<PAGE>
 
                                                                    Exhibit 13.1
                           COMMON STOCK INFORMATION

The common stock of Optical Sensors Incorporated has been traded on the Nasdaq
National Market, under the symbol OPSI, since the company's initial public
offering on February 14, 1996. The following table sets forth the high and low
closing prices for the company's common stock, as reported by the Nasdaq
National Market, for the periods indicated:
<TABLE>
<CAPTION>
 
Quarter ended           High      Low
--------------------  --------  --------
<S>                   <C>       <C>
March 31, 1996         $14.875   $10.375
June 30, 1996           14.250    10.250
September 30, 1996      10.750     5.250
December 31, 1996        9.250     7.750
</TABLE>

The foregoing prices reflect inter-dealer prices, without retail mark-up, mark-
down or commission. As of March 20, 1997, the company had approximately 315 of
record and an estimated 3,100 beneficial holders whose shares were registered in
the names of nominees.

  Optical Sensors Incorporated has never paid any cash dividends on its common
stock, and does not anticipate paying any cash dividends on its common stock in
the foreseeable future. During 1996, the company sold a total of 18,566 shares 
of common stock pursuant to the exercise of stock options with an exercise 
price of $.90 per share, under Rule 701 of the Securities Act of 1933.

<PAGE>
 
SELECTED FINANCIAL DATA SELECTED FINANCIAL DATA

<TABLE>
<CAPTION>
                                                          Years ended December 31, 
                                         -----------------------------------------------------------------
                                                  1996        1995         1994         1993       1992
                                         -----------------------------------------------------------------             
                                                  (In thousands, except per share data)
<S>                                      <C>                <C>            <C>         <C>        <C>
STATEMENTS OF OPERATIONS DATA            
 Net sales                                      $    163    $    --         $    --    $    --    $    --
 Operating expenses                                9,734      8,249           6,463      5,586      3,688   
 Loss from operations                             10,940      8,249           6,463      5,586      3,688 
 Interest income (expense), net                    1,555        118             183        149         35 
 Net loss                                          9,385      8,131           6,280      5,437      3,653 
 Net loss per common share                      $   1.30    $  2.70         $  2.10    $  1.82    $  1.23
                                         
                                         
                                         
                                         
                                                          Years ended December 31, 
                                         -----------------------------------------------------------------
                                                  1996        1995         1994         1993       1992
                                         -----------------------------------------------------------------             
                                                  (In thousands, except per share data)
BALANCE SHEET DATA                       
 Cash and cash equivalents                      $ 30,135    $ 5,395         $ 2,851    $ 9,105    $ 2,284
 Working capital                                  30,039      5,242           2,363      8,734      1,820
 Total assets                                     32,369      6,367           3,582      9,741      2,962
 Long-term debt                                       --         --              --         89        153
 Total shareholders' equity                       31,050      5,778           2,987      9,182      2,313
 
</TABLE>

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

BUSINESS OVERVIEW

Optical Sensors Incorporated (the "Company") has developed the SensiCath system,
a patient-attached, on-demand arterial blood gas ("ABG") monitoring system, 
which provides precise and accurate ABG results within 60 seconds without 
exposure to potentially infectious blood or depleting the patient's blood supply
(the "SensiCath System"). ABG tests measure oxygen ("O\2\"), carbon dioxide 
("CO\2\"), and acid-base ("pH") in a sample of blood taken from the patient's 
artery. The Company believes that the SensiCath System is the first ABG analyzer
to be integrated into both an arterial pressure monitoring line and a critical
care patient monitoring system. The SensiCath System utilizes a disposable,
fiberoptic sensor device ("the SensiCath Sensor") connected to a small modular
instrument that can be configured to integrate with bedside monitoring systems
or to serve as a stand-alone monitor.

The SensiCath System is currently available in two configurations. The first
configuration of the SensiCath System combines the SensiCath Sensor with a
module (the "OnlineABG Module") that plugs into bedside monitors manufactured
by Marquette Medical Systems, Inc. ("Marquette"). The second configuration of
the SensiCath System consists of the SensiCath Sensor, the OnlineABG Module and
a stand-alone monitor ("the OpticalCAM") that can be used as a stand-alone
monitoring device or can interface with bedside monitors supplied by other
manufacturers of patient monitoring equipment. The Company plans to market the
OpticalCAM monitor to all hospitals regardless of the type of monitoring system
used by the hospital. Currently, the OpticalCAM is able to interface with
patient monitoring systems sold by the Hewlett-Packard Company and SpaceLabs
Medical, Inc. The two configurations of the SensiCath System give the Company
access to over 80 percent of the monitored critical care beds in the United
States. The Company's strategy is to become the leader in the design,
development and commercialization of sensors and integrated monitoring systems
for the measurement of ABG and other critical blood analytes at the point-of-
care and thereby establish a new standard of care for critically ill patients.

The Company completed product development of the initial configuration of the
SensiCath System in June 1995 and received 510(k) clearance to market the
SensiCath System from the FDA in January 1996. The Company completed development
of the OpticalCAM monitor in September 1996 and received 510(k) clearance to
market the OpticalCAM monitor from the FDA in January 1997.

RESULT OF OPERATIONS

Fiscal Years Ended December 31, 1996 and 1995

The Company had no sales in 1995.  Net sales for 1996 were $163,068.
Approximately 52% of sales have been to Marquette for demonstration purposes and
for clinical marketing studies, approximately 18% of sales have been to
international distributors for demonstration purposes, and approximately 20% of
sales have been commercial sales to customers.

Costs of products sold to date have been primarily related to the establishment
of commercial manufacturing operations and manufacturing of sensors for clinical
studies and other testing purposes.  Costs of products sold were $1,369,221 and
$981,151 in 1996 and 1995 respectively.  In 1995, production costs were recorded
as research and development expenses because the Company had no sales in that
period.  The increase in 1996 is the result of increased activities to scale-up
manufacturing to meet anticipated future sales demand.

Research and development expenses were $5,632,458 and $4,974,193 (excluding
$981,151 related to costs of products sold described above) in 1996 and 1995,
respectively.  Research and development expenses included payments under an
agreement with Marquette entered into in September 1995 pursuant to which the
Company acquired ownership of the technology used in the SensiCath System.
Payments to Marquette were $553,250 and $759,750 in 1996 and 1995, respectively.
The Company is obligated to make two additional payments of $500,000 each
subject to Marquette selling certain minimum quantities of OnlineABG Modules.
The Company currently expects to make these payments to Marquette in 1997.
Research and development expenses (excluding payments to Marquette) increased
$864,765, or 21%, in 1996 from 1995. The increase in 1996 is primarily
attributable to development expenses incurred for the OpticalCAM. The Company
expects that research and development expenses will remain at comparable levels
during 1997 due to the anticipated payments to Marquette and planned development
of a further miniaturized sensor and new sensors to measure additional blood
analytes.

