increase in accounts payable of $341,000 and
depreciation  and  amortization  of $935,000.  This was offset by an increase in
marketable  securities  of  $2,382,000,  an increase in accounts  receivable  of
$1,342,000 and an increase in inventory of $1,224,000.

Net cash used in investing  activities  was  $2,745,000.  $1,676,000 was used to
purchase  capital  equipment in the current year and  $3,497,000 was utilized to
invest in a private company.  This was offset by the proceeds of $2,795,000 from
the sale of a trading security.

Net cash  provided by  financing  activities  in the current  year was  $70,000.
$989,000 was generated  from the exercise of employee stock options and from the
sale of stock under the Company's  employee stock purchase plan. This was offset
by the repurchase of 130,000 shares of the Company's  common stock for $906,000.
The Company had a $3,000,000 line of credit during the year that was extended to
November  30,  1996.  The Company did not utilize the line of credit  during the
year.

Management  believes  that the  Company  will  meet its cash  requirements  from
current  cash  on  hand,  other  existing  working  capital,   cash  flows  from
operations, and the utilization of the line of credit.











                                     Page 15
<PAGE>

Item 8:  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Consolidated Balance Sheets
(In thousands)


                                                                September 30,
                                                              1996         1995
Assets
Current assets:
  Cash and cash equivalents                                $  9,216     $ 11,265
  Marketable securities                                       2,382            -
  Accounts receivable, less allowance for doubtful
    accounts of $88 in 1996 and in 1995                       5,542        4,200
  Inventories                                                 4,211        2,987
  Deferred and refundable taxes                               2,224        4,348
  Other current assets                                          480          418
                                                           --------     --------
    Total current assets                                     24,055       23,218

Fixed assets-net                                              2,253        1,419
Other assets-net                                              4,391        1,569
                                                           --------     --------
  Total assets                                             $ 30,699     $ 26,206
                                                           ========     ========

Liabilities And Shareholders' Equity
Current liabilities:
  Accounts payable                                         $  2,066     $  1,725
  Accrued liabilities                                         1,544        1,524
                                                           --------     --------
    Total current liabilities                                 3,610        3,249

Commitments (See note)

Shareholders' equity:
  Preferred stock, no par value; 1,000 shares
    authorized, none issued
  Common stock, no par value; 20,000 shares authorized:
    Issued and outstanding; 14,820 shares and 14,552 
      shares at September 30, 1996 and 1995, respectively    20,723       19,916
  Retained earnings                                           6,366        3,041
                                                           --------     --------
    Total shareholders' equity                               27,089       22,957
                                                           --------     --------
  Total liabilities and shareholders' equity               $ 30,699     $ 26,206
                                                           ========     ========


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


                                     Page 16
<PAGE>

Consolidated Statements of Operations
(In thousands except per share data)


                                                     Year Ended September 30,
                                                    1996       1995       1994

Net sales                                         $ 8,593    $ 8,293    $10,774
Royalty revenue                                    14,473     15,421      6,678
                                                  -------    -------    -------
  Total revenue                                    23,066     23,714     17,452

Costs and expenses:
  Cost of goods sold                                6,630      6,807      9,682
  Research and development                          6,551      5,754      7,071
  Selling, general and administrative               8,002      6,944      7,530
                                                  -------    -------    -------
    Operating income (loss)                         1,883      4,209     (6,831)

Interest and other expense                             25        156        419
Interest and other income                          (4,670)      (418)      (289)
                                                  -------    -------    -------
    Income (loss) before income taxes               6,528      4,471     (6,961)

Provision (benefit) for income taxes                2,479     (4,055)         -
                                                  -------    -------    -------
    Net income (loss)                             $ 4,049    $ 8,526    $(6,961)
                                                  =======    =======    =======
Net income (loss) per share                       $   .26    $   .56    $  (.55)
                                                  =======    =======    =======
Number of shares used in per share calculation     15,626     15,166     12,654
                                                  ========    =======    =======

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

                                     Page 17
<PAGE>

<TABLE>

Consolidated Statements of Shareholders' Equity
(In thousands except per share data)

<CAPTION>


                                                    Common    Common    Retained          Total
                                                     Stock     Stock    Earnings   Shareholders'
                                                    Shares    Amount   (Deficit)         Equity
<S>                                                 <C>      <C>         <C>            <C>    
Balances at September 30, 1993                      12,466   $14,727     $ 1,476        $16,203

Issuance of common stock:
  Stock options exercised ($0.34-$3.82
    per share)                                         308       504           -            504
  Employee stock purchase plan ($1.07 and $1.65
    per share)                                         196       258           -            258
Net loss                                                 -         -      (6,961)        (6,961)
                                                    ------   -------     -------        -------
Balances at September 30, 1994                      12,970    15,489      (5,485)        10,004

Issuance of common stock:
  Stock options exercised ($0.34-$4.57
    per share)                                         544     1,262           -          1,262
  Employee stock purchase plan ($1.07 and $3.83
    per share)                                         134       230           -            230
  Private placement                                    900     2,922           -          2,922
  Stock warrants                                         4        13           -             13
Net income                                               -         -       8,526          8,526
                                                    ------   -------     -------        -------
Balances at September 30, 1995                      14,552    19,916       3,041         22,957

Issuance of common stock:
  Stock options exercised ($0.82-$7.94
    per share)                                         310       686           -            686
  Employee stock purchase plan ($4.15 and $5.10
    per share)                                          66       303           -            303
  Stock repurchase                                    (130)     (182)       (724)          (906)
  Stock warrants                                        22         -           -              -
Net income                                               -         -       4,049          4,049
                                                    ------   -------     -------        -------
Balances at September 30, 1996                      14,820   $20,723     $ 6,366        $27,089
                                                    ======   =======     =======        =======

<FN>
The  accompanying  notes are an integral  part of these  consolidated  financial
statements.

