<PAGE>   1

                     SECURITIES AND EXCHANGE COMMISSION
                           WASHINGTON, D.C.  20549

                         ---------------------------
                                   FORM 10-K
              ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                        SECURITIES EXCHANGE ACT OF 1934

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<S>                                                <C>
For the fiscal year ended:  SEPTEMBER 30, 1996     Commission File Number:  1-12238
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                               MHM SERVICES, INC.
             (Exact name of Registrant as specified in its charter)

             DELAWARE                                                52-1223048
(State or other jurisdiction of             (I.R.S. Employer Identification No.)
incorporation or organization)

8000 TOWERS CRESCENT DRIVE, SUITE 810, VIENNA, VIRGINIA                22182
(Address of principal executive offices)                            (Zip Code)

Registrant's telephone number, including area code:  (703) 749-4600

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

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<CAPTION>
                                                                 Name of each exchange
Title of each class                                                on which registered  
--------------------------------------------------------------------------------------
<S>                                                              <C>
COMMON STOCK, PAR VALUE $.01 PER SHARE                           AMERICAN STOCK EXCHANGE
</TABLE>

Securities registered pursuant to Section 12(g) of the Act:  NONE

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

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

The aggregate market value of the Registrant's voting stock held by
nonaffiliates (based upon the closing price of $.375) on December 30, 1996, was
approximately $700,000.  As of December 30, 1996, there were 3,310,448 shares
of Common Stock, par value $.01 per share, outstanding.

                      DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant's Proxy Statement for the Annual Meeting of
Stockholders to be held in 1997 are incorporated by reference into Part III.
The Index to Exhibits begins on page 55.





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<PAGE>   2


                                     PART I


ITEM 1.  BUSINESS

GENERAL

         MHM Services, Inc., through its wholly-owned subsidiaries, MHM of
Colorado, Inc. ("Hospital Division") and MHM Extended Care Services, Inc.
("Extended Care Services Division")  (collectively, the "Company"), offers,
arranges for and manages nonacute healthcare services primarily in
institutional settings.  Since its founding, the Company's goal has been to
offer the highest quality, cost-effective care in the industry.  Until April
1996, the Company's Hospital Division operated seven freestanding psychiatric
and substance abuse facilities, which generated 86% of the Company's net
revenues for fiscal 1995, and had comprised 77% of the Company's total assets
at the end of fiscal 1995.  As a result of the sale of five of the freestanding
facilities in May 1996, and one facility in April 1996, the Hospital Division
represented only 67% of net revenues for fiscal 1996.  See "Sale of
Freestanding Facilities/Continued Operation of Mountain Crest Hospital."  The
Company's Extended Care Services Division provides specialized medical and
behavioral healthcare services to residents of approximately 655 nursing homes
in ten states, and, through its MHM Counseling Services division, provides a
wide range of outpatient behavioral healthcare services to children,
adolescents, adults and families in multiple clinics located in Massachusetts
as well as in home-based and outreach locations, including public schools,
nursing homes, vocational centers, day treatment centers, assisted living
facilities, group homes, rehabilitation hospitals, dialysis centers, and
workshops for the developmentally delayed.  The Extended Care Services Division
also provides behavioral healthcare services to more than 2,000 Medicaid
patients residing in nursing homes under a contract with the State of Georgia.

         Historically, the Company's principal businesses were the operation of
freestanding behavioral healthcare facilities and the management of behavioral
healthcare programs under contracts with acute care hospitals.  The market for
behavioral healthcare has undergone dramatic changes in recent years.  Pressure
on providers to reduce costs has resulted in an increase in the development and
utilization of alternatives to long-term in-patient care, and a decrease in the
utilization of in-patient care and reimbursement rates.  With market forces
emphasizing managed care approaches to healthcare, this trend is anticipated to
continue.

         In response to these changes and their adverse impact on the Company's
operating results, significant changes have been made in the structure of the
Company's operations over the past several years.  In 1994, the Company merged
its contract management business (which represented 29% of the Company's net
revenues in fiscal 1994) with a competitor through the creation of a joint
venture.  In 1995, the Company sold its interest in the joint venture to such
competitor.  In addition, the Company sold six of its seven freestanding
facilities by May 1996 which represented 51% of the Company's net revenue in
fiscal 1996.  Further, the Company decided to pursue a growth strategy focused
on its Extended Care Services Division (which represented 33% and 14% of the
Company's net revenues in fiscal 1996 and 1995, respectively) through the
pursuit of non-physician practice acquisitions and management opportunities.

         As a result of the Company's continued negative operating results, as
well as reduced collections of accounts receivable, including reimbursement
review of certain Medicare claims in southern California, the Company has been
experiencing difficulty generating sufficient cash flows from operations to
meet its obligations and sustain its operations without the use of available
cash reserves.





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<PAGE>   3

The report of the Company's independent auditors on the Company's financial
statements at September 30, 1996, includes an explanatory paragraph which
states that such conditions raise substantial doubt as to the Company's ability
to continue as a going concern.  See "Item 7.  Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "Note 2 to the
Notes to Consolidated Financial Statements."  In a continuing effort to improve
this situation for both the immediate future and the long-term, the Company
sold certain assets relating to its Hospital Division, and is taking steps to
reduce operating expenses, finance its working capital requirements,
restructure debt, raise additional capital and improve its cash flows.
Nevertheless, there can be no assurance that the Company's efforts will result
in positive effects on the Company's financial condition.

SALE OF FREESTANDING FACILITIES/CONTINUED OPERATION OF MOUNTAIN CREST HOSPITAL

         On April 5, 1996, the Company sold Oakview Treatment Center to a
non-profit corporation affiliated with a privately-owned operator of two
psychiatric hospitals for $50,000 in cash and $2,150,000 evidenced by two
promissory notes payable to the Company.  The notes are payable in monthly
installments of principal and interest (at prime) based on a fifteen year
amortization, with the remaining principal due in five years (or earlier under
certain circumstances).  In connection with obtaining a waiver from MEDIQ
Incorporated ("MEDIQ") of an event of default provision of a note payable to
MEDIQ (the "MEDIQ Note") relating to the sale of the assets of a significant
subsidiary, the Company pledged one of the notes receivable (with a principal
balance of $1,875,000) as collateral for the Company's obligations under the
MEDIQ Note.  The Company is reviewing with counsel the validity of the MEDIQ
Note and its legal rights and remedies in the event the MEDIQ Note's validity
is litigated.  See "Item 7.  Management's Discussion and Analysis of Financial
Condition and Results of Operations."

         On May 31, 1996, the Company sold certain assets, consisting
principally of five of its freestanding behavioral healthcare facilities, to
Behavioral Healthcare Corporation, a Delaware corporation ("BHC"), with its
principal offices located in Nashville, Tennessee, pursuant to an Asset
Purchase Agreement (the "BHC Agreement"), dated as of January 24, 1996, and
amended as of April 11, 1996, by and between the Company and BHC (the "BHC
Sale").  The facilities were sold to BHC for approximately $10,209,000,
consisting of $9,049,000 in cash and $1,160,000 (reflecting post-closing
adjustments by both parties) in assumed liabilities of the freestanding
facilities.

         The Company used a portion of the proceeds from the BHC Sale for (i)
the repayment of the principal amount outstanding under the Company's revolving
credit facility ($2,515,000, including related early termination fees of
$174,000); (ii) the extinguishment of a portion of the indebtedness not assumed
by BHC ($692,000, including  early termination fees of $139,000), which
consisted primarily of indebtedness secured by certain of the assets
(particularly a facility and certain equipment) acquired by BHC; and (iii) the
funding of the Company's obligation to complete repairs to two of the
freestanding facilities in the amount of $284,000 (of which $216,000 remains in
escrow)  The Company expects to continue to use the remainder of the proceeds
from the BHC Sale for general working capital, which the Company anticipates
will include expansion of the Extended Care Services Division.  See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations."





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<PAGE>   4



         The Company's freestanding behavioral healthcare facilities
represented 86% and 68% of net revenues for the years ended September 30, 1995
and 1994, respectively.  As a result of the sale of six facilities in 1996, the
freestanding behavioral healthcare facilities represented only 67% of net
revenues for fiscal 1996.

         The Company continues to operate Mountain Crest Hospital a 60-bed
psychiatric hospital located in Fort Collins, Colorado, which also operates
seven alternative care programs for adult, adolescent and geriatric patients,
and serves communities in Colorado.  The Company commenced operating this
facility in August 1994 pursuant to a sublease agreement.  Mountain Crest
Hospital represented 16% of the Company's net revenue in fiscal 1996.  See
"Item 2.  Properties."  As a result of Mountain Crest Hospital's positive
contribution to the Company's operating income, the Company has decided not to
actively seek a buyer for its sole remaining hospital.  The Company anticipates
that Mountain Crest Hospital will contribute approximately 25-35% of the
Company's net revenues in fiscal 1997.

         Mountain Crest Hospital is subject to compliance with various federal,
state and local statutes and regulations, including requirements relating to
facility use, licensure and inspection requirements, licensing or certification
requirements of federal, state and local health agencies and industry
accreditation agencies, such as the Joint Commission on Accreditation of
Healthcare Organizations ("JCAHO").  Mountain Crest Hospital is JCAHO
accredited.

         Many states also have statutory requirements, known as certificate of
need laws, intended to avoid the proliferation of unnecessary or under-utilized
healthcare services and facilities by requiring a healthcare facility to obtain
approval prior to offering services or undertaking certain acts. Mountain Crest
Hospital has obtained the necessary certificate of need approval, and the
Company believes it is operating in compliance with the conditions of such
approval.  Facilities used for healthcare programs must also comply with
licensing requirements of federal, state and local health agencies, and with
the requirements of municipal building, health and fire codes.  In granting and
renewing a facility's license, state health agencies generally consider, among
other factors, the physical condition of the facility, the type of services
offered by the facility, the qualifications of administrative and professional
staff, the quality of professional and other services, and the continuing
compliance of such facility with the laws and regulations applicable to its
operations.  Licensing, certificate of need, reimbursement and other applicable
regulations vary by jurisdiction and are subject to change.  The Company
believes that the Mountain Crest Hospital is materially in compliance with all
applicable requirements.  The Company is not able to predict the impact of
future changes in regulations affecting the industry.

         Many healthcare providers receive reimbursement under one or more of
the Medicare or Medicaid programs for behavioral healthcare services.  The
Company is reimbursed under such programs for services provided at Mountain
Crest Hospital.  In order to receive reimbursement under such programs, each
facility must meet applicable requirements promulgated by the United States
Department of Health and Human Services relating to the type of facility, the
qualifications and requirements of personnel, standards of patient care and
compliance with applicable state and local laws, rules and regulations.  The
Company believes that Mountain Crest Hospital, which is currently subject to
such certification, is materially in compliance with all applicable
requirements.