Selling, general and administrative expenses were $4,102,147 and $2,293,435 in
1996 and 1995, respectively.  Selling, general and administrative expenses
included amortization of deferred compensation expenses (for options granted in
1995) of $623,452 and $1,008,467 in 1996 and 1995, respectively.  Selling,
general and administrative expenses (after adjusting for compensation expenses
described above) increased $2,193,727, or 171%, in 1996 from the prior year.
During 1996, the Company completed the initial hiring of its sales and marketing
staff.  Salaries and benefits for the expanded sales and marketing staff and
travel expenses related to sales and marketing activities accounted for a
significant portion of the 1996 increase in selling, general and administrative
expenses.  Administrative expenses also increased primarily due to the higher
level of activity associated with initial commercialization of the Company's
products and additional costs associated with being a public company. The
<PAGE>
 
Company expects selling, general and administrative expenses to increase in 1997
in an amount similar to the 1996 increase. Substantially all of the anticipated
increase is for sales and marketing staff hired late in 1996 and incremental
marketing activities related to the relaunch of the SenisiCath System.

Net interest income increased $1,437,724 to $1,555,486 in 1996 from 1995.  The
increase is due to interest earned on the proceeds from the Company's initial
public offering, which was completed in the first quarter of 1996.

The Company incurred a net loss of $9,385,272 in 1996 compared to a net loss of
$8,131,017 in 1995.  Since inception, the Company has incurred a cumulative net
loss of $35,215,362.  The increase in net loss in 1996 was primarily due to the
increase in operating expenses described above.  The Company anticipates that
its operating losses will continue for the foreseeable future.

Fiscal Years Ended December 31, 1995 and 1994

The Company did not have any sales in 1995 or 1994.

Research and development expenses increased 25% to $5,955,344 in 1995 from
$4,774,487 in 1994.  The increase was primarily due to payments of $750,000 made
to Marquette in 1995 under the agreement referred to above.  The remainder of
the increase was due to additional development efforts, start-up costs for
establishing commercial manufacturing facilities, initial clinical marketing
studies of the SensiCath System and a write-off of prepaid license fees of
$135,000 related to the cancellation of license agreements.

Selling, general and administrative expenses increased 36% to approximately
$2,293,435 in 1995 from approximately $1,688,309 in 1994.  The increase was due
to an increase in compensation expense of $1,008,000 related to stock options
granted from June through October 1995, offset in part by cost reduction
measures taken by the Company in the fourth quarter of 1994.  These measures
were instituted because of a delay in product development that began in late
1994.

Net interest income decreased 36% to approximately $118,000 in 1995 from
approximately $183,000 in 1994.  The decrease was due to a decline in short-term
investments caused by continued operating losses and capital equipment
purchases.

LIQUIDITY AND CAPITAL RESOURCES

In the first quarter of 1996, the Company completed an initial public offering
of 2,875,000 shares of Common Stock.  The net proceeds to the Company from the
public offering were approximately $33,916,000.  The Company's Common Stock is
quoted on the Nasdaq National Market under the symbol "OPSI."

The Company's cash and cash equivalents were $30,134,800 and $5,394,721 at
December 31, 1996 and December 31, 1995, respectively.  The increase is due to
the proceeds from the public offering, offset by cash used in 1996.  The Company
incurred cash expenditures of $8,779,365

<PAGE>
 
for operations (including lease payments of $725,150 under operating leases for
capital equipment) and $496,084 for capital expenditures in 1996. The capital
equipment expenditures and operating lease payments were principally for the
acquisition of tooling and equipment, primarily for commercial launch of the
Company's products and for research and development purposes. As of December 31,
1996, the Company had no material commitments outstanding for tooling and
equipment. Subsequent to year end, the Company entered into commitments of
approximately $225,000 to acquire tooling for production of the OpticalCAM
monitor.

As of December 31, 1996, the Company had commitments outstanding for
approximately $500,000 to purchase OpticalCAM monitors and OnlineABG Modules.
Subsequent to year end, the Company entered into additional commitments of
approximately $1,700,000 to purchase OpticalCAM monitors and OnlineABG Modules.

The Company increased its inventory levels during 1996 to support future product
sales.  A substantial portion of the inventory level at December 31, 1996
consisted of key components and OnlineABG Modules for which the Company relies
on sole suppliers.

With the proceeds of the initial public offering, the Company believes that
sufficient liquidity is available to satisfy its working capital needs at least
through 1997.

CERTAIN IMPORTANT FACTORS

There are several important factors that could cause the Company's actual
results to differ materially from those anticipated by the Company or which are
reflected in any forward-looking statements of the Company.  These factors, and
their impact on the success of the Company's operations and its ability to
achieve its goals, include the following:

 .  MARKET ACCEPTANACE OF THE SENSICATH SYSTEM. The Company's future revenues
   will depend on market acceptance of the SensiCath System. The company will
   need to demonstrate to health care professionals, hospital administrators and
   third-party payors the accuracy, reliability, ease of use, safety and cost
   effectiveness of the sensicath system. in order to use the SensiCath System,
   hospitals need to acquire the OnlineABG Module, and if they do not have a
   Marquette patient bedside monitoring system the OpticalCAM monitor, both of
   which may require capital expenditure approvals by the hospital.

 .  TIMELY INSTALLATION OF THE SENSICATH SYSTEM. The Company's ability to
   increase sales in the near-term will depend on timely installation and in-
   service training of the onlineABG Module, which is provided by Marquette. the
   company does not have control over the scheduling of this installation and
   in-service training for the OnlineABG Module.

 .  SALES TO INSTALLED BASE.  The Company's plan for increasing sales in 1997 is
   based, in part, on its ability to sell the SensiCath System to Marquette's
   installed base of Tramscope and Solar patient monitoring systems. in order to
   interface with the SensiCath System, Tramscope systems need either hardware
   or software upgrades or both, and previously installed solar systems need a
   software upgrade. These upgrades require an additional investment by
   hospitals with Tramscope systems and hospitals with Solar Systems that are
   not under warranty. Hospitals may be reluctant to absorb the costs associated
   with the

<PAGE>
 
   purchase of an OnlineABG Module and upgrades needed to interface the
   solar and tramscope system with the SensiCath System.

 .  COMPETITION.  Competition among companies attempting to provide ABG and other
   critical blood analyte analysis at the point-of-care is intense and
   increasing. there can be no assurance that the Company's competitors will not
   succeed in developing or marketing technologies and products that are more
   effective or less expensive than the Company's products or that would render
   the Company's products obsolete or non-competitive.

 .  FUTURE REGULATORY APPROVALS.  The Company's ability to market new
   configurations of or improvements to the SensiCath System and any products it
   may develop in the future will require clearances or approvals from the FDA
   and in some instances foreign governmental agencies. The process for
   obtaining necessary regulatory clearances and approvals can be expensive and
   time consuming. There can be no assurance that the Company will be able to
   obtain necessary regulatory approvals and clearances in the future on a
   timely basis, or at all.

 .  SOLE SOURCES OF SUPPLY.  Currently, the Company has only one supplier for the
   OnlineABG module, the OpticalCAM monitor and certain other key components.
   Any disruption or delay in the supply of key components or instrumentation
   could have a material adverse effect on the Company.

<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)

                   
                             Financial Statements

                    Years ended December 31, 1995 and 1996


                                    CONTENTS
<TABLE>
 
<S>                                                    <C>
Report of Independent Auditors........................   1
 
Audited Financial Statements
 
Balance Sheets........................................   2
Statements of Operations..............................   3
Statement of Shareholders' Equity.....................   4
Statements of Cash Flows..............................  12
Notes to Financial Statements.........................  13
 
</TABLE>
<PAGE>
 
                         Report of Independent Auditors


Board of Directors
Optical Sensors Incorporated

We have audited the accompanying balance sheets of Optical Sensors Incorporated
(a development stage company) as of December 31, 1995 and 1996, and the related
statements of operations, shareholders' equity and cash flows for each of the
three years in the period ended December 31, 1996 and the period from May 23,
1989 (inception) to December 31, 1996. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Optical Sensors Incorporated (a
development stage company) at December 31, 1995 and 1996, and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1996 and the period from May 23, 1989 (inception) to December 31,
1996, in conformity with generally accepted accounting principles.