</FN>
</TABLE>


                                     Page 18
<PAGE>

<TABLE>
Consolidated Statements of Cash Flows
(In thousands)


<CAPTION>

                                                              Year Ended September 30,
                                                             1996       1995       1994
<S>                                                          <C>       <C>        <C>     
Cash flows provided by (used in) operating activities:
Net income (loss)                                            $ 4,049   $ 8,526    $(6,961)
  Adjustments to reconcile net income (loss) to
    net cash provided by (used in) operating activities:
  Depreciation and amortization                                  935     1,384      2,495
  Loss on disposal of fixed assets                                15       111        212
  Provision for doubtful accounts                                185       114        237
  Provision for inventory allowances                             480       176        233
  Unrealized gains on marketable securities                   (2,041)        -          -
  Realized gains on marketable securities                     (2,136)        -          -
  Deferred and refundable income taxes                         2,124    (4,104)     1,412
  Decrease (increase) in accounts receivable                  (1,527)     (529)       213
  Decrease (increase) in inventories                          (1,770)    1,825      3,276
  Decrease (increase) in other current assets                    (62)      418        722
  Increase (decrease) in accounts payable                        341      (298)       755
  Increase (decrease) in accrued liabilities                      33       (50)       226
  Decrease in other long-term liabilities                          -         -       (113)
  Royalty revenues utilized to retire note payable                 -         -     (5,000)
                                                             -------   -------    -------
    Net cash provided by (used in) operating activities          626     7,573     (2,293)
                                                             -------   -------    -------
Cash flows provided by (used in) investing activities:
  Acquisition of fixed assets                                 (1,676)   (1,222)      (566)
  Investment in unconsolidated company                        (3,497)        -          -
  Sale of trading security                                     2,795         -          -
  Purchase of other assets                                      (367)     (446)       (66)
                                                             -------   -------    -------
    Net cash used in investing activities                     (2,745)   (1,668)      (632)
                                                             -------   -------    -------
Cash flows provided by (used in) financing activities:
  Issuance of common stock                                       989     4,427        762
  Repurchase of common stock                                    (906)        -          -
  Proceeds from borrowings                                         -     3,646          -
  Repayments of borrowings                                       (13)   (3,723)      (221)
                                                             -------   -------    -------
    Net cash provided by financing activities                     70     4,350        541
                                                             -------   -------    -------
Net increase (decrease) in cash                               (2,049)   10,255     (2,384)
Cash and cash equivalents, beginning of year                  11,265     1,010      3,394
                                                             -------   -------    -------
Cash and cash equivalents, end of year                       $ 9,216   $11,265    $ 1,010
                                                             =======   =======    =======
<FN>
The  accompanying  notes are an integral  part of these  consolidated  financial
statements.
</FN>
</TABLE>


                                     Page 19
<PAGE>

Notes to Consolidated Financial Statements
(In thousands except per share data)

Summary of Significant Accounting Policies:

Zitel  Corporation  (the "Company")  specializes in the design,  manufacture and
marketing  of   high-performance,   mission-critical   storage   subsystems  for
relational database, batch and on-line transaction processing.  The Company also
develops and markets single-system and multi-system  performance  management and
modeling software used on a variety of UNIX and proprietary  platforms to manage
performance of client/server environments. These products are marketed worldwide
through a wide variety of channels  including systems  integrators,  value-added
resellers and distributors,  OEMs, and directly to end users. Additionally,  the
Company is a reseller of Year 2000 services.  Zitel conducts its business within
one  industry  segment.  The  following  is a  summary  of  Zitel's  significant
accounting policies:

Principles of Consolidation:

The consolidated  financial statements include the accounts of Zitel Corporation
and its  wholly-owned  subsidiaries.  Zitel's  preferred  stock  interest in the
unconsolidated company is accounted for under the equity method. All significant
intercompany accounts and transactions have been eliminated.

Use of Estimates:

The preparation of financial  statements in conformity  with generally  accepted
accounting principles requires management to make estimates and assumptions that
affect  the  reported  amount  of  assets  and  liabilities  and  disclosure  of
contingent  assets and  liabilities at the date of the financial  statements and
the  reported  amounts of revenues  and expenses  during the  reporting  period.
Actual results could differ from these estimates.

Cash Equivalents:

For purposes of the statements of cash flows,  the Company  considers all highly
liquid debt instruments  purchased with a maturity of three months or less to be
cash equivalents.





                                     Page 20
<PAGE>

Marketable Securities:

At September 30, 1996, the Company's marketable securities consisted entirely of
common  shares of one company and were  classified  as trading  securities.  The
Company has entered into an agreement whereby it will not sell such shares until
January of 1997,  after  which  time the  Company  intends  to sell the  shares,
dependent upon market conditions. The cost of the marketable securities was $341
thousand and the fair market value of the  securities  on September 30, 1996 was
$2,382 thousand.  The difference  between the cost of those securities and their
fair market  value based on quoted  market  prices on  September  30,  1996,  is
included in other income.

Inventories:

Inventories are stated at the lower of cost (determined on a first-in, first-out
basis) or market.