         The Medicare prospective payment system uses predetermined
reimbursement rates based upon diagnosis-related groups ("DRGs").  The DRG
system established fixed payment amounts per discharge diagnoses generally
provided by acute care hospitals.  Mountain Crest Hospital is currently exempt
from the DRG system.  It is possible that, in the future, mental health
programs could be included in the DRG





                                      4
<PAGE>   5



system.  The Company is not able to predict the impact, if any, on its business
or operations of such a change in the Medicare reimbursement system.

         Federal law contains certain provisions designed to ensure that
services rendered by healthcare providers to Medicare and Medicaid patients are
medically necessary and meet professionally recognized standards.  Those
provisions include a requirement that admissions of Medicare and Medicaid
patients to hospitals must be reviewed in a timely manner to determine medical
necessity.  In addition, these provisions state that a hospital may be required
to reimburse the government for the cost of Medicare paid services determined
by a peer review organization to have been medically unnecessary.  Mountain
Crest Hospital has quality assurance programs and procedures for utilization
review and retrospective patient care evaluation.  Various state and federal
laws regulate the relationships between providers of healthcare services and
referral sources.  Among these laws are the Medicare and Medicaid anti-fraud
and abuse provisions (the "Fraud and Abuse Statute").  The Fraud and Abuse
Statute prohibits individuals or entities participating in the Medicare or
Medicaid programs from knowingly and willfully offering, paying, soliciting, or
receiving remuneration in order to induce referrals for items or services
reimbursed under those programs.  The policy objective of this statute is to
ensure that the purpose for a referral is quality of care and not monetary gain
by the referring individual.  This prohibition applies to Medicare patients,
Medicaid patients and other beneficiaries of certain federally-funded programs,
and imposes felony criminal penalties and civil sanctions, as well as exclusion
from the Medicare or Medicaid programs, for violations.  This provision also
sets forth certain specific exceptions to the general prohibition, and
authorizes the Department of Health and Human Services to promulgate, by
regulation, additional payment practices (known as "safe harbors") which will
be immune from prosecution.  In 1991, regulations were issued creating certain
"safe harbors" for relationships between healthcare providers and referral
sources.  Any relationship that satisfies the terms of a safe harbor is
protected from criminal prosecution and civil sanctions.  Failure to satisfy
the requirements of a safe harbor does not necessarily mean that the
relationship is prohibited; rather, the failure to fit within a safe harbor
means the arrangement is not immune from scrutiny and the possibility of
punishment.  The Company has agreements with the physicians who provide
professional services at Mountain Crest Hospital, which generally provide for
payments to such persons by the Company as compensation for their
administrative services.  The Company believes that its relationships comply
with the Fraud and Abuse Statute provisions and the safe harbor regulations,
and has an on-going compliance monitoring program.

         The Omnibus Budget Reconciliation Act of 1993 includes provisions
prohibiting certain physician referrals.  These provisions ("Stark II")
prohibit a physician who has a financial relationship with an entity from
referring to that entity for the furnishing of "designated health services" for
which payment would otherwise be made by Medicare or Medicaid.  Furthermore,
the entity may not present a claim or bill an individual, third party payor or
other entity for "designated health services" furnished pursuant to such a
referral.  Inpatient and outpatient hospital services are specifically included
in the definition of "designated health services."

         Although the Fraud and Abuse Statute and Stark II prohibitions apply
to Medicare patients, Medicaid patients and other beneficiaries of certain
federally-funded programs, many state laws extend





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the prohibition to all payors.  The Company believes its relationships comply
with all state and federal statutes and regulations restricting patient
referrals.

         There are federal, state and local regulations relating to certain
aspects of the Company's business, including civil commitment of patients to
psychiatric programs and disclosure of information concerning patient
treatments.  Many states have adopted "patient bill of rights" regulations
which set forth standards for least restrictive treatment, patient
confidentiality, patient access to mail and telephones, patient access to legal
counsel and requirements that patients be treated with dignity.  Moreover, many
states have reporting requirements and procedures.  The Company's facilities
have adopted and implemented policies and procedures consistent with such
regulations.

         In recent years, media and public attention has been focused on
allegations of fraudulent practices related to the nature and duration of
patient treatments and related billing practices by certain psychiatric care
providers.  These alleged practices have been the subject of federal and state
investigations, as well as legal proceedings.  Although not involving the
Company, there is a possibility that such activities and investigations could
have a negative impact on the entire industry.  The Company is not able to
determine the extent of such impact, if any, on the Company's business or
operations.  Several large companies have suffered financial difficulties
resulting from their psychiatric care operations.  These companies have been
prompted to sell, close or convert to other uses many facilities throughout the
United States.

SALE OF CONTRACT MANAGEMENT BUSINESS

         In August 1994, the Company combined its contract management business
with that of Horizon Mental Health Services, Inc.  ("Horizon") of Denton, Texas
through the formation of a new company, Horizon Mental Health Management,
L.L.C. (the "Joint Venture").  The Joint Venture, owned 27.5% by the Company
and 72.5% by Horizon, managed over 150 in-patient and alternative mental health
programs for acute care  hospitals located in 34 states, and was the leading
contract manager of mental health programs offered by general acute care
hospitals in the United States.  In March 1995, Horizon completed an initial
public offering of its stock and, in accordance with the terms of the Joint
Venture agreement, acquired the Company's interest in the Joint Venture for
approximately $9,600,000 (net of related expenses).  The sale resulted in a
gain of approximately $500,000 (net of income taxes of $3,000,000).  In
connection with the sale, the Company assigned to Horizon all of its rights and
interests in its management contracts, including related accounts receivable.
The Company's contract management business represented approximately 29% of net
revenues for the year ended September 30, 1994.  See "Item 7.  Management's
Discussion and Analysis of Financial Condition and Results of Operations."

EXTENDED CARE SERVICES DIVISION

         General.  The Company's Extended Care Services Division represented
approximately 33% and 14% of net revenues for the years ended September 30,
1996 and 1995, respectively.  The increase resulted from the Company's sale of
six of its seven freestanding facilities and the growth in the business of the
Extended Care Services Division, primarily relating to certain acquisitions.
Going forward, the Company's strategy is to continue to grow its Extended Care
Services Division through internal expansion and acquisitions.  Subsequent to 
September 30, 1996, the Company acquired Liberty Bay Colony Health





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Services, Inc.'s. extended care operations servicing approximately 60 extended
care facilities in Massachusetts.  See "Item 7.  Management's Discussion and
Analysis of Financial Condition and Results of Operations."  The Company
believes that this strategy will enable the Company to establish regional
low-cost provider networks and secure contracts with managed care and other
third party payors at competitive rates.

         The Company's Extended Care Services Division was formed in October
1993 to pursue opportunities to provide on-site care to nursing home residents
and other patients needing less acute care.  In November 1993, the Company
acquired the assets of Atlanta-based ICH Services, L.L.C. (successor to HCI
Services, Inc.), which provides behavioral health and other specialized medical
services to residents of extended care facilities, such as nursing homes,
skilled nursing facilities and assisted living facilities.  See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of
Operations."

         The focus of the Company's on-site medical and behavioral healthcare
service programs is to arrange for the provision of clinically-appropriate
cost-effective care to residents of extended care facilities.  The aim of the
programs is to maximize the level of functioning and improve the quality of
life of residents, as well as decrease the frequency and duration of in-patient
treatment.

         The market for specialized medical and behavioral healthcare services
for residents of extended care facilities has benefitted from adoption of the
Omnibus Budget Reconciliation Act ("OBRA") by the Federal government in 1987
(as amended in 1989, 1992 and 1996).  OBRA  mandated that all long-term care
facilities make mental health and other specialized medical services, such as
dental, podiatry and optometry, available to their residents in order for the
facility to continue to be certified for Medicare and Medicaid.  OBRA also
created the requirement for Pre-Admission Screening and Annual Resident Review
("PASARR") of nursing home residents to evaluate their physical and mental
health prior to admission and annually thereafter.  The 1996 OBRA amendments
repealed the annual review of mentally ill and mentally retarded residents of
nursing facilities but required such facilities to promptly notify appropriate
state authorities after a significant change in the physical or mental
condition of a resident who is mentally ill or mentally retarded and mandated
that an assessment review be conducted of the resident after such notification.

         In the fourth quarter of fiscal 1994, the Extended Care Services
Division began providing mental health services to Medicaid patients residing
in nursing homes in the State of Georgia under a contract pursuant to the
PASARR Program.  This program was created by the State of Georgia to provide a
way for extended care facilities to comply with the OBRA mandate.  The contract
with the State of Georgia, which is for a term of three and one-half years, is
renewable on an annual basis.  In July 1996, the Company received notification
that it had been approved to commence the third year of the contract.  There is
no assurance that the Company will be successful in renewing the contract
following its termination in November 1997.  As of September 30, 1996,
Georgia's PASARR program included approximately 2,400 residents in 320 nursing
homes.  The Company believes that the Georgia contract could present a model
for other extended care facilities and other states to establish programs to
comply with OBRA.





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         Growth Strategy.  The internal expansion activities of the Extended
Care Services Division are designed to increase market share in existing
markets. The Company screens professional recruitment candidates by examining
their professional experience, business background, availability and other
factors.  The Company credentials all healthcare professionals to insure that
they satisfy applicable licensure, certification or registration requirements.
There can be no assurance that the Company will be successful in its efforts to
expand the operations of the Extended Care Services Division, or that the
Extended Care Services Division will generate operating profits.

         In addition, the Company believes that the Extended Care Services
Division provides a platform to expand into the non-physician practice
management business, providing management services to professionals such as
psychologists, social workers, nurses, dentists, podiatrists and optometrists.
The operations of the Extended Care Services Division comprise the principal
management services which can be provided to professionals to enhance their
efficiency and competitiveness by reducing the time spent on administration and
enabling increased clinical efforts.  Management services provided would
include billing, collections, marketing, payroll and other administrative
services.