                                                  /s/ Ernst & Young LLP

Minneapolis, Minnesota
February 7, 1997

                                                                               1
<PAGE>
 
                          Optical Sensors Incorporated
                         (A Development Stage Company)

                                 Balance Sheets
<TABLE>
<CAPTION>
                                                  DECEMBER 31
                                              1995           1996
                                        -----------------------------
<S>                                       <C>            <C>
ASSETS
Current assets:
 Cash and cash equivalents                $  5,394,721   $ 30,134,800
 Accounts receivable                                 -         91,040
 Inventory                                           -        931,917
 Prepaid expenses and other current          
   assets                                      436,503        200,731
                                          ------------   ------------    
Total current assets                         5,831,224     31,358,488
 
Property and equipment:
 Research and development equipment            375,124        292,488
 Leasehold improvements                        174,673        199,211
 Furniture and equipment                        35,796         77,895
 Marketing equipment                                 -        344,448
 Production equipment                                -        167,635
                                          ------------   ------------     
                                               585,593      1,081,677
 Less accumulated depreciation                (373,237)      (488,043)
                                          ------------   ------------
                                               212,356        593,634
Other assets:
 Patents                                       230,549        328,630
 Other assets                                   93,002         88,445
                                          ------------   ------------
                                               323,551        417,075
                                          ------------   ------------  
Total assets                              $  6,367,131   $ 32,369,197
                                          ============   ============
 
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
 Accounts payable                         $    116,609   $    740,804
 Employee compensation                         468,952        577,228
 Other liabilities and accrued expenses          3,753          1,541
                                          ------------   ------------     
Total current liabilities                      589,314      1,319,573
 
Commitments
 
SHAREHOLDERS' EQUITY
Preferred Stock, par value $.01 per
 share
 Authorized shares--5,000,000
Convertible Preferred Stock, Series A
 through E, par value $.01 per share:
 Issued and outstanding shares                  
  1995--4,766,974; 1996--0                      47,670              -
Common Stock, par value $.01 per share:
 Authorized shares--30,000,000
 Issued and outstanding shares                  
  1995--610,443; 1996--8,341,497                 6,105         83,415
Additional paid-in capital                  32,970,358     66,974,345
Deficit accumulated during the             
 development stage                         (25,830,090)   (35,215,362)
Deferred compensation                       (1,171,226)      (547,774)
Note receivable from officer                  (245,000)      (245,000)
                                          ------------   ------------
 Total shareholders' equity                  5,777,817     31,049,624
                                          ------------   ------------  
Total liabilities and shareholders'
 equity                                   $  6,367,131   $ 32,369,197
                                          ============   ============
</TABLE>
See accompanying notes.

                                                                               2
<PAGE>
 
                          Optical Sensors Incorporated
                         (A Development Stage Company)

                            Statements of Operations
<TABLE>
<CAPTION>
 
 
                                                                                       CUMULATIVE
                                                                                      MAY 23, 1989
                                                                                     (INCEPTION) TO
                                                   YEAR ENDED DECEMBER 31             DECEMBER 31,
                                              1994          1995          1996            1996
                                        -----------------------------------------------------------
 
<S>                                       <C>           <C>           <C>            <C>
Net sales                                 $             $             $    163,068     $    163,068
Cost of goods sold                                                      (1,369,221)      (1,369,221)
                                        -----------------------------------------------------------
Gross margin                                                            (1,206,153)      (1,206,153)
 
Operating expenses:
 Research and development                   4,774,487     5,955,344      5,632,458       25,022,866
 Selling, general and administrative        1,688,309     2,293,435      4,102,147       11,020,959
                                        -----------------------------------------------------------
 Operating loss                            (6,462,796)   (8,248,779)   (10,940,758)     (37,249,978)
 
Interest expense                               17,057        19,333                         141,385
Interest income                              (200,439)     (137,095)    (1,555,486)      (2,176,001)
                                        -----------------------------------------------------------
                                             (183,382)     (117,762)    (1,555,486)      (2,034,616)
                                        -----------------------------------------------------------
Net loss and deficit accumulated during
 development stage                        $(6,279,414)  $(8,131,017)  $ (9,385,272)    $(35,215,362)
                                        =========================================================== 
 
Net loss per common share:
 Primary                                  $     (2.10)  $     (2.70)        $(1.30)
 Supplemental                             $     (1.21)  $     (1.32)        $(1.20)
 
Shares used in calculation of net loss
per share:
  Primary                                   2,986,000     3,011,000      7,222,000
  Supplemental                              5,172,000     6,149,000      7,818,000
 
</TABLE>
See accompanying notes.

                                                                               3
<PAGE>
 
                          Optical Sensors Incorporated
                         (A Development Stage Company)

                       Statement of Shareholders' Equity

           Period from May 23, 1989 (inception) to December 31, 1996
<TABLE>
<CAPTION>
 
 
                                             SERIES A         SERIES B         SERIES C
                                            CONVERTIBLE      CONVERTIBLE      CONVERTIBLE
                                          PREFERRED STOCK  PREFERRED STOCK  PREFERRED STOCK
                                        ---------------------------------------------------
                                          SHARES   AMOUNT  SHARES   AMOUNT  SHARES   AMOUNT
                                        ---------------------------------------------------

<S>                                       <C>      <C>     <C>      <C>     <C>      <C> 
Subscriptions for sale of Common Stock
 at $.45 per share
Payments received on stock
 subscriptions, net of placement costs
Issuance of Common Stock
Issuance of Common Stock for consulting  
 services
Net loss for period of May 23, 1989
 (inception) to December 31, 1989        ---------------------------------------------------
Balance at December 31, 1989
 
Issuance of Common Stock, net of
 offering costs of $121,502
Issuance of Common Stock for services
 provided in the private placement
Issuance of Common Stock for consulting
 services
Issuance of Common Stock upon debt
 conversion 
Payments received on stock subscription
Issuance of Common Stock 
Net loss                                 ---------------------------------------------------
Balance at December 31, 1990
 
Issuance of Series A Convertible
 Preferred Stock net of offering costs     
 of $49,904                                94,370   $944          
Issuance of Common Stock for technology
Net loss                                 ---------------------------------------------------    
Balance at December 31, 1991               94,370    944
 
</TABLE>

                                                                               4
<PAGE>
 
<TABLE>
<CAPTION>
 
 
                                  
                                  DEFICIT
                                ACCUMULATED   PREFERRED AND
  COMMON STOCK      ADDITIONAL   DURING THE      COMMON       
-----------------    PAID-IN    DEVELOPMENT       STOCK           DEFERRED
 SHARES    AMOUNT    CAPITAL       STAGE      SUBSCRIPTION      COMPENSATION     TOTAL
-----------------------------------------------------------------------------------------
                                                             
                                                             
<S>        <C>     <C>          <C>           <C>               <C>           <C>
                                                             
127,037    $1,270  $   57,022                     $(58,292)                   $         -
                                                             