Fixed Assets:

Fixed  assets,  other  than  leasehold   improvements,   are  depreciated  on  a
straight-line  basis over their  estimated  useful lives (2-7 years).  Leasehold
improvements  are  amortized  over the lesser of their  useful life or remaining
term of the related  lease.  When assets are  disposed  of, the cost and related
accumulated  depreciation  are removed from the accounts and the resulting gains
and losses are included in the results of operations.

Deferred Software Implementation Costs:

The  Company  capitalizes  substantially  all costs  related to the  purchase of
software and its implementation  which includes purchased  software,  consulting
fees and the use of certain  specified  Company  resources.  As of September 30,
1996,  $238  thousand in costs had been  capitalized  and are  included in other
long-term assets. No amortization has been charged as of September 30, 1996.

Revenue Recognition:

Revenue is  recognized  at the time products are shipped to customers and at the
time  services  are  rendered.  Royalty  revenue is  recognized  when earned and
receipt is assured.



                                     Page 21
<PAGE>

Research and Development Expenditures:

Research and development expenditures are charged to operations as incurred.

Foreign Currency Translation:

The U.S.  dollar is considered to be the  functional  currency for the Company's
foreign operations.  Accordingly,  non-monetary assets and liabilities have been
translated  into  U.S.  dollars  at  a  historical  rate;  monetary  assets  and
liabilities  have been translated  into U.S.  dollars using the exchange rate at
the balance sheet date; and revenues and expenses have been generally translated
into U.S.  dollars at the  weighted  average  exchange  rate  during the period.
Foreign  currency  transaction  gains  and  losses,  as well as the  effects  of
translation (which have not been material in the aggregate), are included in the
accompanying statements of operations.

Income Taxes:

The Company accounts for income taxes under the liability  method.  Deferred tax
assets and  liabilities  are  determined  based on the  difference  between  the
financial  reporting  and tax bases of assets and  liabilities  and are measured
using enacted tax rates and laws that will be in effect when the differences are
expected to reverse.

Recent Accounting Pronouncement:

During March 1995, the Financial Accounting Standards Board issued Statement No.
121,  "Accounting  for the  Impairment of Long-Lived  Assets and for  Long-Lived
Assets to be Disposed Of," which  requires the Company to review for  impairment
long-lived  assets,  certain  identifiable  intangibles and goodwill  related to
those  assets  whenever  events or changes in  circumstances  indicate  that the
carrying amount of an asset may not be recoverable.  In certain  situations,  an
impairment loss would be recognized. Statement No. 121 will be effective for the
Company's  fiscal year 1997.  The Company  has studied the  implications  of the
statement  and based on its  initial  evaluation,  does not  expect it to have a
material impact on the Company's financial condition or results of operations.

During October 1995, the Financial  Accounting  Standards Board issued Statement
No. 123 (SFAS No. 123), "Accounting for Stock-

                                     Page 22
<PAGE>

Based  Compensation,"  which establishes a fair value based method of accounting
for  stock-based  compensation  plans.  The Company is currently  following  the
requirements of APB Opinion No. 25,  "Accounting for Stock Issued to Employees."
The Company will adopt SFAS No. 123 in fiscal year 1997 utilizing the disclosure
alternative.

Net Income (Loss) Per Share:

Net income  (loss) per share  amounts are  computed  by dividing  the net income
(loss) by the weighted  average  number of common  shares and common  equivalent
shares (when dilutive) outstanding during each year presented using the treasury
stock method.

Concentrations of Credit Risk:

Financial instruments which potentially subject the Company to concentrations of
credit  risk  consist  principally  of cash and trade  receivables.  The Company
places its cash investments with high credit quality financial  institutions and
limits the amount of exposure to any one financial  institution.  Concentrations
of  credit  risk  with  respect  to trade  receivables  are  limited  due to the
diversity of the Company's  customers both  geographically  and within different
industry segments.
                                        Year Ended September 30,
                                         1996    1995    1994
Supplemental Cash Flow Information:
Cash paid during the period for:
  Interest                               $  -    $ 57    $310
  Income taxes                             82     136      19

Fair Value of Financial Instruments:

Carrying  value  amounts  of  certain of the  Company's  financial  instruments,
including cash and cash equivalents,  accounts receivable,  accounts payable and
other accrued liabilities approximate fair value due to their short maturities.

                                             September 30,
                                           1996        1995
Inventories:
  Raw materials                          $ 1,515     $   734
  Work in progress                           738         733
  Finished goods                           1,958       1,520
                                         -------     -------
                                         $ 4,211     $ 2,987
                                         =======     =======
                                     Page 23
<PAGE>

                                                      September 30,   
                                                    1996        1995
Fixed Assets:                                     
  Manufacturing equipment                         $ 3,666     $ 3,504
  Office furniture and equipment                    2,250       2,197
  Engineering equipment                             4,334       4,462
  Leasehold improvements                              666         638
                                                  -------     -------
                                                   10,916      10,801
                                                  
  Less accumulated depreciation                   
    and amortization                               (8,663)     (9,382)
                                                  -------     -------
                                                  $ 2,253     $ 1,419
                                                  =======     =======
                                                  
Other Assets:                                     
  Investment in unconsolidated companies          $ 3,563     $ 1,000
  Other                                             1,252         885
                                                  -------     -------
                                                    4,815       1,885
                                                  
  Less accumulated amortization                      (424)       (316)
                                                  -------     -------
                                                  $ 4,391     $ 1,569
                                                  =======     =======
                                         
Investment in Unconsolidated Companies:

At September  30, 1995,  Zitel had a $1.0 million  investment in a company which
was  accounted for under the cost method.  During fiscal year 1996,  the company
completed  its  initial  public  offering  and  Zitel  sold  a  portion  of  its
investment.  The remaining  investment  is  classified  as a trading  marketable
security at September 30, 1996.