         In furtherance of this strategy, the Company has completed several
acquisitions (described below), routinely reviews potential acquisition
candidates, and is pursuing other acquisition and management opportunities.
The Company plans to continue its expansion into the practice management
business, which is the thrust of the Company's long-term growth strategy, by
acquiring additional practices  and/or securing long-term management agreements
with additional practices.  Other than the Liberty Bay Colony Health Services
acquisition discussed below, the Company has not entered into definitive
agreements with respect to other acquisitions, and there can be no assurances
that any acquisitions will be completed or management opportunities will be
secured.  In addition, based upon the Company's limited liquidity and capital
resources, there can be no assurance that the Company will have sufficient
resources to pursue and/or complete any other acquisitions.  Depending upon the
availability of working capital, the Company's plans to further expand the
Extended Care Services Division could be extremely restricted, and the
Company's results of operations and financial condition may be adversely
affected.  See "Item 7.  Management's Discussion and Analysis of Financial
Condition and Results of Operations."

         Acquisition of SCC/Recent Determination to Discontinue Operations.  In
July 1995, the Company's Extended Care Services Division acquired certain
assets of Supportive Counseling Care ("SCC").  SCC, based in Manhattan Beach,
California, is a professional corporation which provided behavioral healthcare
services to residents of approximately 50 extended care facilities.  As
consideration for the acquired assets, the Company paid $500,000 in cash and
notes.  The Company's Extended Care Services Division also entered into a
40-year management contract to provide administrative services to SCC.  The
transaction represented expansion of the Company's operations into the West
Coast region and expansion into non-physician practice management.

         In November 1996, the Company decided to discontinue the operations of
SCC based upon SCC's continued operating losses and negative cash flow,
resulting in part from significant delays in Medicare reimbursement.  The
Company shut down SCC's operations in early December 1996.  Fixed assets of
approximately $12,000 will either be sold or redeployed elsewhere in the
Company.  All other SCC assets have been written off as of September 30, 1996.
See "Item 7.  Management's Discussion and Analysis of Financial Condition and
Results of Operations."

         Acquisition of Clinic Operations in Massachusetts (MHM Counseling
Services).  In December 1995, the Company's Extended Care Services Division
acquired the operations of several behavioral





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health clinics located in the metropolitan Boston, Massachusetts area from
National Mentor, Inc.  As consideration for the acquired assets, the Company
paid $150,000 in cash and agreed to pay $338,000 in 36 equal monthly
installments.  The main clinic in Charlestown, Massachusetts, and the one
satellite clinic in Taunton, Massachusetts, employ approximately 70 behavioral
health professionals, and provided clinical behavioral healthcare services to
approximately 1,400 patients in 1996.  The Company has changed the name of the
clinics to MHM Counseling Services.  MHM Counseling Services offers diverse
programs designed to meet the needs of often overlooked and underserved
populations:  school children, the mentally impaired and physically disabled,
those with chronic medical illnesses, and older adults.  Services can be
obtained at a number of convenient clinic sites across Massachusetts as well as
in home-based and outreach locations, including public schools, nursing homes,
vocational centers, day treatment centers, assisted living facilities, group
homes, rehabilitation hospitals, dialysis centers, and workshops for the
developmentally delayed.  The clinics provide scheduling, administration,
billing and marketing services.  The acquisition expanded the Company's
geographic reach  into Massachusetts and the Northeast region of the United
States.  The programs of the clinics also expand the Company's product
offerings, particularly in counseling services for schools.  The Company
further expects to add some of the clinics' product offerings to its existing
operations.

         Acquisition of Extended Care Operations in Massachusetts (Liberty
Bay).  Effective as of December 1, 1996, the Company's Extended Care Services
Division acquired, pursuant to an Agreement (the "Liberty Bay Agreement") by
and among the Company, MHM Extended Care Services, Inc., Liberty Bay Colony
Health Services, Inc ("Liberty Bay") and Liberty Management Group, Inc.
("Liberty Management"), certain assets and contractual rights from Liberty Bay
which constituted Liberty Bay's geropsychiatric management services operations
in Massachusetts.  Liberty Bay, a wholly-owned subsidiary of Liberty
Management, provided behavioral healthcare services on a contract basis to
residents of approximately 60 extended care facilities in Massachusetts.  The
Company has commenced integrating these operations with MHM Counseling
Services.  The combined operations will operate under the name "MHM/Bay Colony
Counseling Services", and, as a result of the acquisition, will serve
approximately 80 extended care facilities.  See "Item 7.  Management's
Discussion and Analysis of Financial Condition and Results of Operations."

         As consideration for the purchase, the Company paid Liberty Bay
$150,000 in cash and issued a promissory note in the principal amount of
$150,000 (the "Liberty Bay Note").  The Liberty Bay Note provides for quarterly
interest payments at an annual rate of 9% and the payment of the principal
amount in one installment on December 1, 1999.  The Company also agreed to pay
Liberty Bay additional consideration consisting of 20% of "cash flow" (as such
term is defined in the Liberty Bay Agreement) from the acquired contracts over
the five year period commencing December 1, 1996.  Such additional
consideration is payable annually by the Company and is calculated on a
contract-by-contract basis.

         Operations of the Extended Care Services Division.  In general, the
Company's extended care services are provided under annual contracts with
extended care facilities, which are typically cancelable upon thirty days
notice.  The Company schedules provider visits to the facilities and handles
billing and administration.  The Company's professionals visit the facilities
either on an as-needed basis or at regularly scheduled intervals.  The
obligations of the facility are generally limited to providing space in the
facility for the Company's professional to meet with residents and assisting
the Company in locating





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residents who may need care.  The Company's Extended Care Services Division
does not receive any compensation from the facility.  The services provided by
the Company's professionals are provided only as needed by the resident.  The
residents are not required by the facility or the Company to utilize the
Company's professionals.

         The healthcare professionals providing services under the Company's
programs are either employees of the Company or render their services on an
independent contract basis pursuant to annual agreements with the Company,
which typically are renewed automatically on an annual basis and cancelable
upon sixty days notice.

         As of December 15, 1996, the Extended Care Services Division
(including the operations of MHM/Bay Colony Counseling Services and  the
Georgia PASARR contract) had contracts to arrange for professionals (employed
by or under contract with the Company) to provide services (including mental
health, podiatric, optometry and dental services) to residents of 655 extended
care facilities in the following states:


<TABLE>
<CAPTION>
                State                                Number of Facilities
                -----                                --------------------
                                                                         
                                                                         
                <S>                                           <C>        
                Florida                                        17        
                Georgia                                       324        
                Indiana                                        54        
                Massachusetts                                  84        
                New Jersey                                      2        
                North Carolina                                125        
                Ohio                                            5        
                Pennsylvania                                    3        
                Tennessee                                      24        
                Virginia                                       17        
                                                              ---        
                                                                         
                                                                         
                Total                                         655        
                                                              ===        
</TABLE>


         The Extended Care Services Division competes with national, regional
and local companies which provide services to residents of extended care
facilities in a manner similar to that of the Company.  In addition, the
Company competes with community-based acute care hospitals which operate
programs to serve the needs of residents of extended care facilities, as well
as national hospital chains which have targeted this market for expansion.  The
Company also competes with regional and local behavioral healthcare and other
medical professionals (and their affiliated professional corporations) which
provide services in extended care facilities.  Some of the Company's
competitors are larger and have greater financial and other resources than the
Company.  The Company believes that competition in this business is primarily
on the basis of quality, range of services and availability of professionals.

         Based upon increased pressure to control healthcare costs and improve
operating efficiencies, the Company believes an opportunity exists for the
Company to consolidate the operations and management of regional and local
practices into provider networks.  The Company also competes for professional
practice acquisition and management opportunities with other practice
management businesses which are larger and have greater financial and other
resources than the Company.  The Company believes that





                                      10
<PAGE>   11



competition for acquisition and management opportunities is primarily on the
basis of price, terms of the transaction and value-added services that the
acquiror can provide to the practice.  There can be no assurance that the
Company will be able to successfully compete against such other businesses.

         The business of the Extended Care Services Division is affected by
federal, state and local laws and regulations concerning, among other matters,
professional licensure and reimbursement.  Licensing, reimbursement and other
applicable regulations vary by jurisdiction and are subject to change.  The
Company is not able to predict the impact of future changes in regulations
affecting the industry.  Certain of the services provided by the Company's
professionals to residents of extended care facilities are reimbursed under the
Medicare and/or Medicaid programs.  Accordingly, certain of the Company's
relationships and arrangements are subject to compliance with the Medicare and
Medicaid Fraud and Abuse Statute described above.  As mentioned, this statute
sets forth certain specific exceptions to the general prohibition, and
authorizes the Department of Health and Human Services to promulgate, by
regulation, additional payment practices (known as "safe harbors") which will
be immune from prosecution.  In 1991, regulations were issued creating certain
"safe harbors" for relationships between healthcare providers and referral
sources.  Any relationship that satisfies the terms of a safe harbor is
protected from criminal prosecution and civil sanctions.  However, failure to
satisfy the requirements of a safe harbor condition does not necessarily mean
that the relationship is prohibited; rather, the failure to fit within a safe
harbor means the arrangement is not immune from scrutiny and the possibility of
prosecution and sanctions.   The Company believes that its relationships comply
with the Fraud and Abuse Statute as well as all other state and federal
statutes and regulations restricting patient referrals.

         The services provided by the Company's Extended Care Services Division
are also reimbursed under the Medicare and/or Medicaid programs.  Certain of
such services are federally-mandated for residents of extended care facilities.
Any changes in Medicare and/or Medicaid reimbursement methodologies or program
mandates could have an adverse impact on the results of the Extended Care
Services Division.  See "Item 7.  Management's Discussion and Analysis of
Financial Condition and Results of Operations."

         Current Medicare regulations do not require a physician to certify the
need for outpatient mental health services for each patient (other than for
partial hospitalization treatment).  However, these regulations do require that
such services be part of an established plan of treatment.  Some of the fiscal
intermediaries administering the Medicare program in specific geographic
regions require a physician's referral and an established plan of treatment to
qualify for reimbursement for mental health services.

         The Company anticipates that some Medicaid administrators may contract
with managed care organizations to administer the delivery of care to Medicaid
participants.  The Company is implementing a marketing strategy to attract
managed care opportunities.  In this situation, the Company's Extended Care
Services Division and/or the professionals providing services at extended care
facilities under the Company's programs require approval by such managed care
organizations in order to receive reimbursement under the Medicaid programs.

         Psychiatrists, psychologists, social workers and nurses are required
to be licensed in the state or states in which they practice.  Licensure
requirements are administered by state agencies.  The





                                       11
<PAGE>   12


Company's screening process includes confirmation of necessary licensure, and
the Company continually monitors license status, as well as satisfaction of
continuing education and other related requirements.