                       (3,987)                      55,792                         51,805
9,560          96      13,205                      (10,000)                         3,301
                                                             
  350           4       1,256                                                       1,260
                                                             
                                $  (181,793)                                     (181,793)
-----------------------------------------------------------------------------------------
136,947     1,370      67,496      (181,793)       (12,500)                      (125,427)
                                                             
                                                             
92,678        927     711,671                                                     712,598
                                                             
6,260          63         (63)                                                          -
                                                             
640             6       5,751                                                       5,757
                                                             
                                                             
26,088        261     117,135                                                     117,396
                                                    12,500                         12,500
                                                             
16,667        167     149,833                                                     150,000
                                   (636,266)                                     (636,266)
-----------------------------------------------------------------------------------------
279,280     2,794   1,051,823      (818,059)                                      236,558
                                                             
                                                             
                    1,011,652                      (10,635)                     1,001,961
2,778          28      24,972                                                      25,000
                                 (1,511,013)                                   (1,511,013)
-----------------------------------------------------------------------------------------
282,058     2,822   2,088,447    (2,329,072)       (10,635)                      (247,494)
</TABLE>

                                                                               5
<PAGE>
 
                          Optical Sensors Incorporated
                         (A Development Stage Company)

                 Statement of Shareholders' Equity (continued)

<TABLE>
<CAPTION>
 
 
 
                                             SERIES A         SERIES B           SERIES C
                                            CONVERTIBLE      CONVERTIBLE       CONVERTIBLE
                                          PREFERRED STOCK  PREFERRED STOCK   PREFERRED STOCK
                                        ------------------------------------------------------
                                          SHARES   AMOUNT  SHARES   AMOUNT   SHARES    AMOUNT
                                        ------------------------------------------------------
 
<S>                                       <C>      <C>     <C>      <C>     <C>        <C>
Issuance of Series B Convertible
 Preferred Stock, net of offering costs                    
 of $93,903                                                418,387  $4,184
Issuance of Series B Convertible
 Preferred Stock upon debt cancellation                     81,129     811 
Issuance of Common Stock for consulting
 services
Payment received on stock subscriptions
Net loss                                ------------------------------------------------------
Balance at December 31, 1992               94,370    $944  499,516   4,995
 
Issuance of Series C Convertible
 Preferred Stock, net of offering costs                                       
 of $815,320                                                                  958,200  $ 9,582 
Issuance of Series C Convertible
 Preferred Stock upon debt cancellation                                        79,817      798
Issuance of Common Stock upon exercise
 of warrants
Issuance of Common Stock
Net loss                                ------------------------------------------------------
Balance at December 31, 1993               94,370     944  499,516   4,995  1,038,017   10,380
 
Issuance of Common Stock upon exercise
 of warrants and options
Value assigned to warrants issued in
 connection with debt and lease
 financings
Net loss                                ------------------------------------------------------
Balance at December 31, 1994               94,370     944  499,516   4,995  1,038,017   10,380
 
</TABLE>

                                                                               6
<PAGE>
 
<TABLE>
<CAPTION>
 
 
                                
                                    DEFICIT
                                  ACCUMULATED   PREFERRED AND
  COMMON STOCK       ADDITIONAL    DURING THE    COMMON       
-----------------     PAID-IN     DEVELOPMENT     STOCK          DEFERRED
 SHARES    AMOUNT     CAPITAL        STAGE      SUBSCRIPTION    COMPENSATION     TOTAL
----------------------------------------------------------------------------------------
                                                              
<S>        <C>     <C>          <C>            <C>             <C>           <C>
                                                              
                   $ 5,173,589                                               $ 5,177,773
                                                              
                                                              
                     1,021,416                                                 1,022,227
                                                              
317        $    3        2,853                                                     2,856
                                                      $10,635                     10,635
                                $ (3,653,474)                                 (3,653,474)
---------------------------------------------------------------------------------------- 
282,375     2,825    8,286,305    (5,982,546)         $    --                  2,312,523
                                                              
                                                              
                    11,248,418                                                11,258,000
                                                              
                     1,004,924                                                 1,005,722
                                                              
6,658          66       35,787                                                    35,853
833             8        7,492                                                     7,500
                                  (5,437,113)                                 (5,437,113)
---------------------------------------------------------------------------------------- 
289,866     2,899   20,582,926   (11,419,659)                                  9,182,485
                                                              
                                                              
778             7        7,493                                                     7,500
                                                              
                        76,051                                                    76,051
                                  (6,279,414)                                 (6,279,414)
----------------------------------------------------------------------------------------
290,644     2,906   20,666,470   (17,699,073)                                  2,986,622
</TABLE>

                                                                               7
<PAGE>
 
                          Optical Sensors Incorporated
                         (A Development Stage Company)

                 Statement of Shareholders' Equity (continued)

<TABLE>
<CAPTION>
 
 
 
                                             SERIES A         SERIES B           SERIES C            SERIES D          SERIES E
                                            CONVERTIBLE      CONVERTIBLE       CONVERTIBLE         CONVERTIBLE        CONVERTIBLE
                                          PREFERRED STOCK  PREFERRED STOCK   PREFERRED STOCK     PREFERRED STOCK    PREFERRED STOCK
                                        -------------------------------------------------------------------------------------------
                                          SHARES   AMOUNT  SHARES   AMOUNT   SHARES    AMOUNT    SHARES    AMOUNT   SHARES   AMOUNT
                                        -------------------------------------------------------------------------------------------
 
<S>                                       <C>      <C>     <C>      <C>     <C>        <C>      <C>        <C>      <C>      <C>
Value assigned to options issued in
 connection with a consulting agreement
Issuance of Series D Convertible
 Preferred Stock, net of offering costs
 of $88,501                                                                                     1,900,183  $19,002
Issuance of Series D Convertible
 Preferred Stock upon debt cancellation
Issuance of Common Stock upon exercise
 of options and warrants
Issuance of Convertible Preferred Stock
 pursuant to antidilution provisions in
 Series A through C                        18,853  $  189  157,061  $1,571    377,991  $ 3,779
Issuance of Series E Convertible
 Preferred Stock, net of offering costs
 of $33,660                                                                                                         370,338  $3,703
Value assigned to warrants in
 connection with debt and lease
 financing
Deferred compensation related to stock
 options
Amortization of deferred compensation
Net loss                                  ----------------------------------------------------------------------------------------- 

Balance at December 31, 1995              113,223   1,133  656,577   6,566  1,416,008   14,159  2,210,828   22,109  370,338   3,703
 
</TABLE>

                                                                               8
<PAGE>
 
<TABLE>
<CAPTION>
 
 
                                                 DEFICIT
                                               ACCUMULATED   PREFERRED AND
  COMMON STOCK      ADDITIONAL     OFFICER     DURING THE       COMMON    
-----------------    PAID-IN     RECEIVABLE    DEVELOPMENT      STOCK         DEFERRED
 SHARES    AMOUNT    CAPITAL      FOR STOCK       STAGE      SUBSCRIPTION   COMPENSATION      TOTAL
------------------------------------------------------------------------------------------------------
<S>        <C>     <C>           <C>          <C>            <C>            <C>            <C>
                   $     6,150                                                             $     6,150
                                                                          
                     5,877,647                                                               5,896,649
                                                                          
                       975,689                                                                 978,796
                                                                          
319,799     3,199      288,147    $(245,000)                                                    46,346
                                                                          