In November  1995,  Zitel  purchased 9.6 million  shares of preferred  stock and
certain technology rights, to be commercialized, of a company in the development
stage, in exchange for $3.35 million in cash, $66 thousand in equipment and $150
thousand in future rent and administrative  services.  As of September 30, 1996,
the  company  had  utilized   approximately  $147  thousand  of  such  rent  and
administrative  services.  The technology rights include an exclusive license to
manufacture  and market  certain  products using  proprietary  technology of the
company,  subject  to a  royalty  to the  company.  Zitel  also has an option to
purchase 500

                                     Page 24
<PAGE>

thousand shares of the company's  common stock from a shareholder of the company
at $.60 per share, exercisable beginning July 1997.

The following is a summary of financial information with respect to the company,
as of September 30, 1996:

         Net sales                            $     -
         Gross profit                               -
         Net loss                              (1,873)
         Current assets                         2,612
         Non-current assets                     1,009
         Current liabilities                      324

In July 1996,  Zitel entered into an agreement to resell services of the company
on a commission  basis. The agreement also provides Zitel the exclusive right to
create portable,  on-site centers for the performance of services offered by the
company for certain accounts in certain circumstances.

Note Receivable From Related Party:

The  Company  holds a note  receivable  from  an  officer  of an  unconsolidated
company.  The note bears interest at 8% per annum and has a principle balance of
$300 thousand.  As of September 30, 1996, interest in the amount of $18 thousand
has been prepaid on the note. The note is included in other long-term  assets at
September 30, 1996.

                                             September 30,
                                           1996        1995
Accrued Liabilities:
  Accrued payroll and related            $   435     $   637
  Accrued vacation                           594         526
  Accrued commissions                         24          24
  Other accrued liabilities                  491         337
                                         -------     -------
                                         $ 1,544     $ 1,524
                                         =======     =======

Line of Credit:

The Company has a $3.0 million  bank line of credit  which  expired on September
30, 1996 and was subsequently  extended to November 30, 1996. Interest is at the
prime rate (8.25% at September 30, 1996) and is payable monthly.  The Company is
required to

                                     Page 25
<PAGE>

maintain  certain  specified  financial  ratios and  profitable  operations on a
quarterly  basis.  As of  September  30,  1996,  the Company  had no  borrowings
outstanding under the line of credit.

Commitments:

The  Company  leases  its  primary  manufacturing  and office  facility  under a
noncancelable  operating  lease  which  expires in March  1998.  The  Company is
responsible for taxes,  maintenance and insurance.  Rent expense  incurred under
all operating  leases and charged to operations was $574 thousand in 1996,  $606
thousand in 1995 and $682 thousand in 1994.

Future  minimum  obligations  under the  facility  lease at  September  30, 1996
aggregate approximately $753 thousand, payable as follows:

               Fiscal Year
                   1997          $502
                   1998           251


Capital Stock:
-------------

Preferred Stock:

In October 1983, the Company  authorized one million shares of preferred  stock.
The Board of Directors  has the authority to establish all rights and terms with
respect  to  the  preferred   stock  without   future  vote  or  action  by  the
shareholders.

Private Placement:

In November 1994,  the Company  issued 900 thousand  shares of common stock in a
private placement.  Net proceeds from this transaction were $2.9 million. Common
stock purchase warrants totaling approximately 46 thousand were issued as a part
of this transaction.  The warrants,  which are immediately  exercisable at $3.51
per share, expire in December 1999.

Stock Option Plans:

At September  30, 1996,  the Company had reserved 4.6 million  common shares for
issuance  under  its  1990  Stock  Option,   1982  Incentive   Option  and  1984
Supplemental Stock Option Plans. Under the Company's stock option plans, options
become exercisable at

                                     Page 26
<PAGE>

dates and in amounts as specified by the Compensation  Committee of the Board of
Directors  and expire two to ten years  from the date of grant.  Options  may be
granted to  employees  at prices not less than fair market  value at the date of
grant. At September 30, 1996, there were no shares reserved for future grants.

Activity in the  Company's  option plans  during  fiscal 1996 is  summarized  as
follows:
                                       Options Outstanding
                              Shares      Per Share     Amount Total
Balances, September 30, 1995   1,860     $ .34-$9.50      $ 5,377
  Granted                        260     $4.82-$9.88        1,851
  Canceled                       (40)    $1.19-$7.94         (190)
  Exercised                     (310)    $ .82-$7.94         (660)
                               -----     -----------      -------
Balances, September 30, 1996   1,770     $ .34-$9.88      $ 6,378
                               =====                      =======
                                                      
At September 30, 1996,  options for 1,044  thousand  shares were  exercisable at
prices ranging from $0.34 to $9.88.

Preferred Share Purchase Rights Plan:
In June 1996, the Company adopted a Preferred Share Purchase Rights Plan whereby
shareholders  will receive one right to purchase one one-hundredth of a share of
a new series of preferred  stock  ("Rights") for each  outstanding  share of the
Company's  common stock held at the date of record,  July 1, 1996. The Rights do
not become  exercisable  or  transferable  apart from the common  stock  until a
person  or  group  (a)  acquires  beneficial  ownership  of 15% or  more  of the
Company's  common  stock  or (b)  announces  a tender  or  exchange  offer,  the
consummation  of which would  result in ownership by a person or group of 15% or
more  of the  Company's  common  stock.  The  Rights  will be  distributed  as a
non-taxable  dividend and will expire in ten years from the date of  declaration
of the dividend.  The exercise price is $69.50 per 1/100 of a share of preferred
stock.