         In certain states, the employment of psychiatrists, psychologists,
other mental healthcare professionals and other medical professionals by
business corporations is a permissible practice.  However, many states,
including some states in which the Company operates, prohibit or otherwise
limit business corporations, such as the Company, from providing behavioral
health and other medical services through the direct employment of
psychiatrists, psychologists and other professionals.  In such states, the
Company contracts with professional corporations owned by such professionals,
and arranges for the provision of such services.  The Company believes that the
operations of the Extended Care Services Division are structured in compliance
with such rules, or, if necessary, can be restructured in a cost-effective
manner.  However, there can be no assurance that other states in which the
Company operates will not enact similar or more restrictive legislation or
regulations.

EMPLOYEES

         As of December 15, 1996, the Company had 53 full-time employees and 43
part-time employees engaged in the operations of the Mountain Crest
freestanding facility and 154 full-time employees and 32 part-time  employees
engaged in the operations of the Extended Care Services Division (including
MHM/Bay Colony Counseling Services).  In addition, as of such date, the Company
had 12 employees engaged in corporate and administrative operations.  The
Company leases its employees under a contract with Administaff Companies, Inc.
("Administaff").  The contract was executed June 30, 1996, and may be
terminated by either party upon thirty days prior written notice.  Under the
contract, Administaff and the Company are each responsible for compliance with
specified laws and for specified purposes but also are considered co-employers
for certain other purposes.  The Company pays Administaff a fee based upon a
percentage of the Company's gross payroll.  The Company believes that it has
reduced its overall costs related to employees through this contract with
Administaff which represents one aspect of its general efforts to reduce its
operating expenses.  See "Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations."

         The Company's employees include healthcare professionals, such as
psychiatrists, psychologists, social workers, nurses, counselors and
occupational and activities therapists, and employees engaged in corporate,
finance, marketing, administration and other support positions.  None of the
Company's employees are covered by a collective bargaining agreement, and the
Company considers its employee relations to be good.  The Company's
relationships with certain healthcare professionals are pursuant to contracts
with each professional establishing independent contractor relationships.

COMPANY HISTORY

         The Company was incorporated in 1981 in the Commonwealth of Virginia,
and in October 1994 changed its state of incorporation to Delaware.  From 1986
to August 1993, the Company was a wholly-owned subsidiary of MEDIQ Incorporated
("MEDIQ").  In August 1993, MEDIQ distributed the stock of the Company to
MEDIQ's shareholders.





                                      12
<PAGE>   13

FORWARD-LOOKING STATEMENTS

         This report includes forward-looking statements based on management's
current plans and expectations, relating to, among other matters, the proposed
business activities of the Company, estimates of amounts that are not yet
determinable and the proposed activities of the Company relating to improving
its liquidity.  Such statements involve risks and uncertainties which may cause
actual future activities and results of operations to be materially different
from that suggested in this report, including, among others, the use of
available cash resources to fund continued operating losses, the amount and
timing of receipt of government reimbursement and the results of the review of
SCC's claims by the Medicare fiscal intermediary, risks associated with
industry consolidation and acquisitions, the need to manage growth, the
possible need to use the net cash proceeds from the sale of freestanding
facilities for the retirement of certain indebtedness and competition.


ITEM 2.  PROPERTIES

         The Company's executive offices are located in Vienna, Virginia
pursuant to a lease expiring in December 1998.  Pursuant to such lease, the
Company pays annual rent of $22.61 per square foot on approximately 6,600
square feet, with annual increases in an amount  equal to 3% of the prior
year's base rent.  In its efforts to reduce its operating costs, the Company
terminated its prior lease in McLean, Virginia with annual rent of
approximately $307,000 in favor of its present lease with annual rent of
approximately $150,000.  Mountain Crest Hospital is operated pursuant to a
sublease expiring in 2000 and requires base rental payments of $20,000 monthly
and additional rent equal to 6.5% of the net revenues of the facility and 50%
of the facility's excess cash flows (as defined in the lease agreement).  In
addition, the Extended Care Services Division leases office space in
California, Georgia and Massachusetts for its operations.  The Company believes
that its facilities are adequate to carry on its business as currently
conducted.


ITEM 3.  LEGAL PROCEEDINGS

         The Company is involved in two lawsuits with Horizon and one or more
of its affiliates.  The Company sued Horizon, Horizon Mental Health Management,
Inc. and the Joint Venture in the Delaware Court of Chancery on August 9, 1995
(C.A. No. 14465) under several agreements governing the distribution of profits
to the Company from the Joint Venture.  The Delaware Chancery Court granted the
Company's motion for summary judgment that entitled it to receive its pro rata
share of the Joint Venture's net cash flow for March 1995 with accrued interest
which, through October 3, 1996, amounted to $433,330.  That judgment has been
appealed by Horizon to the Delaware Supreme Court.  On July 31, 1996, Horizon
and Horizon Mental Health Management, Inc. sued an affiliate of the Company,
MHM/LLC, Inc., in the District Court of Denton County, Texas, 211th Judicial
District (Cause No. 96-30528).  Plaintiffs' Petition alleges breach by the
Company of its indemnity obligations under certain Joint Venture agreements and
seeks unspecified damages which the Company believes total no more than
$120,000.  The Company intends to vigorously contest this action.





                                       13
<PAGE>   14


         The Company is involved in various other legal proceedings incidental
to its business, some of which may be covered by insurance.  The Company knows
of no litigation, either pending or threatened, which is likely to have a
material adverse effect on the Company's consolidated financial statements.


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

         No matters were submitted to a vote of security holders during the
quarter ended September 30, 1996.





                                      14
<PAGE>   15



                                    PART II


ITEM 5.  MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED
         SECURITY HOLDER MATTERS

MARKET INFORMATION

         The following table sets forth, for the periods indicated, the high
and low prices for the common stock as listed on the American Stock Exchange
("AMEX").

<TABLE>
<CAPTION>
                                                             High                        Low
                                                             ----                        ---
                                                           
<S>                                                        <C>                        <C>
Year ended September 30, 1996:                             
         First Quarter                                     $3.750                     $1.750
         Second Quarter                                     2.625                      1.000
         Third Quarter                                      1.875                      1.250
         Fourth Quarter                                     1.500                       .750
                                                           
Year ended September 30, 1995:                             
         First Quarter                                     $3.938                     $2.500
         Second Quarter                                     3.313                      1.875
         Third Quarter                                      3.438                      2.000
         Fourth Quarter                                     3.750                      2.250
</TABLE>

         Based upon the Company's financial condition and operating results, it
falls within the AMEX guidelines for suspension and delisting.  The AMEX has
discretion to consider a variety of factors in making a decision to suspend or
delist a security, including a company's prospects for growth.  There can be no
assurance that the Company will continue to be listed on the AMEX or satisfy
the standards for listing on another exchange or Nasdaq.  Failure to be listed
on an exchange or Nasdaq would adversely affect the price of the Company's
common stock and the ability of the Company's shareholders to sell their
shares.

COMMON STOCK HOLDERS

         As of December 27, 1996, there were approximately 1,669 holders of
record of the Company's common stock.  Since a portion of the common stock is
held in "street" name or nominee name, the Company is unable to determine the
exact number of beneficial holders.

DIVIDENDS

         The Company has never declared or paid any cash dividends.  The
declaration of dividends in the future will at all times be subject to the sole
discretion of the Company's Board of Directors, and will depend upon the
operating results, capital requirements and financial position, general
economic conditions and other pertinent conditions or restrictions relating to
any future financing.





                                       15
<PAGE>   16


ITEM 6.  SELECTED CONSOLIDATED FINANCIAL DATA

         The selected consolidated financial information presented below has
been derived from the audited financial statements of the Company.  This data
is qualified in its entirety by reference to, and should be read in conjunction
with the Company's Consolidated Financial Statements and notes thereto and
Management's Discussion and Analysis of Financial Condition and Results of
Operations, included elsewhere herein.

STATEMENT OF OPERATIONS DATA

<TABLE>
<CAPTION>
                                                                         Year Ended September 30,
                                          ------------------------------------------------------------------------------
                                               1996        1995(1)         1994(1)             1993            1992
                                          -------------  -----------   ---------------   ---------------  --------------
                                                           (in thousands, except per share data)


 <S>                                     <C>            <C>             <C>               <C>            <C>
 Net revenues                            $   34,670     $   41,109      $   48,286        $  46,667      $   46,446

 Costs and expenses:
     Operating                               25,765         28,918          33,895           31,760          31,631
     General and administrative               9,718         10,085          10,644            8,448           7,964
     Provision for bad debts                  6,320          4,467           2,009            1,444           1,311
     Depreciation and amortization            1,034          1,603           1,617            1,826           2,329
     Loss on sale of  facilities (2)          4,440             --              --               --              --
     Writedown of long-term assets (3)          461          2,228              --               --              --
     Restructuring charges (4)                   --             --             966               --              --
     Writedown of goodwill (5)                   --             --              --               --          23,141
     Management fees - MEDIQ (6)                 --             --              --            1,111           3,266
 Other (credits) charges:
     Equity in earnings of Joint
       Venture                                   --           (835)           (292)              --              --
     Gain on sale of Joint Venture               --         (3,542)             --               --              --
     Interest expense - MEDIQ                 1,097          1,171             932              834           1,051
     Interest expense -other                    290            366             389              328             413
     Other (income) expense-net                (233)          (223)            (33)             (50)           (105)
                                         ----------     ----------      ----------        ---------      ----------
 Income (loss) before income tax
     expense (benefit), extraordinary
     item and cumulative effect of a
     change in accounting principle         (14,222)        (3,129)         (1,841)             966         (24,555)
 Income tax (benefit) expense                  (308)           894            (525)             451            (158)
 Extraordinary item (7)                        (463)            --              --               --               -
 Cumulative effect of a change in
     accounting principle (8)                                                 (732)                                 
                                         ----------     ----------      ----------        ---------      ----------
 Net (loss) income                       $  (14,377)    $   (4,023)     $  ( 2,048)       $     515      $  (24,397)
                                         ==========     ==========      ==========        =========      ==========

 (Loss) earnings per share               $    (4.34)    $    (1.22)     $     (.63)       $     .17      $    (8.18)
                                         ==========     ==========      ==========        =========      ==========

 Weighted average shares outstanding          3,310          3,310           3,267            2,980           2,980
                                         ==========     ==========      ==========        =========      ==========
</TABLE>





                                      16
<PAGE>   17
BALANCE SHEET DATA


<TABLE>
<CAPTION>
                                                                          September 30,
                                            ------------------------------------------------------------------------
                                                  1996       1995(1)       1994(1)          1993          1992
                                                                        (in thousands)
 <S>                                           <C>          <C>           <C>           <C>           <C>
 Working capital                               $ 2,947      $  5,923      $    485      $  7,377      $  3,837
 Total assets                                   10,828        30,283        41,900        37,364        36,407
 Long term debt, less current maturities           257         2,422           716         4,532           157
 Due to MEDIQ, less current maturities           9,967        10,733        11,500        11,500        11,009
 Stockholders' (deficit) equity                (3,582)        10,795        14,818        15,546        15,031
</TABLE>

               See Notes to Selected Consolidated Financial Data





                                      17
<PAGE>   18



Notes to Selected Consolidated Financial Data:

(1)      Effective August 1, 1994, the Company formed a joint venture ("Joint
         Venture") to combine its contract management business with that of
         Horizon Mental Health Services, Inc. ("Horizon").  The Joint Venture,
         which was owned 27.5% by the Company and 72.5% by Horizon, managed
         both companies' hospital behavioral health care contracts.  The
         operating results of the contract management business were included in
         the Company's results of operations through the commencement of the
         Joint Venture on August 1, 1994.  On March 20, 1995, Horizon completed
         its initial public offering and, in accordance with the terms of the
         Joint Venture Agreement, acquired the Company's interest in the Joint
         Venture for approximately $9,600,000 (net of related expenses).  The
         sale resulted in a pre-tax gain of $3,542,000 (approximately $500,000
         net of taxes).