                        (5,539)                                           
                                                                          
                     2,962,637                                                               2,966,340
                                                                          
                        19,464                                                                  19,464
                                                                          
                     2,179,693                                               $(2,179,693)
                                                                          
                                                                               1,008,467     1,008,467
                                              $ (8,131,017)                                 (8,131,017)
------------------------------------------------------------------------------------------------------ 
610,443     6,105   32,970,358     (245,000)   (25,830,090)                   (1,171,226)    5,777,817
</TABLE>

                                                                               9
<PAGE>
 
                          Optical Sensors Incorporated
                         (A Development Stage Company)

                 Statement of Shareholders' Equity (continued)

<TABLE>
<CAPTION>
 
 
 
                               SERIES A             SERIES B               SERIES C                SERIES D              SERIES E
                             CONVERTIBLE          CONVERTIBLE           CONVERTIBLE             CONVERTIBLE            CONVERTIBLE
                           PREFERRED STOCK      PREFERRED STOCK       PREFERRED STOCK         PREFERRED STOCK        PREFERRED STOCK

                          ---------------------------------------------------------------------------------------------------------
                            SHARES   AMOUNT    SHARES    AMOUNT     SHARES     AMOUNT      SHARES     AMOUNT     SHARES    AMOUNT
                          ---------------------------------------------------------------------------------------------------------
 
<S>                          <C>        <C>       <C>       <C>       <C>         <C>        <C>        <C>        <C>      <C>
Issuance of Common Stock
 in conjunction with
 public offering, net of
 expenses of
$3,459,218
Conversion of Preferred
 Stock in conjunction with (113,223)  $(1,133)  (656,577)  $(6,566) (1,416,008) $(14,159) (2,210,828) $(22,109) (370,338)  $(3,703)
 public offering
Issuance of Common Stock
 upon exercise of options
 and warrants
Value assigned to warrants
 in connection with debt
 and lease financing
Amortization of deferred
 compensation
Net loss                   --------------------------------------------------------------------------------------------------------
Balance at December 31,        -      $ -           -      $ -            -     $ -             -     $ -           -      $ -
 1996
                           ========================================================================================================
</TABLE>
See accompanying notes.

                                                                              10
<PAGE>
 
<TABLE>
<CAPTION>
 
 
                                                   DEFICIT
                                                 ACCUMULATED   PREFERRED AND
       COMMON STOCK    ADDITIONAL    OFFICER     DURING THE       COMMON     
--------------------    PAID-IN    RECEIVABLE    DEVELOPMENT      STOCK          DEFERRED
  SHARES     AMOUNT     CAPITAL     FOR STOCK       STAGE      SUBSCRIPTION    COMPENSATION      TOTAL
---------------------------------------------------------------------------------------------------------
                                                                             
<S>          <C>      <C>          <C>          <C>            <C>             <C>            <C>
                                                                             
                                                                             
2,875,000    $28,750  $33,887,032                                                             $33,915,782
                                                                             
4,766,974     47,670                                                                                    -  
                                                                             
89,080           890       98,856                                                                  99,746
                                                                             
                                                                             
                           18,099                                                                  18,099
                                                                             
                                                                                    623,452       623,452
                                                $ (9,385,272)                                  (9,385,272)
---------------------------------------------------------------------------------------------------------
8,341,497    $83,415  $66,974,345   $(245,000)  $(35,215,362)  $ -                $(547,774)  $31,049,624
=========================================================================================================
</TABLE>

                                                                              11
<PAGE>
 
                          Optical Sensors Incorporated
                         (A Development Stage Company)

                            Statements of Cash Flows
<TABLE>
<CAPTION>
 
 
                                                                                      CUMULATIVE
                                                                                     MAY 23, 1989
                                                                                    (INCEPTION) TO
                                                   YEAR ENDED DECEMBER 31            DECEMBER 31,
                                              1994          1995          1996           1996
                                        ----------------------------------------------------------
<S>                                       <C>           <C>           <C>           <C>
 
OPERATING ACTIVITIES
Net loss                                  $(6,279,414)  $(8,131,017)  $(9,385,272)    $(35,215,362)
Adjustments to reconcile net loss to
 net cash used in
operating activities:
  Depreciation and amortization               110,453       104,800       124,452          634,904
  Loss on write-off of research and
   development equipment                            -             -             -          133,919
  Loss on write-off of prepaid royalties            -       135,201             -          135,201
  Amortization of deferred loss on sale        
   leaseback                                   11,196             -             -           11,196 
  Deferred compensation amortization                -     1,008,467       623,452        1,631,919
  License fee financed with long-term               
   debt                                             -             -             -          193,700
  Issuance of Common Stock for services             -             -             -           37,091
  Issuance of Common Stock in lieu of               
   interest payments on notes payable               -             -             -           35,412
  Amortization of warrants in connection
  with debt and lease financing                26,534        19,464        18,099           64,097
  Issuance of options in connection with
  consulting services                          49,540         6,150             -           55,690
  Changes in operating assets and
   liabilities:
   Receivables                                      -             -       (91,040)         (91,040)
   Inventories                                      -             -      (931,917)        (931,917)
   Prepaid expenses and other assets         (131,337)     (414,391)      132,602         (617,394)
   Accounts payable and accrued expenses      100,732        82,572       730,259        1,319,573
                                        ----------------------------------------------------------
Net cash used in operating activities      (6,112,296)   (7,188,754)   (8,779,365)     (32,603,011)
 
INVESTING ACTIVITIES
Purchases of property, plant and              
 equipment                                   (85,637)      (66,999)     (496,084)      (1,704,529)  
Proceeds from disposal of equipment                -             -             -           46,947
                                        ---------------------------------------------------------
Net cash used in investing activities         (85,637)      (66,999)     (496,084)      (1,657,582)
 
FINANCING ACTIVITIES
Proceeds from sale leaseback                        -             -             -         283,030
Net proceeds from issuance of Common            
 Stock                                          7,477        46,346    34,015,528       35,044,676
Net proceeds from issuance of Preferred             
 Stock                                              -     9,841,785             -       27,290,155
Proceeds from notes payable                         -     1,053,663             -        3,177,926
Payments on long-term debt                    (63,806)   (1,142,415)                    (1,396,894)
Reimbursement to founder and shareholder            -             -             -           (3,500)
Net cash provided by (used in)          ----------------------------------------------------------
 financing activities                         (56,329)    9,799,379    34,015,528       64,395,393 
                                        ----------------------------------------------------------                                 
 
Increase (decrease) in cash and cash       
 equivalents                               (6,254,262)    2,543,626    24,740,079       30,134,800
Cash and cash equivalents at beginning      
 of period                                  9,105,357     2,851,095     5,394,721                -
Cash and cash equivalents at end of     ----------------------------------------------------------  
 period                                   $ 2,851,095   $ 5,394,721   $30,134,800     $ 30,134,800
                                        ==========================================================
</TABLE>
See accompanying notes.

                                                                              12
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)

                         Notes to Financial Statements

                               December 31, 1996


1. BUSINESS ACTIVITY

Optical Sensors Incorporated (the "Company") is a development stage company
engaged in developing, manufacturing and marketing fiberoptic chemical sensors
for blood gas monitoring for medically unstable patients in critical and
intensive care units. The Company was incorporated on May 23, 1989 and
reincorporated in Delaware on January 4, 1996.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

CASH EQUIVALENTS

The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents. Investments classified as
cash equivalent consist primarily of commercial paper and municipal bonds. The
market value of investments is based on quoted market prices which approximates
cost.