Employee Benefit Plans:
----------------------
Stock Purchase Plan:
In April 1984, the Board of Directors approved the adoption of an Employee Stock
Purchase Plan under which 400 thousand  shares of common stock were reserved for
issuance to eligible employees.

                                     Page 27
<PAGE>

In January 1988,  January 1990, January 1992, and January 1995, the shareholders
approved amendments to increase the shares reserved for the Plan by 300 thousand
shares,  400 thousand  shares,  400 thousand  shares,  and 500 thousand  shares,
respectively.  Employees who do not own 5% or more of the outstanding shares are
eligible to participate through payroll deductions,  which may not exceed 10% of
an  employee's  compensation.  At the end of each  offering  period,  shares are
purchased  by the  participants  at 85% of the lower of the fair market value at
the beginning or the end of the offering period.  The 15% discount is treated as
equivalent  to the cost of issuing stock for financial  reporting  purposes.  66
thousand  shares were issued under the Plan during fiscal 1996.  Since inception
of the Plan, approximately 1,600 thousand shares have been issued.

Savings and Investment Plan:

The Company has a Savings and Investment  Plan,  qualified under sections 401(k)
and  401(a) of the  Internal  Revenue  Code,  that  enables  participating  U.S.
employees to prepare for retirement. The Plan allows eligible employees to defer
up to 15%, but no greater than $9.5  thousand per year,  of their  earnings on a
pre-tax basis through  contributions to the Plan. The Plan provides for employer
contributions  at the  discretion  of the Board of Directors;  however,  no such
contributions were made in fiscal 1996, 1995, or 1994.

Income Taxes:

For the year ended September 30, 1994,  there was no provision for income taxes.
The provision  (benefit) for income taxes for the years ended September 30, 1996
and 1995 is as follows:

                                          1996        1995
     Current expense:
       Federal                          $    77     $   125
       State                                 23           -
       Foreign                                -           7
                                        -------     -------
                                            100         132
     Deferred tax expense (benefit):
       Federal                            2,091      (3,735)
       State                                288        (452)
                                        -------     -------
                                        $ 2,479     $(4,055)
                                        =======     =======

                                     Page 28
<PAGE>

The Company's effective tax rate for the years ended September 30, 1996 and 1995
differs from the U.S. federal statutory income tax rate as follows:

                                                1996     1995
    Federal income tax at statutory rate        34.0%    34.0%
    State taxes, net of federal benefit          6.1      6.1
    Tax credits                                 (2.7)    (9.7)
    Other, net                                    .6      2.8
    Net operating losses utilized                  -    (33.5)
    Change in valuation allowance                  -    (90.4)
                                             -------  -------
                                                38.0%   (90.7%)
                                             =======  =======

The following  table shows the major  components of the deferred tax asset as of
September 30, 1996 and 1995:

Deferred tax assets and liabilities:            1996     1995
  Current:
    Accounts receivable, inventory and
      other reserves                         $   694  $   691
    Accrued liabilities                          286      264
    Net operating losses                         373    1,673
    Tax credit carryforwards                   1,015    1,114
    Appreciation of marketable securities       (819)       -
    Other                                        259      445
                                             -------  -------
    Net deferred tax asset                   $ 1,808  $ 4,187
                                             =======  =======

At September  30,  1996,  the Company has federal and state net  operating  loss
(NOL)  carryforwards  of $1.0 million and $.5 million,  respectively,  to reduce
future taxable income.  These carryforwards  expire in 1998 through 2009, if not
utilized.

As a result  of the  acquisition  of CHI  Systems,  Inc.  in 1992,  CHI  Systems
experienced  a change of  ownership  as defined by the  Internal  Revenue  Code.
Consequently,  utilization of  approximately  $500 thousand and $100 thousand of
the Company's federal and state NOL carryforwards, respectively, will be subject
to an annual limitation of approximately  $100 thousand  available to offset CHI
Systems'  separate taxable income.  These  carryforwards  expire in 1998 through
2008, if not utilized.



                                     Page 29
<PAGE>

Research and Development Contract:

During fiscal year 1992, the Company entered into a joint  development  contract
to develop a product with a third party.  The Company  received funding from the
third party based on completion milestones.  In addition, upon completion of the
project,  the Company has and will receive a royalty based on sales by the third
party of the product  developed.  All  expenses  incurred  by the  Company  were
charged to research and development  expense as incurred.  Amounts received from
the third party were  recognized  as a reduction  of  research  and  development
expense on a percentage of completion  basis and amounted to $1,101 thousand for
the year ended  September 30, 1994.  For the year ended  September 30, 1994, the
Company incurred expenses of $2,928 thousand related to the contract.  Royalties
totaling  approximately  $14.5  million,  $15.4  million and $300  thousand were
received from the third party in fiscal years 1996, 1995 and 1994, respectively.

Foreign Operations:

The  Company's  foreign   operations  are  those  of  its  European  branch  and
subsidiary.  All of their sales are made to unaffiliated European customers. The
following table summarizes the Company's European operations:

                                    1996    1995    1994
     Net sales                    $2,924  $1,566  $2,138
     Operating income (loss)         585    (124)   (489)
     Total assets                  1,368     386   1,176

Export Sales:

Export sales from domestic  operations were $1.4 million,  $1.5 million and $2.8
million in 1996, 1995 and 1994, respectively.