(2)      The Company completed the sale of six of its seven freestanding
         behavioral health facilities in 1996 and recorded a loss of $4,440,000
         consisting primarily of the write off of intangibles related to the
         facilities of $3,184,000, loss on the sale of certain property, plant,
         and equipment aggregating $319,000, transaction expenses of $568,000,
         severance expenses of $349,000, and other expenses of $680,000, offset
         by estimated Medicare depreciation recapture income of approximately
         $660,000.

(3)      In the fourth quarter of 1996, the Company wrote off the assets
         related to the discontinued operations of SCC including property,
         plant and equipment and goodwill resulting in a charge of $461,000.
         In the fourth quarter of 1995, the Company determined that the
         recoverability of certain of the assets, including property, plant and
         equipment and goodwill, related to one of the Company's freestanding
         facilities, was impaired, other than temporarily.  Accordingly, the
         carrying value of such assets was reduced to estimated fair value,
         resulting in a charge of $2,228,000.

(4)      In connection with the commencement of the Joint Venture, the Company
         recorded a restructuring charge of $966,000 related to the downsizing
         of its corporate activities.

(5)      In 1992, MEDIQ determined that the value of goodwill related to the
         Company was impaired, other than temporarily.  Accordingly, the
         carrying value of such goodwill was reduced to its estimated fair
         value resulting in a charge of $23,141,000.

(6)      Represents primarily an allocation of MEDIQ's claimed overhead, as
         well as claimed costs to provide services to the Company. In
         anticipation of the August 1993 distribution of the Company's stock to
         MEDIQ's stockholders, MEDIQ discontinued charging management fees to
         the Company effective April 1, 1993.  The Company had continued to
         obtain certain services from MEDIQ pursuant to a services agreement
         which terminated in 1996.  Fees for services rendered by MEDIQ were
         $38,000, $140,000 and $138,000 in 1996, 1995 and 1994, respectively,
         and were included in general and administrative expenses.

(7)      The Company recorded an extraordinary item in the amount of $463,000
         consisting primarily of costs related to the early retirement of the
         Company's long-term debt and the subsequent  write off of associated
         loan acquisition costs.

(8)      Represents the cumulative effect of a change in the Company's method
         of accounting for certain preopening costs and certain costs incurred
         in securing management contracts.





                                       18
<PAGE>   19

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

         The following discussion should be read in conjunction with the
financial statements, and notes thereto, included elsewhere in this report.

GENERAL

         In response to continuing changes in the behavioral healthcare
industry, the Company made significant changes in its operations in 1994, 1995
and 1996, including the divestiture of the Company's contract management
business and substantially all of its freestanding behavioral healthcare
facilities (see "Recent Developments"), so that the Company could focus on its
principal remaining business -- its Extended Care Services Division (which
commenced operations in the Fall of 1993).  The Extended Care Services Division
has experienced growth through internal development (principally from a
contract with the State of Georgia) and acquisitions.

         As a result of the Company's continued negative operating results, as
well as reduced collections of accounts receivable, the Company has been
experiencing difficulty generating sufficient cash flows from operations to
meet its obligations and sustain its operations without the use of available
cash resources.  The report of the Company's independent auditors on the
Company's financial statements for the fiscal year ended September 30, 1996,
includes an explanatory paragraph which states that such conditions raise
substantial doubt as to the Company's ability to continue as a going concern.
The financial statements do not include any adjustments that might result from
the outcome of this uncertainty.  In a continuing effort to improve this
situation for both the immediate future and the long-term, the Company sold
certain assets relating to its Hospital Division, and is taking steps to reduce
operating expenses, finance its working capital requirements, restructure debt,
raise additional capital and improve its cash flows.  Nevertheless, there can
be no assurance that the Company's efforts will result in positive effects on
the Company's financial condition.


RECENT DEVELOPMENTS

         Based upon the adverse impact on the Company's operating results of
cost-reduction pressures on in-patient care and the Company's belief that such
pressures would likely continue to have an adverse impact on future results,
the Company decided to pursue a strategy focused on growing its Extended Care
Services Division.  As a result, the Company sold six of its seven freestanding
behavioral health facilities.  In 1995, the operations of the freestanding
facilities represented 86% of net revenues and had comprised 77% of the
Company's total assets at the end of fiscal 1995.  As a result of the sale of
six facilities in 1996, the freestanding facilities represented only 67% of net
revenues for fiscal 1996.

         On April 5, 1996, the Company sold Oakview Treatment Center (the
"Oakview Sale") to a non-profit corporation affiliated with a privately-owned
operator of two psychiatric hospitals for





                                      19
<PAGE>   20

$50,000 in cash and $2,150,000, evidenced by two promissory notes payable to
the Company.  For financial statement purposes, the notes were recorded at an
estimated net realizable value of $1,400,000.  The notes are payable in monthly
installments of principal and interest (at prime) based on a 15 year
amortization, with the remaining principal due in five years (or earlier under
certain circumstances).  In connection with obtaining consent to the Oakview
Sale as required under the terms of the Company's revolving credit facility,
the Company pledged both of the notes receivable relating to the Oakview Sale
as collateral for the Company's obligations under the revolving credit
facility.  In connection with obtaining a waiver from MEDIQ of an event of
default provision of the MEDIQ Note relating to the sale of the assets of a
significant subsidiary, the Company pledged one of the notes receivable (with a
principal balance of $1,875,000) as collateral for the Company's obligations
under the MEDIQ Note.  In connection with the BHC Sale (discussed below) the
revolving credit facility has been repaid and the pledges under the revolving
credit facility have been terminated, but the pledge under the MEDIQ Note
continues.  See "Liquidity and Capital Resources."

         On May 31, 1996, the Company sold certain assets, consisting
principally of five of its freestanding behavioral healthcare facilities (Aspen
Hill Hospital, Pacific Shores Hospital, Pinon Hills Hospital, Pinon Hills
Residential Treatment Center and Windsor Hospital) (the "Hospitals"), to BHC
pursuant to the BHC Agreement.  The Hospitals were sold for approximately
$10,209,000, consisting of $9,049,000 in cash and $1,160,000 in assumed
liabilities of the freestanding facilities (reflecting post-closing adjustments
by both parties).  The BHC Agreement, as amended, also provides for certain
Medicare depreciation recapture amounts to be allocated between the Company
(85%) and the purchaser (15%).  Such recapture amounts relate to potential
adjustments for prior years to reflect the loss on the sale of the Hospitals as
a retroactive increase in the Company's depreciation expense for purposes of
cost-based reimbursements.  The Company estimates that its share of the amounts
to be collected pursuant to such Medicare recapture will be approximately
$1,270,000 of which the Company recorded approximately 50% and that it will
receive final settlements within one to three years from the filing date of
October 31, 1996.  See "Liquidity and Capital Resources."

         The Company used a portion of the proceeds from the BHC Sale for (i)
the repayment of the principal amount outstanding under the Company's revolving
credit facility ($2,515,000, including related early termination fees of
$174,000); (ii) the extinguishment of a portion of the indebtedness not assumed
by BHC and paid by the Company at the closing of the sale ($692,000, including
early termination fees of $139,000), which consisted primarily of indebtedness
secured by certain of the assets (particularly a facility and certain
equipment) acquired by BHC; and (iii) the funding of the Company's obligation
to complete repairs to two of the freestanding facilities sold to BHC in the
amount of $284,000 (of which $216,000 remains in escrow).  The Company expects
to continue to use the proceeds from the BHC Sale for general working capital,
which the Company anticipates will include expansion of the Extended Care
Services Division. See "Liquidity and Capital Resources."

         The Company's freestanding facilities represented the majority of the
Company's historical business and have contributed significantly to the
Company's cash flows.  In addition, the freestanding facilities helped to
absorb certain corporate-related expenses that now have to be borne primarily
by the Extended Care Services Division.  Since its founding in October 1993,
the Extended Care Services Division has generated 33%, 14% and 3% of net
revenues for the years ended September 30, 1996, 1995, and 1994, respectively.
Going forward, the Extended Care Services Division will account for a
substantial portion of the Company's revenues.  The expansion of the Extended
Care Services Division has also resulted in increased costs, and thus, with the
allocation of corporate overhead related to the operations of the Extended Care
Services Division, the Extended Care Services Division has not yet achieved
profitable results.  No assurances can be given that the Company will be
successful in





                                       20
<PAGE>   21


generating profits from the Extended Care Services Division, or that
the strategy of focusing on growing the Extended Care Services Division through
internal expansion and acquisition will not result in further increased costs.
The Company has recently completed three acquisitions described below,
routinely reviews potential acquisition candidates, and is pursuing other
acquisition and management opportunities.  The Company plans to continue its
expansion into the practice management business, which is the thrust of the
Company's long-term growth strategy, by acquiring additional practices and/or
securing long-term management agreements with additional practices.  To date,
however, the Company has not entered into definitive agreements with respect to
other acquisitions, and there can be no assurances that any acquisitions will
be completed or management opportunities will be secured.  In addition, since
the Company's liquidity and capital resources may be limited by certain future
events, there can be no assurance that the Company will have sufficient
resources to pursue and/or complete any other acquisitions.  For example, in
the event the Company continues to use the remainder of the proceeds of the BHC
Sale to fund its continued operating losses or needs to use such funds to repay
the amounts outstanding under the MEDIQ Note, as described below, the Company's
plans to expand the Extended Care Services Division would be significantly
hampered, and the Company's results of operations and financial condition may
be adversely affected.