INVENTORIES

Inventories consist of ABG modules and raw materials which are recorded at the 
lower of cost (FIFO basis) or market.

PROPERTY AND EQUIPMENT

Property and equipment are stated at cost. Depreciation is provided on a
straight-line basis over three to five years. Leasehold improvements are
amortized over the shorter of the term of the lease or life of the asset.

                                                                              13
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)


2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

PATENTS

Patents are stated at cost and are amortized upon issuance of a patent on a
straight-line basis over sixty months. The carrying value of patents will be
reviewed if the facts and circumstances suggest that it may be impaired. If this
review indicates that patent cost will not be recoverable, as determined based
on the undiscounted cash flows over the remaining amortization period, the
Company's carrying value of the patents will be reduced by the estimated
shortfall of cash flows.

INCOME TAXES

The Company accounts for income taxes using the liability method. Deferred
income taxes are provided for temporary differences between the financial
reporting and tax bases of assets and liabilities.

STOCK-BASED COMPENSATION

The Company follows Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees ("APB 25"), and related interpretations in accounting
for its stock options. Under APB 25, when the exercise price of stock options
equals the market price of the underlying stock on the date of grant, no
compensation expense is recognized.

In October 1995, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation
("Statement 123"). The Company adopted the disclosure only provisions of
Statement 123. Accordingly, the Company has made pro forma disclosures of what
net loss and loss per share would have been had the provisions of Statement 123
been applied to the Company's stock options.

                                                                              14
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)


2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

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 amounts reported in the financial statements and accompanying notes.
Actual results could differ from the estimates.

ACCOUNTING FOR LONG-LIVED ASSETS

The Company records losses on long-lived assets used in operations when
indicators of impairment are present and the undiscounted cash flows estimated
to be generated by those assets are less than the assets' carrying amount.

NET LOSS PER SHARE

Net loss per share is computed using the weighted average number of common
shares outstanding. Common equivalent shares from stock options and warrants are
excluded from the computation as their effect is antidilutive except that,
pursuant to the Securities and Exchange and Exchange Commission (SEC) Staff
Accounting Bulletins, common and common equivalent shares issued during the
period beginning twelve months prior to the filing of the Company's initial
public offering at prices substantially below the public offering price have
been included in the calculation as if they were outstanding for all periods
prior to the initial public offering presented (using the treasury stock method
and the public offering price for stock options, warrants and the if-converted
method for convertible preferred stock).

3. SALES OF COMMON STOCK

In 1989, the Company issued 4,930 shares of Common Stock in exchange for a
release from a covenant not to compete. The non-compete covenant related to the
founder's position of president with a former company.

                                                                              15
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)


3. SALES OF COMMON STOCK (CONTINUED)

Also, in 1989 and 1990, the Company sold 93,789 shares of Common Stock in a
private placement for $844,100 less related costs of $121,502 plus 6,260 shares
of Common Stock issued at $9.00 per share for services provided in the private
placement. Additionally, in July 1990, the Company sold 16,667 shares of Common
Stock for $150,000 related to the same offering.

4. CONVERTIBLE PREFERRED STOCK

In February 1991, the Company created a new class of stock, Convertible
Preferred Stock, Series A. From March 1991 to November 1991, the Company sold
94,370 shares of this new class at $11.25 per share for a total consideration of
$1,062,500, less related offering costs of $49,904. Each share sold includes a
warrant to purchase one-fifth of a share of Common Stock at $11.25 per share.
The shares had a liquidation preference of $11.25 per share.

In April 1992, the Company created a new class of Preferred Stock, Convertible
Preferred Stock, Series B. From April 1992 to July 1992, the Company sold
418,387 shares of this new class at $12.60 per share for a total consideration
of $5,271,676 less related offering costs of $93,903. Each share sold includes a
warrant to purchase one-fourth of a share of Common Stock at $12.60 per share.
The shares had a liquidation preference of $12.60 per share. See Note 5 for
cancellation of related bridge loans.

In June 1993, the Company created a new class of Preferred Stock, Convertible
Preferred Stock, Series C. From June 1993 to September 1993, the Company sold
958,200 shares of this new class at $12.60 per share for a total consideration
of $12,073,752 less related offering costs of $815,320. In connection with the
sale thereof, the Company issued warrants to a placement agent to purchase
79,869 shares of Common Stock at $7.38 per share. The shares had liquidation
preference of $12.60 per share. See Note 5 for cancellation of related bridge
loans.

                                                                              16
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)



4. CONVERTIBLE PREFERRED STOCK (CONTINUED)

In July 1995, the Company created a new class of Preferred Stock, Convertible
Preferred Stock, Series D. From July 1995 to September 1995, the Company sold
2,210,828 shares of this new class at $3.15 per share for a total consideration
of $6,963,946 less related offering costs of $88,501. The shares also had a
liquidation preference of $3.15 per share. See Note 5 for cancellation or
conversion of related bridge loans.

On November 28, 1995, the Company sold an aggregate of 370,338 shares of Series
E Preferred Stock to certain existing shareholders, pursuant to the Company's
Series E Convertible Preferred Stock Purchase Agreement, at a price of $8.10 per
share for a total consideration of $3,000,000 less related offering costs of
$33,660. These shares had a liquidation preference of $8.10 per share.

The Company completed an initial public offering of Common Stock in 1996 in
which it sold 2,875,000 shares of Common Stock, resulting in net proceeds of
$33,915,782. 

At the time of the initial public offering, all shares of outstanding Preferred
Stock were converted into an aggregate of 4,766,974 shares of Common Stock.

5. NOTES PAYABLE

In 1989, the Company received working capital loans totaling $110,000. The notes
bore interest at an annual rate of 12%. In April 1990, notes totaling $85,000
plus the accrued interest of $4,396 were converted to Common Stock at a
conversion price of $4.50 per share. In November 1990, the remaining note
totaling $25,000 plus the accrued interest of $3,000 was converted to Common
Stock at a conversion price of $4.50 per share.

                                                                              17
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)



5. NOTES PAYABLE (CONTINUED)

In 1991, the Company received working capital convertible bridge loans totaling
$220,000. One of the notes for $50,000 was from a company that is owned by a
Company Director. In 1992, the Company received an additional $780,000 of
working capital convertible bridge loans. The notes bore interest at an annual
rate of 2% over the First Bank National Association reference rate. Upon the
completion of the sale of Series B Convertible Preferred Stock on April 28,
1992, the convertible bridge loans of $1,000,000 plus the accrued interest of
$22,227 were automatically canceled as payment for 81,129 shares of Series B
Convertible Preferred Stock at a price of $12.60 per share. In consideration of
the purchase of the notes, the Company issued warrants to the investors to
purchase 24,076 shares of Common Stock at $9.00 per share.

In 1993, the Company received working capital convertible bridge loans totaling
$999,933. The notes bore interest at an annual rate of 8%. Upon completion of
the sale of Series C Convertible Preferred Stock, bridge loans of $999,933 plus
the accrued interest of $5,789 were automatically canceled as payment for 79,817
shares of Series C Convertible Preferred Stock at a price of $12.60 per share.
In consideration of the purchase of the notes, the Company issued warrants to
the investors to purchase 26,871 shares of Common Stock at $12.60 per share.