Major Customers:

Sales to two customers  amounted to 13% and 11.8% of net sales in 1996. Sales to
one  customer  amounted  to  14.3%  and  14.5% of net  sales  in 1995 and  1994,
respectively.



                                     Page 30
<PAGE>

Subsequent Events:

On November 27, 1996,  the Company's  common stock was split  two-for-one in the
form of a stock  dividend to  shareholders  of record on November 18, 1996.  All
applicable  share and per-share  data in these  financial  statements  have been
restated to give effect to the stock split.



















                             Page 31
<PAGE>

Report of Independent Accountants

To the Shareholders and Board of Directors
Zitel Corporation

We  have  audited  the  accompanying   consolidated   balance  sheets  of  Zitel
Corporation and  subsidiaries as of September 30, 1996 and 1995, and the related
consolidated statements of operations,  shareholders' equity, and cash flows for
each  of  the  three  years  in the  period  ended  September  30,  1996.  These
consolidated  financial  statements  are  the  responsibility  of the  Company's
management.  Our  responsibility is to express an opinion on these  consolidated
financial statements based on our audits.

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

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material respects,  the consolidated  financial position of Zitel
Corporation  and  subsidiaries  as of  September  30,  1996  and  1995,  and the
consolidated  results of their  operations  and their cash flows for each of the
three years in the period ended September 30, 1996, in conformity with generally
accepted accounting principles.







COOPERS & LYBRAND L.L.P.
COOPERS & LYBRAND L.L.P.
San Jose, California
October 24, 1996, except for the note entitled  "Subsequent Events" to which the
date is November 18, 1996.


                                     Page 32
<PAGE>

Item 9:  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
         ACCOUNTING AND FINANCIAL DISCLOSURE

     None.

                            PART III

Item 10:  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The information regarding directors under the caption "Election of Directors" of
the Proxy  Statement for the Annual Meeting of  Shareholders to be held February
27,  1997,  is  incorporated  herein by  reference.  The  information  regarding
executive officers under the caption  "Executive  Officers of the Registrant" is
included herein on pages 9 and 10.

Item 11:  EXECUTIVE COMPENSATION

The information under the caption "Executive Compensation of the Proxy Statement
for the  Annual  Meeting  of  Shareholders  to be held  February  27,  1997,  is
incorporated herein by reference.

Item 12:  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
          MANAGEMENT

The  information  under the caption  "Security  Ownership of Certain  Beneficial
Owners  and  Management"  of the  Proxy  Statement  for the  Annual  Meeting  of
Shareholders  to be held  on  February  27,  1997,  is  incorporated  herein  by
reference.

Item 13:  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

          None.

                                     PART IV

Item 14:  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
          FORM 8-K

     (a)  Financial Statements and Schedules

          The  consolidated  financial  statements,  together  with  the  report
thereon  from Coopers & Lybrand,  appear in Item 8 in this Form 10-K.  Financial
statement  schedules  not included in this Form 10-K have been  omitted  because
they are not  applicable or the required  information  is shown in the financial
statements or the notes thereto.

                                     Page 33
<PAGE>

          (1)  Financial Statements:

  Consolidated Balance Sheets (p. 16)
  Consolidated Statements of Operations (p. 17)
  Consolidated Statements of Shareholders' Equity (p. 18)
  Consolidated Statements of Cash Flows (p. 19)
  Notes to Consolidated Financial Statements (pgs. 20-31)
  Report of Independent Accountants (p. 32)

          (2)  Financial Statement Schedules:

  Report of Independent Accountants (p. 41)
  SCHEDULE VIII-Valuation and Qualifying Accounts (p. 42)

          (3)  Exhibits

               Exhibits  filed as part of this report are listed below.  Certain
               exhibits have been  previously  filed with the Commission and are
               incorporated by reference.
Exhibit
Number                       Description
-------                      -----------

3.1   Restated Articles of Incorporation. (7)

3.2   Bylaws. (2)

10.1  1982  Incentive  Stock Option Plan,  as amended,  and form of Stock Option
      Grant. (3)

10.2  1984 Supplemental Stock Option Plan and form of Stock Option Grant. (3)

10.3  1984 Stock Purchase Plan, as amended through November 1987. (7)

10.4  Agreement  dated  February 27, 1979 among Robert H. Welch,  Jack  Melchor,
      Bernard Wagner,  Tony Tadin,  John C. Blackie,  John J. DePalma,  James F.
      Riley and the Company, amended as of November 15, 1979. (1)

10.5  Agreement for the Sale and Purchase of Intel Memory Product Lines dated as
      of  February  2, 1983  between  the  Company  and Intel  Corporation,  and
      amendments dated March 16, 1983, April 22, 1983, June 23, 1983 and October
      25, 1983 (portions deleted pursuant to a Confidentiality Order). (1)

                                     Page 34
<PAGE>

10.6  Stock Purchase  Agreement dated September 29, 1980 between the Company and
      Oxford  Venture  Fund,  Oxford  Venture  (California)  Fund II, and Oxford
      Venture Offshore Fund. (1)

10.7  Stock Purchase Agreement dated June 2, 1983 between the Company and Oxford
      Venture Fund,  Oxford  Venture  (California)  Fund II, and Oxford  Venture
      Offshore Fund. (1)