         Acquisition of Supportive Counseling Care/Recent Determination to
Discontinue Operations.  In July 1995, the Company's Extended Care Services
Division acquired certain assets of Supportive Counseling Care ("SCC") of
Manhattan Beach, California, a provider of behavioral healthcare services to
extended care facilities, and entered into a 40-year management contract to
provide administrative services to SCC.  As consideration for the acquired
assets, the Company paid $500,000 in cash and notes.  The Company's Extended
Care Services Division also entered into a 40-year management contract to
provide administrative services to SCC.  The operating results related to these
assets are included in the Company's consolidated results of operations from
the date of acquisition.  The operations of SCC are primarily responsible for
an increase in the Company's provision for bad debts from the prior year
period.  See "Results of Operations - Fiscal Year 1996 Compared to Fiscal Year
1995."  In November 1996, the Company decided to discontinue the operations of
SCC based upon SCC's continued operating losses and negative cash flow,
resulting in part from significant delays in Medicare reimbursement.  The
Company shut down SCC's operations in early December 1996.  Fixed assets of
approximately $12,000 will either be sold or redeployed elsewhere in  the
Company.  All other SCC assets have been written off as of September 30, 1996.
See "Liquidity and Capital Resources."

         The Company issued a purchase warrant in connection with the SCC
acquisition.  Such warrant provides the holder thereof, upon the occurrence of
certain events (such as an initial public offering of such subsidiary, MHM
Extended Care Services, Inc.), the right (subject to certain vesting
conditions) until July 1998 to acquire 9,000 shares (subject to adjustment
under certain circumstances) of the common stock of such subsidiary at a
purchase price of $1.00 per share (subject to adjustment under certain
circumstances).  Such subsidiary currently has 1,000,000 and 100,000 shares of
its common stock, par value $.01 per share, authorized and issued,
respectively.

         Acquisition of Clinic Operations in Massachusetts (MHM Counseling
Services).  In December 1995, the Company's Extended Care Services Division
acquired the behavioral healthcare clinic





                                      21
<PAGE>   22



operations of National Mentor, Inc. located in Charlestown and Taunton,
Massachusetts.  As consideration for the acquired assets, the Company paid
$150,000 in cash and agreed to pay $338,000 in 36 equal monthly installments. 
The Company renamed the operations "MHM Counseling Services". The operating
results of the acquired business are included in the Company's consolidated
results of operations from the date of acquisition.

         Acquisition of Extended Care Operations in Massachusetts (Liberty
Bay).  Effective as of December 1, 1996, the Company's Extended Care Services
Division acquired, pursuant to an Agreement (the "Liberty Bay Agreement") by
and among the Company, MHM Extended Care Services, Inc., Liberty Bay Colony
Health Services, Inc ("Liberty Bay") and Liberty Management Group, Inc.
("Liberty Management"), certain assets and contractual rights from Liberty Bay
which constituted Liberty Bay's geropsychiatric management services operations
in Massachusetts.  Liberty Bay, a wholly-owned subsidiary of Liberty
Management, provided behavioral healthcare services on a contract basis to
residents of approximately 60 extended care facilities in Massachusetts.  The
Company has commenced integrating these operations with MHM Counseling Services
and the combined operations will operate under the name "MHM/Bay Colony
Counseling Services," and, as a result of the acquisition, will serve
approximately 80 extended care facilities.

         As consideration for the purchase, the Company paid Liberty Bay
$150,000 in cash and issued a promissory note in the principal amount of
$150,000 (the "Liberty Bay Note").  The Liberty Bay Note provides for quarterly
interest payments at an annual rate of 9% and the payment of the principal
amount in one installment on December 1, 1999.  The Company also agreed to pay
Liberty Bay additional consideration consisting of 20% of "cash flow" (as such
term is defined in the Liberty Bay Agreement) from the acquired contracts over
the five year period commencing December 1, 1996.  Such additional
consideration is payable annually by the Company and is calculated on a
contract-by-contract basis.

OVERVIEW OF REVENUE SOURCES

         Patient service revenues, which represented approximately 67%, 86%,
and 68% of net revenues in 1996, 1995 and 1994, respectively, were derived by
the Company's freestanding facilities based on covered charges billed primarily
to third party payors, including Medicare, Medicaid and other
government-sponsored programs.  Such revenues can be  significantly affected by
changes in utilization and reimbursement rates.  Typically, payments from such
payors are made at amounts less than the amounts charged, based on existing
contractual relationships or reimbursement methodologies.  The Company records
net patient service revenues based upon expected reimbursement.  Certain
government-sponsored programs pay primarily on a cost reimbursement basis.  The
Company is reimbursed for cost reimbursable items at a tentative rate, with
final settlement generally determined several years after submission of fiscal
year cost reports and audits thereof by the fiscal intermediary.  Differences
between amounts recorded as tentative settlements and final audited amounts are
reflected as adjustments to contractual allowances in the year in which
settlement is determined.  The Company also receives patient service revenues
under payment agreements with commercial insurance carriers, health maintenance
organizations and preferred provider organizations.

         The Company's Extended Care Services Division generates revenues from
administrative services for physicians and other healthcare professionals
providing care to residents of extended care facilities.  Such revenues
represented approximately 33%, 14% and 3% of total revenues in 1996, 1995 and
1994, respectively.





                                       22
<PAGE>   23


         Contract management revenues represented approximately 29% of the
Company's revenues in 1994.

JOINT VENTURE

         In August 1994, the Company formed a joint venture (the "Joint
Venture") to combine its contract management business with that of Horizon
Mental Health Services, Inc. ("Horizon") of Denton, Texas.  The Joint Venture,
which was owned 27.5% by the Company and 72.5% by Horizon, managed both
companies' hospital behavioral healthcare contracts.  The operating results of
the Company's contract management business were included in the Company's
results of operations through the commencement of the Joint Venture on August
1, 1994.  From August 1994 to March 20, 1995, the Company's 27.5% interest in
the operating results of the Joint Venture was included as "equity in earnings
of joint venture" in the Consolidated Statement of Operations.  On March 20,
1995, Horizon completed an initial public offering of its stock, and, in
accordance with the terms of the Joint Venture agreement, acquired the
Company's interest in the Joint Venture for approximately $9,600,000 (net of
related expenses).  The sale resulted in a gain of approximately $500,000 (net
of income taxes of $3,000,000).

ACQUISITION OF MOUNTAIN CREST HOSPITAL

         In connection with the commencement of the Joint Venture in August
1994, the Company began operating Mountain Crest Hospital, a 60-bed psychiatric
facility in Fort Collins, Colorado, under a sublease agreement with Horizon
expiring in December 2000.  This sublease agreement requires base rental
payments of $20,000 monthly and additional rent equal to 6.5% of the net
revenues of the facility and 50% of the facility's excess cash flows (as
defined in the lease agreement).

ACQUISITION OF BUSINESS OF ICH SERVICES, L.L.C./MODIFICATION TO DEFERRED
CONSIDERATION OBLIGATIONS

         In November 1993, the Company acquired the assets of  Atlanta-based
ICH Services, L.L.C. ("ICH") (successor to HCI Services, Inc.), which provides
behavioral health and other specialized medical services to residents of
extended care facilities.  The acquired operations formed the core of the
Company's Extended Care Services Division.  The purchase price for the assets
consisted of 330,000 shares of the Company's common stock, as well as certain
additional consideration payable, in cash or additional shares of the Company's
common stock at the option of the former ICH members, after the third
anniversary of the acquisition in an amount equal to approximately twenty
percent of the appraised fair market value of the acquired operations as of
such third anniversary.

         In an effort to avoid the time, expense, and possibility of
disagreement inherent to the appraisal process, the Company has had discussions
with ICH for the purpose of modifying the terms of the additional
consideration.  Although no definitive agreement has been reached to date, the
Company expects to execute such an agreement with the former ICH members in the
near future.  As proposed, such agreement, which would replace the existing
additional consideration provisions, would require the Company to issue an
aggregate of an additional 266,089 shares of Common Stock to the former ICH





                                      23
<PAGE>   24



members as soon as practicable after obtaining listing approval from the
American Stock Exchange for such shares and pay the former ICH members (in the
aggregate) approximately $52,562 in cash.  The Company would agree to promptly
file a listing application with the AMEX (or any other exchange or Nasdaq, as
the case may be, should the Company's shares be delisted from the AMEX.  See
"Market Information").  The proposed amendment would require the Company to pay
to each former ICH member on November 1, 1997, a one time adjustment payment
equal to the positive difference, if any, between (i) $3.56 per share
multiplied by the number of Company shares such former ICH member received as
additional consideration and (ii) the gross proceeds received by such former
ICH member from the sale of all of such former ICH member's shares of common
stock of the Company received as additional consideration.

         There can be no assurance that the Company and ICH will reach a
definitive agreement.  If no agreement is reached, the Company would be
required to comply with the terms of the original agreement.  The original
agreement did not contain any ceiling on the number of shares of common stock
of the Company that the Company could be required to issue under the earn-out.
Under the terms of the original agreement, within 90 days of November 18, 1996,
the Company would have had to provide the former ICH members additional
consideration of approximately 20% of MHM Extended Care Services, Inc.'s fair
market value as determined by an independent valuation in cash or shares of the
common stock of its parent, MHM Services, Inc.

CHANGE IN ACCOUNTING PRINCIPLE

         Effective October 1, 1993, the Company changed its method of
accounting for certain preopening costs and certain costs incurred in securing
management contracts.  Prior to the change, these costs were deferred and
amortized over the estimated periods of benefit, ranging from 3 to 5 years.
Based on trends  in industry practice, management reevaluated such policy.  In
light of the type and nature of the costs involved and changes in the Company's
business, management concluded that it was preferable to expense these costs as
incurred.  The cumulative effect on prior years of the change in accounting
principle as of October 1, 1993, was $1,110,000, or $732,000 net of income
taxes.   The effect of the change in 1994 was an increase in loss before the
cumulative effect of the change in accounting principle of $473,000, or
$312,000 net of income taxes.





                                       24
<PAGE>   25


RESULTS OF OPERATIONS

         The following table sets forth, for the periods indicated, the
percentage relationship that components of the Company's results of operations
bear to net revenues.