In 1995, the Company received working capital convertible bridge loans totaling
$967,887. The notes bore interest at an annual rate of 8%. Upon completion of
the sale of Series D Convertible Preferred Stock, bridge loans of $967,887, plus
the accrued interest of $10,909, were automatically canceled or converted into
310,645 shares of Series D Convertible Preferred Stock at a price of $3.15 per
share. In consideration of the purchase of the notes, the Company issued
warrants to the investors to purchase 61,429 shares of Common Stock at $3.15 per
share.

                                                                              18
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)



6. LEASES

The Company leases its office and research and development facility under an
operating lease that expires on November 30, 1999. Operating expenses, including
maintenance, utilities, real estate taxes and insurance, are paid by the
Company. The Company also leases certain office equipment under operating
leases.

In November 1992, the Company entered into an operating lease for capital
equipment, which included a sale leaseback transaction. The Company recognized a
loss on the sale leaseback of approximately $39,000. The loss has been deferred
and was amortized over the term of the lease as an increase of rental expense.
Under the lease agreement, the Company is allowed to lease up to $1,000,000 of
equipment between November 5, 1992 and May 4, 1994. Assets leased under the
agreement at December 31, 1995 and 1996 were approximately $1,002,000. The term
of the lease is 42 months with payments due the first of each month. Rental
payments are based on the total amount of equipment leased each month.

In March 1994, the Company entered into two lease transactions. Under the lease
agreements, the Company was allowed to lease up to $1,350,000 and $150,000,
respectively, of equipment between April 1, 1994 and April 1, 1995. Assets
leased under the agreement at December 31, 1996 were approximately $462,000 and
$79,000, respectively. Terms of the lease are 42 and 33 months, respectively,
with payments due the first of each month. Rental payments are based on the
total amount of equipment leased each month.

In August 1995, the Company entered into an equipment lease agreement in which
$500,000 became available immediately to the Company and the remaining balance
of $475,000 became available after the Company received FDA marketing clearance
for its product. Assets leased under the agreement at December 31, 1996 were
approximately $799,267. The term of the lease is 42 months with payments due the
first of each month. Rent payments are based on the total amount of equipment
leased each month.

Total rent expense under operating leases was $585,000, $765,000 and $921,000
for the years ended December 31, 1994, 1995 and 1996, respectively.

                                                                              19
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)



6. LEASES (CONTINUED)

Future minimum lease payments under noncancelable operating leases with initial
or remaining terms of one year or more as of December 31, 1996 are as follows:
<TABLE>
<CAPTION>
 
Year ending December 31:
<S>                         <C>
  1997                      $  660,000
  1998                         475,000
  1999                         372,000
  2000                          32,000
                          ------------
                            $1,539,000
                          ============
</TABLE>
7. INCOME TAXES

At December 31, 1996, the Company had cumulative net operating loss
carryforwards for tax purposes of approximately $32,300,000 plus research and
development tax credit carryforwards of approximately $1,000,000. These
carryforwards are available to offset future taxable income through 2011.

As a result of the sales of Preferred Stock and additional shares of Common
Stock, the Company has experienced a change in ownership under the net operating
loss limitation rules. The use of losses, incurred through the change in
ownership date, to offset future taxable income, will be limited during the
carryforward period. The credits will also be subject to limitations under these
same rules.

                                                                              20
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)



7. INCOME TAXES (CONTINUED)

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amount of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities are as follows:
<TABLE>
<CAPTION>
 
                                                  DECEMBER 31
                                              1996           1995
                                        -----------------------------
<S>                                       <C>            <C>
Deferred tax assets:
 Net operating loss carryforwards         $ 11,900,000   $  8,900,000
 Tax credit carryforwards                    1,000,000        800,000
 Deferred compensation on stock options        604,000        373,000
 Vacation accrual                               71,000         69,000
 Book over tax depreciation                     98,000         69,000
 Other                                                          1,000
                                        -----------------------------
 
Total deferred tax assets                   13,673,000     10,212,000
 
Deferred tax liabilities:
 Deferred loss on sale leaseback                     -          2,000
                                        -----------------------------
Total deferred tax liabilities                       -          2,000
                                        -----------------------------
 
Net deferred tax assets                     13,673,000     10,210,000
Valuation allowance                        (13,673,000)   (10,210,000)
                                        -----------------------------
                                          $          -   $          -
                                        =============================
</TABLE>

                                                                              21
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)



8. STOCK OPTIONS AND WARRANTS

The Company has three stock option plans that include both incentive and non-
statutory stock options to be granted to directors, officers, employees and
consultants of the Company. Option activity is summarized as follows:
<TABLE>
<CAPTION>
                                                                    WEIGHTED
                                                                     AVERAGE
                                            SHARES                  EXERCISE
                                          AVAILABLE     OPTIONS     PRICE PER
                                          FOR GRANT   OUTSTANDING     SHARE
                                        -------------------------------------
 
<S>                                       <C>         <C>           <C>
 Balance at December 31, 1993                60,261       273,072       $9.05
  Additional shares reserved for             51,556                      9.00
   issuance
  Granted--incentive stock options          (83,687)       83,687        9.00
  Granted--non-statutory stock options       (1,498)        1,498        9.00
  Options canceled                           15,650       (15,650)       9.00
                                        -------------------------------------
 Balance at December 31, 1994                42,282       342,607        9.04
  Additional shares reserved                948,444 
  Granted--incentive stock options         (698,666)      698,666        1.25
  Granted--non-statutory stock options     (289,240)      289,240         .94
  Options canceled                          305,854      (305,854)       8.83
  Options exercised                                      (319,861)        .91
                                        -------------------------------------
 Balance at December 31, 1995               308,674       704,798        1.80
  Granted--incentive stock options         (151,650)      151,650        8.42
  Options canceled                           36,140       (36,140)       4.62
  Options exercised                                       (86,300)        .94
                                        -------------------------------------
 Balance at December 31, 1996               193,164       734,008       $3.11
                                        =====================================
</TABLE>

                                                                              22
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)



8. STOCK OPTIONS AND WARRANTS (CONTINUED)

The weighted average fair value of options granted is summarized as follows:
<TABLE>
<CAPTION>
 
                                 1996   1995
                               --------------
 
<S>                              <C>    <C>
 Stock price = exercise price    $5.22  $4.03
 Stock price > exercise price     5.36   2.70
</TABLE>
The exercise price of options outstanding at December 31, 1996 ranged from $.90
to $13.00 per share, as summarized in the following table:
<TABLE>
<CAPTION>
 
                                                        WEIGHTED AVERAGE        NUMBER OF              WEIGHTED 
         RANGE OF            SHARES OUTSTANDING AT           REMAINING            SHARES             AVERAGE EXERCISE
      EXERCISE PRICE           DECEMBER 31, 1996          CONTRACTUAL LIFE      EXERCISABLE           PRICE PER SHARE
----------------------------------------------------------------------------------------------------------------------
                                                                                                                      
<S>                          <C>                       <C>                  <C>                         <C>           
$  .90 to $  5.00                     538,619             8.54 years           155,015                    $1.13       
 5.01 to   9.00                       139,009             9.23                  34,528                     8.94       
 9.01 to 13.00                         56,380             7.87                  14,110                     9.90       
                              ----------------------------------------------------------------------------------------
Total                                 734,008             8.62 years           203,653                    $3.06       
                              ========================================================================================
</TABLE>
The number of shares exercisable at December 31, 1994 and 1995 was 154,240 and
197,887 respectively at a weighted average exercise price of $9.08 and $1.90 per
share, respectively.