10.8  Agreement  dated as of October 1, 1983  between the Company and  Motorola,
      Inc. (portions deleted pursuant to a Confidentiality Order). (1)

10.9  Agreement  and Plan of  Reorganization  among the  Company,  Zitel  Merger
      Corporation and Gifford Computers Systems, Inc. (4)

10.10 Agreement  for  Purchase  and Sale of Assets  dated as of November 1, 1985
      between the Company and React Corporation with Exhibits  (portions deleted
      pursuant to a Confidentiality Order). (5)

10.11 Agreement  for Purchase  and Sale of Marketing  Rights dated as of June 8,
      1986 between the Company and React Corporation  (portions deleted pursuant
      to a Confidentiality Order). (6)

10.12 Lease  agreement  dated  February  7,  1986  between  the  Company,   John
      Arrillaga, Trustee, and Richard T. Peery, Trustee. (7)

10.13 Senior Management Incentive Plan (SMIP) dated November 18, 1987. (8)

10.14 Unisys  Cooperative  Marketing  Agreement dated April 13, 1990 between the
      Company and Unisys  Corporation  and Amendment  One effective  October 25,
      1990. (The Company has applied for confidential  treatment of a portion of
      this Exhibit.) (9)

10.15 Amendment  Two to the Unisys  Cooperative  Marketing  Agreement  effective
      February 5, 1991. (10)

10.16 Amendment Three to the Unisys Cooperative  Marketing  Agreement  effective
      March 31, 1991. (10)

10.17 Amendment Four to the Unisys  Cooperative  Marketing  Agreement  effective
      June 30, 1991. (10)



                                     Page 35
<PAGE>

10.18 Sublease  agreement dated August 11, 1992 between the Company and Credence
      Systems Corporation. (11)

10.19 Loan and Security  Agreement  dated August 2, 1993 between the Company and
      IBM Credit Corporation. (12)

10.20 Development  Agreement  between  the  Company  and IBM  Corporation  dated
      October 14, 1992. (Confidential treatment has been requested for a portion
      of the exhibit.) (13)

10.21 Amendment No. 1 dated June 23, 1993 to the Development  Agreement  between
      the Company and IBM  Corporation  dated  October 14,  1992.  (Confidential
      treatment has been requested for a portion of the exhibit.) (13)

10.22 Amendment No. 2 dated July 26, 1993 to the Development  Agreement  between
      the Company and IBM  Corporation  dated  October 14,  1992.  (Confidential
      treatment has been requested for a portion of the exhibit.) (13)

10.23 Amendment  No. 3 dated  November  29,  1993 to the  Development  Agreement
      between  the  Company  and  IBM   Corporation   dated  October  14,  1992.
      (Confidential  treatment has been requested for a portion of the exhibit.)
      (13)

10.24 Amendment No. 4 dated April 15, 1994 to the Development  Agreement between
      the Company and IBM  Corporation  dated  October 14,  1992.  (Confidential
      treatment has been requested for a portion of the exhibit.) (13)

10.25 Loan and Security  Agreement,  dated as of September 30, 1994, between the
      Company and CoastFed Business Credit Corporation. (14)

10.26 Accounts Collateral  Security  Agreement,  dated as of September 30, 1994,
      between the Company and CoastFed Business Credit Corporation. (14)

10.27 Lease  Agreement  dated  February  16, 1995  between the Company and Renco
      Investment Company. (15)

10.28 Series A  Preferred  Stock  Purchase  Agreement  between  the  Company and
      MatriDigm Corporation dated November 17, 1995. (Confidential treatment has
      been requested for a portion of the exhibit.  The confidential portion has
      been omitted and filed separately with the Commission.)(16)

                                     Page 36
<PAGE>

11.1  Statement regarding computation of earnings per share.

22.1  Subsidiaries of the Company.

24.1  Consent of Independent Accountants.

27    Financial Data Schedule.

----------

(1)  Incorporated  by  reference  to the  indicated  exhibits  to the  Company's
Registration Statement on Form S-1 (File No. 2-87445) filed on October 27, 1983.

(2)  Incorporated  by  reference  to the  indicated  exhibits  to the  Company's
Registration Statement on Form S-8 (File No. 2-90366) filed on April 6, 1984.

(3)  Incorporated  by  reference  to the  indicated  exhibits  to the  Company's
Registration Statement on Form S-8 (File No. 2-96804) filed on March 29, 1985.

(4) Incorporated by reference to the indicated exhibits to the Company's Current
Report on Form 8-K filed on September 20, 1984.

(5) Incorporated by reference to the indicated  exhibits to the Company's Annual
Report on Form 10-K filed December 18, 1985.

(6)  Incorporated  by  reference  to the  indicated  exhibits  to the  Company's
Quarterly Report on Form 10-Q filed August 14, 1986.

(7) Incorporated by reference to the indicated  exhibits to the Company's Annual
Report on Form 10-K filed December 17, 1987.

(8) Incorporated by reference to the indicated  exhibits to the Company's Annual
Report on Form 10-K filed December 21, 1988.

(9) Incorporated by reference to the indicated  exhibits to the Company's Annual
Report on Form 10-K filed December 20, 1990.

(10) Incorporated by reference to the indicated exhibits to the Company's Annual
Report on Form 10-K filed December 20, 1991.

(11) Incorporated by reference to the indicated exhibits to the Company's Annual
Report on Form 10-K filed December 18, 1992.



                                     Page 37
<PAGE>

(12)  Incorporated  by  reference  to the  indicated  exhibits to the  Company's
Quarterly Report on Form 10-Q filed August 13, 1993.