<TABLE>
<CAPTION>
                                                                           Year Ended September 30,                
                                                              ------------------------------------------------
                                                                    1996               1995              1994  
                                                              ------------           --------         --------

 <S>                                                               <C>                <C>               <C>
 Net revenues                                                      100.0%             100.0%            100.0%
 Costs and expenses:
     Operating                                                      74.3               70.3              70.2
     General and administrative                                     28.0               24.5              22.0
     Provision for bad debts                                        18.2               10.9               4.2
     Depreciation and amortization                                   3.0                3.9               3.3
     Loss on sale of freestanding facilities                        12.8                 --                --
     Writedown of long-term assets                                   1.3                5.4                --
     Restructuring charges                                            --                 --               2.0
 Other (credits) charges:
     Equity in earnings of Joint Venture                              --               (2.0)              (.6)
     Gain on sale of Joint Venture                                    --               (8.6)               --
     Interest expense - MEDIQ                                        3.2                2.8               1.9
     Interest expense - other                                         .8                 .9                .8
     Other (income) expense - net                                    (.6)               (.5)               --
                                                                   -----              -----             ----- 
 Loss before income taxes, extraordinary item and
     cumulative effect of a change
     in accounting principle                                       (41.0)              (7.6)             (3.8)
 Income tax (benefit) expense                                        (.9)               2.2              (1.1)
                                                                   -----              -----             ----- 
 Loss before extraordinary item and cumulative
     effect of a change in accounting principle                    (40.1)              (9.8)             (2.7)
 Extraordinary item - loss on early extinguishment of debt          (1.3)                --                --   
                                                                                          -               ---
 Cumulative effect of a change in accounting principle                --                 --              (1.5)
                                                                   -----              -----             ----- 
 Net loss                                                          (41.4)%             (9.8)%            (4.2)%
                                                                 =========          =========         =========

</TABLE>




                                      25
<PAGE>   26



Fiscal Year 1996 Compared to Fiscal Year 1995

         Net revenues for 1996 were $34,670,000 as compared to $41,109,000 for
the prior year, a decrease of $6,439,000 or 16%, reflecting an increase in net
revenues from the Extended Care Services Division, more than offset by
decreased net revenues from the freestanding facilities.  Net revenues from
freestanding facilities were $23,255,000 (including $5,694,000 from Mountain
Crest Hospital, the Company's remaining freestanding facility) in 1996, a
decrease of $12,116,000, or 34%, as compared to the prior year.  The decrease
in net revenues resulted primarily from the sale of five of the freestanding
facilities on May 31, 1996 and the sale of Oakview Treatment Center on April 5,
1996.  Going forward, the Extended Care Services Division will account for a
substantial portion of the Company's net revenues.  Net revenues from the
Extended Care Services Division were $11,415,000 in 1996, as compared to
$5,738,000 in the prior year.  This increase is the result of net revenues of
$4,448,000 (as compared to $1,317,000 in 1995) attributable to an acquisition
in July 1995 (SCC) and $1,456,000 attributable to an acquisition in December
1995 (MHM Counseling Services), as well as increased net revenues under a
contract with the State of Georgia to provide mental health services to
Medicaid patients in nursing homes.  SCC operations were discontinued in early
December 1996.  See provision for bad debts discussion below.

         Operating expenses for 1996 were $25,765,000 as compared to
$28,918,000 in the prior year.  This decrease was attributable to the sale of
six of the Company's seven freestanding behavioral healthcare facilities,
offset by increases in costs associated with the expansion of the Extended Care
Services Division.   The level of operating costs of the Extended Care Services
Division, together with the increased provision for bad debts (described below)
and general and administrative expenses, have had an adverse impact on
operating results.

         General and administrative expenses for 1996 were $9,718,000 or 28% of
net revenues, as compared to $10,085,000 or 25% of net revenues, in the prior
year. This decrease was attributable to the sale of six of the Company's seven
freestanding behavioral healthcare facilities, offset by increases in costs
associated with the expansion of the Extended Care Services Division.   The
level of operating costs of the Extended Care Services Division, together with
the increased provision for bad debts (described below) and general and
administrative expenses, have had an adverse impact on operating results.

         The provision for bad debts for 1996 increased to $6,320,000 as
compared to $4,467,000 in the prior year.  As a percentage of net revenues, bad
debt expense was 18%, as compared to 11% in the prior year.  The increase in
the provision for bad debts resulted primarily from the operations of SCC
(acquired in July 1995) which are subject to Medicare reimbursement limits,
with the remaining charges billed to the patients or other third party payors.
In March 1996, the Company became aware that SCC's claims, as well as claims
submitted by other industry providers in the region, for reimbursement under
the Medicare program were being subjected to a pre-payment review process by
the Medicare fiscal intermediary in Southern California commencing in April
1996.  Under applicable Medicare rules, therefore, SCC is now required to
include specified supporting documentation with its claims for reimbursement.
Since the commencement of this prepayment review, SCC received an increased
number of denials and requests for additional information.  In addition, SCC
received notice of a proposed suspension of Medicare payments based upon a
review of certain claims by such fiscal intermediary.  This suspension is not
expected to become effective pending the review of additional information
provided by SCC to the fiscal intermediary.  SCC plans to appeal the denied
claims, as well as pursue the claims under review by the fiscal intermediary,
and is actively engaged in data collection and analysis in order to support the
claims submitted to Medicare.  SCC will not receive reimbursement





                                       26
<PAGE>   27


for claims that are not reversed on appeal.  In addition, it is
possible that the fiscal intermediary's review of SCC's claims may result in
further investigation and possible sanctions against SCC, which may include
repayment of any alleged overpayments, suspension or exclusion from the
Medicare program, fines or other penalties.  Based upon the number of denials,
the Company's assessment of available documentation and knowledge of, and
experience with, the appeal process, the Company has increased its provision
for bad debts by approximately $1,000,000 in the third and fourth quarters of
fiscal 1996.  The allowance for doubtful accounts represents approximately 90%
of the Company's net accounts receivable balance from SCC's operations as of
September 30, 1996.  In addition, the number of denials has had an adverse
impact on the Company's cash flow from operations. There can be no assurance
that the appeal process will result in a significant percentage of reversals,
that additional denials will not be received by SCC or the Company's other
operations, that actual bad debt experience will not exceed the Company's
estimates or that the review of SCC's claims will not result in further
investigation and sanctions.  In November 1996, the Company decided to
discontinue the operations of SCC based upon SCC's continued operating losses
and negative cash flow, resulting in part from significant delays in Medicare
reimbursement.  The Company shut down SCC's operations in early December 1996.
Fixed assets of approximately $12,000 will either be sold or redeployed
elsewhere in the Company.  All other SCC assets have been written off as of
September 30, 1996

         Depreciation and amortization expense for 1996 was $1,034,000 as
compared to $1,603,000 in the prior year.  The decrease in depreciation and
amortization expense was attributable to the sale of the six freestanding
facilities.

         The Company completed the sale of six of its seven freestanding
behavioral health facilities in 1996 and recorded a loss of $4,440,000
consisting primarily of the write off of intangibles related to the facilities
of $3,184,000, loss on the sale of certain property, plant, and equipment
aggregating $319,000, transaction expenses of $568,000, severance expenses of
$349,000, and other expenses of $680,000, offset by estimated Medicare
depreciation recapture income of approximately $660,000.

         In the fourth quarter of 1996, the Company wrote off the assets
related to the discontinued operations of SCC including property, plant and
equipment and intangibles resulting in a charge of $461,000.

         Interest expense for 1996 was $1,387,000, as compared to $1,537,000 in
the prior year.  The decrease is primarily attributable to the extinguishment
of the working capital line of credit and paydown on the MEDIQ note.

         Pretax loss for 1996 before extraordinary item was $14,222,000 as
compared to pretax loss of $3,129,000 in the prior year.  The pretax loss for
the current period included a loss of $4,440,000 related to the sale of the
freestanding behavioral health facilities, increases in the bad debt provision
related to SCC reimbursement denials of approximately $1,000,000 and write off
of long-term assets of $461,000 related to the closing of SCC in December 1996.
The prior period included a pretax gain of $3,542,000 on the sale of the
Company's interest in the Joint Venture as well as earnings of $835,000 related
to the Joint Venture offset by the writedown of certain assets in the amount of
$2,228,000 described below.  In





                                      27
<PAGE>   28



addition, the increase in costs associated with expansion of the Extended Care
Services Division, as well as the increased provision for bad debts, have had
an adverse impact on operating results for 1996.

         In 1996, the Company recorded an extraordinary item in the amount of
$463,000, consisting primarily of costs related to the early retirement of the
Company's long-term debt and the subsequent write off of associated loan
acquisition costs.

Fiscal Year 1995 Compared to Fiscal Year 1994

         Net revenues were $41,109,000, as compared to $48,286,000 for 1994, a
decrease of $7,177,000, or 15%.  This decrease reflects the elimination of
contract management revenues which were $13,825,000 in the prior year (see
Joint Venture above), partially offset by an increase in net revenues from
freestanding facilities and the Extended Care Services Division.  Net revenues
from freestanding facilities increased $2,292,000, or 6.9% to $35,371,000. This
increase reflects net revenues of $5,723,000 from the freestanding facility
acquired in August 1994 (as compared to $909,000 in 1994), partially offset by
a decrease of $2,522,000, or 7.8%, in same store revenues.  The decrease in
same store revenues resulted from lower average reimbursement rates and
decreases in inpatient average lengths of stay, partially offset by a 3.3%
increase in admissions and an increase in equivalent patient days.  Same store
equivalent patient days increased 4.7% over the prior year as a result of the
continued growth of alternative care programs in response to managed care and
other market forces.  These same market forces have resulted in a 9.2% decrease
in average lengths of stay for inpatient programs, which reflects increased
utilization at one of the Company's residential  treatment centers, which
traditionally have longer lengths of stay than the Company's other freestanding
facilities, offset by a 15.1% decrease in average lengths of stay at the
Company's other freestanding facilities.  Market forces have also resulted in
decreased inpatient reimbursement rates as a result of changes in payor mix,
including higher charity care utilization, and lower average reimbursement
rates for alternative care programs as compared to inpatient programs.  The
combination of these factors resulted in a 14% decrease in net revenue per
equivalent patient day.

         Net revenues from the Extended Care Services Division were $5,738,000,
as compared to $1,329,000 in the prior year.  This increase was primarily the
result of a full year of revenues under a contract with the State of Georgia to
provide mental health services to Medicaid patients in nursing homes.  The
contract, which commenced in the fourth quarter of fiscal 1994, is under the
Pre-Admission Screening and Annual Resident Review (PASARR) Program, has a term
of three and one-half years, renewable annually during its term, and provides
for fixed fees based upon the number of residents participating in the program.
This contract represented 47% of net revenues of the Extended Care Service
Division in 1995.  The increase also reflects $1,317,000 of revenues
attributable to SCC, acquired in July 1995.