Pro forma information regarding net loss and loss per share is required by
Statement 123, and has been determined as if the Company had accounted for its
employee stock options under the fair value method of Statement 123. The fair
value for these options was estimated at the date of grant using a minimum value
option pricing model with the following weighted-average assumptions for 1996
and 1995, respectively: risk-free interest rates ranging from 5.5% to 6.3%,
volatility factor of the expected market price of the Company's Common Stock of
 .79 and a weighted-average expected life of the option of 7 years.

                                                                              23
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)  


8. STOCK OPTIONS AND WARRANTS (CONTINUED)

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. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value statement, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its employee
stock options.

For purposes of pro forma disclosures, the estimated fair value of the options 
is amortized to expense over the options' vesting period. The Company's pro 
forma information is as follows:

<TABLE> 
<CAPTION> 
                                                        1995           1996
                                                    --------------------------
<S>                                                 <C>           <C> 
Pro forma net loss                                  $ 8,131,017   $ 9,451,264
Pro forma net loss per common share                 $      2.70   $      1.31
</TABLE> 

These pro forma amounts may not be indicative of future years' amounts since the
Statement provides for a phase-in of option values beginning with those granted
in 1995.

At December 31, 1996, the Company has total exercisable warrants outstanding to
purchase shares of its Common Stock as follows: 2,777 shares at $.90 per share,
71,706 shares at $3.15 per share, 79,869 shares at $7.38 per share, 36,298
shares at $9.00 per share, 9,095 shares at $11.25 per share and 151,730 shares
at $12.60 per share. These warrants expire at various dates in 1997 through
2001.

DEFERRED COMPENSATION

For options granted during the period June 17, 1995 through October 3, 1995 to
purchase a total of 971,640 shares of Common Stock at exercise prices ranging
from $.90 to $2.70 per share in August 1995, the Company recognized $2,179,693
as deferred compensation for the excess of the deemed value for accounting
purposes of the Common Stock issuable upon exercise of such options over the
aggregate exercise price of such options. The deferred compensation expense is
amortized ratably over the vesting period of the options. Deferred compensation
expense was $1,008,467 and $623,452 for the years ended December 31, 1995 and
1996, respectively.

                                                                              24
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)      

 
8. STOCK OPTIONS AND WARRANTS (CONTINUED)

The remaining unamortized deferred compensation is expected to be charged to
operations as follows:
<TABLE>
 
<S>                      <C>
  1997                   $325,984
  1998                    166,186
  1999                     55,604
                       ----------
                         $547,774
                       ==========
</TABLE>
9. LICENSE AGREEMENTS

In June 1991, the Company entered into a license agreement to license certain
fiberoptic chemical sensor technology from another licensor. In consideration
for the technology, the Company agreed to pay $88,000 upon execution of the
agreement and executed a promissory note in the amount of $352,000 payable in
four equal amounts annually. In June 1995, the final payment was made on the
promissory note. The Company does not intend to use the technology in the future
and, therefore, does not anticipate paying any royalties under the agreement.

In August 1991, the Company entered into an agreement to purchase additional
fiberoptic chemical sensor technology for $10,000. In addition, the Company
issued 2,778 shares of Common Stock to the licensor upon assignment of the
technology. The Company also issued a warrant to the licensor to purchase 2,777
shares of Common Stock which may be exercised if sales of product that are based
significantly on the technology acquired aggregate $1,000,000. In addition, the
Company has agreed to pay royalties on sales of industrial and environmental
products for which the technology purchased is a significant part. The royalties
shall be 5%, 4% and 3% on the first, second and third $10 million sales
increments and 2% on sales in excess of $40 million. For sales of such products
by any future licensees of the Company, the Company shall pay 25% of all
licensing fees received up to $500,000 and 10% thereafter. The Company has made
all payments for the technology. The Company does not intend to use the
technology in the future and, therefore, does not anticipate paying any
royalties under the agreement.

                                                                              25
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)      


9. LICENSE AGREEMENTS (CONTINUED)

In October of 1994, the Company entered into an agreement to have certain
mathematical models developed related to chemical sensor technology. In
consideration for the mathematical models, the Company has agreed to pay a fee
of $45,000, payable in four installments of $11,250 beginning October 1, 1994.
The Company has made all payments under the agreement. This agreement can be
canceled with a 90 day notice.

In September 1995, the Company entered into an agreement to acquire technology
and the exclusive worldwide right to transfer and exploit such technology. In
consideration for the technology, the Company has agreed to pay $2,000,000
payable as follows: $500,000 upon execution of the agreement, $500,000 upon
completion of the technology, $500,000 once the product has been sold and
installed in 20 hospitals and $500,000 once the product has been sold and
installed in an additional 50 hospitals. The Company also agreed to pay $50,000
per month for engineering and technical support from August 1, 1995 through
January 31, 1996. As of December 31, 1996, the Company has $1,000,000 remaining
under this agreement which directly relates to products sold.

                                                                              26
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)


10. EMPLOYMENT AGREEMENT

The Company has an employment agreement ("agreement") with the President and
Chief Executive Officer of the Company. The agreement provides for a base salary
currently at $185,000 per year, which may be increased by the Board of Directors
and provides for an annual incentive bonus in an amount not less than 20% of the
base salary if the Company reaches milestones agreed to by the Board and the
President. The President also receives an automobile allowance of $500 per
month. The agreement requires the President to assign to the Company patents and
other proprietary rights related to the Company's business and to keep the
Company's proprietary information confidential. The President is also prohibited
from competing with the Company for a period of one year following termination
of employment with the Company. Additionally, the agreement provides for
severance pay equal to twelve months of base salary if the President is
terminated without cause.

In connection with the employment agreement, the Company granted the President
options to purchase 121,162 shares of Common Stock at a price of $9.00 per
share. In August of 1995, these options were canceled, and the Board of
Directors granted the President a non-statutory option to purchase 272,222
shares of Common stock at a price of $.90 per share.

In September 1995, the President exercised this option under the Company's 1991
Stock Option Plan to purchase 272,222 shares of Common Stock at a price of $.90
per share. The right to retain certain of the shares is subject to the
President's continued employment through August 2, 1999. As payment for the
shares, the President executed a $245,000 promissory note, payable in full on
August 1, 1998, at an interest rate of 5.91%. The note is secured by the shares
of Common Stock and proceeds of any dividend or other distribution attributable
to the shares.

                                                                              27
<PAGE>
 
                         Optical Sensors Incorporated
                         (A Development Stage Company)


                   Notes to Financial Statements (Continued)        


11. EMPLOYEE BENEFIT PLANS

In July 1992, the Company adopted a 401(k) savings plan. Employees employed on
July 1, 1992 were automatically eligible to participate and employees hired
after July 1, 1992 are eligible to participate after six months of service and
attaining the age of 21. Employees may contribute up to the maximum amount which
will not violate provisions of the Plan or cause the Plan to exceed the maximum
amount allowable as a deduction to the employer. The Company, at its discretion,
may make matching contributions equal to a percentage of the employee's
contribution. The Company did not contribute to the Plan in 1994, 1995 or 1996.

                                                                              28