(13)  Incorporated  by  reference  to the  indicated  exhibits to the  Company's
Quarterly Report on Form 10-Q filed May 13, 1994.

(14) Incorporated by reference to the indicated exhibits to the Company's Annual
Report on Form 10-K filed December 22, 1994.

(15)  Incorporated  by  reference  to the  indicated  exhibits to the  Company's
Quarterly Report on Form 10-Q filed May 11, 1995.

(16)  Incorporated  by  reference  to the  indicated  exhibits to the  Company's
Quarterly  Report on Form 10-Q filed  February  13, 1996 and Form 10-QA filed on
December 16, 1996.

     (b) Reports on Form 8-K

         None.

For the purposes of complying  with the  amendments to the rules  governing Form
S-8  under  the  Securities  Act of  1933,  the  undersigned  Registrant  hereby
undertakes as follows, which undertaking shall be incorporated by reference into
Registrant's  Registration  Statements  on Form S-8 No.'s  33-40361 and 33-47697
(filed May 3, 1991 and May 6, 1992).

Insofar as indemnification  for liabilities  arising under the Securities Act of
1933 may be permitted to  directors,  officers  and  controlling  persons of the
Registrant pursuant to the foregoing  provisions,  or otherwise,  the Registrant
has been advised that in the opinion of the Securities  and Exchange  Commission
such indemnification is against public policy as expressed in the Securities Act
of  1933  and is,  therefore,  unenforceable.  In the  event  that a  claim  for
indemnification  against  such  liabilities  (other  than  the  payment  by  the
Registrant of expenses  incurred or paid by a director,  officer or  controlling
person of the  Registrant  in the  successful  defense  of any  action,  suit or
proceeding)  is  asserted by such  director,  officer or  controlling  person in
connection with the securities being registered,  the Registrant will, unless in
the opinion of its counsel the matter has been settled by controlling precedent,
submit  to a  court  of  appropriate  jurisdiction  the  question  whether  such
indemnification  by it is against public policy as expressed in the Act and will
be governed by the final adjudication of such issue.

                                     Page 38
<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 Report to be signed on its
behalf by the undersigned, thereunto duly authorized.

                              ZITEL CORPORATION




                              By:  /s/ Jack H. King
                                 ------------------------------
                                   Jack H. King
                                   President and Director
                                   Chief Executive Officer
                                   December 20, 1996

KNOW ALL PERSONS BY THESE  PRESENTS,  that each person whose  signature  appears
below  constitutes  and appoints  Jack H. King and Henry C. Harris,  jointly and
severally, his attorneys-in-fact,  each with the power of substitution,  for him
in any and all  capacities,  to sign any amendments to this Report on Form 10-K,
and to file the same,  with exhibits  thereto and other  documents in connection
herewith,  with the Securities  and Exchange  Commission,  hereby  ratifying and
confirming  all  that  each  of said  attorneys-in-fact,  or his  substitute  or
substitutes, may do or cause to be done by virtue hereof.










                                     Page 39
<PAGE>

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


Signature             Title                            Date
---------             -----                            ----


Jack H. King          President and Director           December 20, 1996
Jack H. King          (Chief Executive Officer)



Henry C. Harris       Vice President -                 December 20, 1996
Henry C. Harris       Finance and Administration,
                      Secretary (Chief Financial
                      and Accounting Officer)



Catherine P. Lego     Director                         December 20, 1996
Catherine P. Lego



William R. Lonergan   Director                         December 20, 1996
William R. Lonergan



William M. Regitz     Director                         December 20, 1996
William M. Regitz



Robert H. Welch       Director                         December 20, 1996
Robert H. Welch








                                     Page 40
<PAGE>

                        REPORT OF INDEPENDENT ACCOUNTANTS




To the Shareholders and Board of Directors
Zitel Corporation
Fremont, California

Our audit of the  consolidated  financial  statements of Zitel  Corporation  and
Subsidiaries  referred to in our report dated October 24, 1996 appearing in Item
8 in this Annual  Report on Form 10-K also  included  an audit of the  financial
statement schedule listed in Item 14a of this Form 10-K.

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.
Coopers & Lybrand L.L.P.
San Jose, California
October 24, 1996












                                     Page 41
<PAGE>

                                  SCHEDULE VIII

                                ZITEL CORPORATION

                        VALUATION AND QUALIFYING ACCOUNTS
                        FISCAL YEARS 1994, 1995 AND 1996

   Column A      Column B    Column C      Column D    Column E
   --------      --------    --------      --------    --------
                             Additions
                            Charged to
                 Balance      Revenues    Write-offs  Balance at
                Beginning    and Costs       and        End of
  Description   of Period   and Expense   Deductions    Period
  -----------   ---------   -----------   ----------    ------

     1994
--------------
Allowance for
  Doubtful
  Accounts       $259,000     $ 282,000     $  45,000   $496,000

Provision for
  Obsolete
  Inventory      $139,000     $ 730,000     $ 318,000   $551,000

     1995
--------------
Allowance for
  Doubtful
  Accounts       $496,000     $(408,000)            -   $ 88,000

Provision for
  Obsolete
  Inventory      $551,000     $ 278,000     $ 520,000   $309,000

     1996
--------------
Allowance for
  Doubtful
  Accounts       $ 88,000             -             -   $ 88,000

Provision for
  Obsolete
  Inventory      $309,000     $ 480,000     $ 289,000   $500,000


                                     Page 42