         Operating expenses were $28,918,000, as compared to $33,895,000 in
1994.  This decrease was primarily attributable to the restructuring of the
Company's business in connection with the formation of the Joint Venture,
resulting in a decrease in operating expenses of $10,277,000.  This decrease
was partially offset by a full year of expenses of the freestanding facility
acquired in August 1994 of $3,345,000 (as compared to $549,000 in 1994),
increased costs associated with the growth of the Extended Care Services
Division of $2,103,000 and increased operating expenses at the Company's same
store freestanding facilities of $401,000.  The increase in operating expenses
at the Company's same store facilities was primarily a result of higher
personnel costs associated with increased utilization at certain of the
Company's freestanding facilities and the expansion of alternative care
programs.  Operating expenses, as a percentage of net revenues, were comparable
with the prior year period.





                                       28
<PAGE>   29


         General and administrative expenses were $10,085,000, as compared to
$10,644,000 in 1994.  The restructuring of the Company's operations in 1994
resulted in a decrease in general and administrative expenses of approximately
$2,300,000.  This decrease was partially offset by a full year of expenses of
the freestanding facility acquired in August 1994 of $1,802,000 (as compared to
$307,000 in 1994) and an increase in general and administrative expenses
associated with growth at the Extended Care Services Division of $457,000.
General and administrative expenses, as a percentage of net revenues, increased
to 24.5%, as compared to 22.0% in the prior year, as a result of the addition
of the freestanding facility in August 1994.  General and administrative
expenses at this facility are higher, as a percentage of net revenue, than the
Company's other freestanding facilities as a result of higher lease expense.

         The provision for bad debts increased $2,458,000 to $4,467,000 and, as
a percentage of net revenues, increased to 10.9%, from 4.2% in 1994.  These
increases primarily resulted from management's assessment of collection
patterns which were adversely affected by admissions screening problems at
certain of the freestanding facilities.  The  Company is taking steps to
correct such screening problems.  The increase in the provision for bad debts
also resulted from an acquisition in July 1995 (SCC), changes in payor mix and
the elimination of contract management revenues, which had only nominal amounts
of bad debt expense.

         Depreciation and amortization expense of $1,603,000 was comparable to
1994.

         Interest expense was $1,537,000, an increase of $216,000 from 1994,
primarily attributable to increases in interest rates.

         In the fourth quarter of 1995, the Company determined that the
recoverability of certain assets, including property, plant and equipment and
goodwill, related to one of the Company's freestanding facilities was impaired,
other than temporarily.  Such determination was based upon management's
evaluation of the key indicators of the Company's business, including
continuing operating losses at such facility.  Based upon management's analysis
of expected future operating losses and cash flows, management determined that
the facility's cash flows would not be sufficient to enable the Company to
recover its investment, and that an impairment in the value of such facility
had occurred.  Upon reaching this conclusion, and consistent with the policy
described above, the amount of such impairment was determined to be $2,228,000.
This determination was based upon the difference between the carrying value and
the fair value.  Fair value was estimated through internal evaluation by the
Company's management and confirmed by an independent valuation of the
freestanding facility and a proposal from a third party to buy the facility.
Based upon future operating results and cash flows, management's assessment of
recoverability of the investment in the other freestanding facilities does not
indicate permanent impairment.  However, in the event these facilities are sold
as anticipated, the Company would be unable to recover its investments and
would incur losses on such sales.  See "Note 5 to Notes to the Consolidated
Financial Statements" regarding loss on subsequent sale of freestanding
facilities.

         Pretax loss for 1995 was $3,129,000, as compared to $1,841,000 in the
prior year, which included a restructuring charge of $966,000 recorded in
connection with the formation of the Joint





                                      29
<PAGE>   30



Venture.  The current period included a pretax gain of $3,542,000 on the sale
of the Company's interest in the Joint Venture as well as earnings of $835,000
related to the Joint Venture offset by a charge of $2,228,000 related to the
writedown of certain assets, described above.  Operating results from the
Company's freestanding facilities were adversely affected in 1995 by lower
average reimbursement rates and decreases in inpatient average lengths of stay
as a result of managed care and other market forces.  Management expects
operating results for the near future to continue to be adversely affected by
these factors.  See "Recent Developments."

INCOME TAXES

         The Company's effective tax rates were disproportionate to the
statutory tax rates primarily as a result of operating losses on which no prior
year income taxes can be recovered for 1996, permanent differences related to
the disposition of the Company's interest in the Joint Venture for 1995 and as
a result of the amortization of goodwill for 1995 and 1994.  Effective October
1, 1993, the Company adopted on a prospective basis the provisions of Statement
of  Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income
Taxes".

IMPACT OF INFLATION

         Behavioral health programs are labor intensive.  As wages and employee
benefit costs increase during inflationary periods, and outside suppliers pass
cost increases through to the Company, costs rise proportionately.  The Company
has implemented systems to monitor and control increases in expenses.
Government-sponsored programs, including Medicare and Medicaid, which represent
a substantial portion of the Company's revenues, and contractual arrangements
with other third party payors, may limit the Company's ability to obtain
corresponding revenue increases.

LIQUIDITY AND CAPITAL RESOURCES

         At September 30, 1996, the Company had cash and cash equivalents of
$3,611,000.  At that date, such funds were currently invested in short-term
interest bearing securities.

         Cash used in operating activities was $4,882,000 for 1996, as compared
to $2,348,000 for the prior year.  The increase is the result of using
available cash resources to fund continued operating losses.  In a continuing
effort to improve this situation for both the immediate future and the
long-term, the Company sold certain assets relating to its Hospital Division,
and is taking steps to reduce operating expenses, finance its working capital
requirements, restructure debt, raise additional capital and improve its cash
flows.

         Cash provided by investing activities in 1996 included $9,049,000 in
proceeds from the BHC Sale and $50,000 in proceeds from the sale of the Oakview
Treatment Center.  Cash used in investing activities for 1996 included $273,000
for capital expenditures and $150,000 for the acquisition of clinic operations
in Massachusetts.  The Company anticipates capital expenditures of
approximately $50,000 during 1997, primarily for computer equipment.  The
Company has used and anticipates using a portion of the proceeds from the sale
of its freestanding facilities to continue its expansion of the Extended Care
Services Division.  However, based upon the Company's liquidity and capital
resources, there can be no assurance the Company will have sufficient resources
to expand this division.  See "Recent Developments."  Non-cash investing
activities also included notes received in connection with the sale of Oakview
Treatment Center recorded at net estimated realizable value of $1,400,000 and
net liabilities assumed by BHC of $1,160,000 (reflecting post-closing
adjustments by the Company and BHC).





                                       30
<PAGE>   31


         Net cash used in financing activities for 1996 included debt
repayments of $3,280,000.  The Company used a portion of the proceeds from the
BHC Sale for the repayment of the principal amount outstanding under the
Company's revolving credit facility ($2,515,000, including related early
termination fees of $174,000).  In connection with this repayment, the facility
was terminated.  Non-cash financing activities included a $338,000 note payable
incurred in connection with the acquisition of clinic operations in
Massachusetts, payable in 36 monthly installments.

         As of September 30, 1996, the Company had $10,733,000 outstanding
under its note payable to MEDIQ Incorporated ("MEDIQ") (original principal
amount of $11,500,000) that was executed in connection with the distribution of
the Company's stock to MEDIQ's stockholders (the "MEDIQ Note").  The Company is
reviewing with counsel the validity of the MEDIQ Note and its legal rights and
remedies in the event the MEDIQ Note's validity is litigated.  The MEDIQ Note
bears interest at prime plus 1.5% per annum, with monthly payments of interest
only through September 1995, and then monthly principal and interest payments
for the following three years, based on a fifteen year amortization period,
with the remaining balance due in August 1998.  The MEDIQ Note may be prepaid
in whole or in part without penalty.  The MEDIQ Note is collateralized by a
note receivable (in the amount of $1,875,000) obtained by the Company as
partial consideration for the sale of the Oakview Treatment Center, one of the
Company's former freestanding facilities.  The Company pledged the note
receivable to MEDIQ in connection with obtaining a waiver from MEDIQ of an
event of default provision of the MEDIQ Note relating to the sale of the assets
of a significant subsidiary in connection with such sale.

         The Company does not anticipate that cash flows from operations will
be sufficient to repay the MEDIQ Note upon maturity in 1998.  In addition, as
reflected in the financial statements of the Company for the fiscal year ended
September 30, 1996, and the report of the Company's independent auditors
thereon, the Company has been experiencing difficulty generating sufficient
cash flows to meet its obligations and sustain its operations and, as a result,
may not be able to meet the monthly principal and interest obligations under
the MEDIQ Note.  A portion of the net proceeds from the BHC Sale has been used,
and is expected to continue to be available to the Company to fund the monthly
obligations and a portion of the principal obligations upon maturity, if
necessary, of the MEDIQ Note.  MEDIQ has pledged the MEDIQ Note as collateral
for certain of its indebtedness to a third party unaffiliated with MEDIQ or the
Company.  In the event of default by MEDIQ on such indebtedness, such third
party would obtain all of MEDIQ's rights under the MEDIQ Note, including the
right to the payment of principal and interest as and when due in accordance
with the terms of the MEDIQ Note.

         The MEDIQ Note also provides for certain events of default, including:
"The . . . sale of all or substantially all of the assets of [the Company] . .
 ."  In an attempt to preclude the possibility of a dispute as to whether the
BHC Sale constituted the sale of all or substantially all of the assets of the
Company for purposes of the MEDIQ Note, the Company, prior to the sale, sent
MEDIQ a letter requesting a waiver of this provision in connection therewith.
MEDIQ sent the Company a letter in which MEDIQ declined to grant such a waiver.
Since the completion of the BHC Sale, the Company has not received any notice
of default under the MEDIQ Note on this basis.  The Company, based upon
discussions with legal counsel, does not believe the MEDIQ Note is in default. 
Nevertheless, in the event MEDIQ attempts to accelerate the MEDIQ Note, the 
Company intends to aggressively defend its position in any legal





                                      31
<PAGE>   32



proceeding.  There can be no assurances that the Company would be able to
obtain a favorable decision in such a legal proceeding.  In the event the
Company were to receive an adverse decision on this matter, the outstanding
principal balance on the MEDIQ Note would become immediately due and payable in
full.  In that event, the Company may be required to apply any remaining
proceeds from the BHC Sale toward the repayment of the outstanding principal of
the MEDIQ Note, obtain alternative sources of cash with which to satisfy such
obligation, or obtain from MEDIQ a modification to the MEDIQ Note.  The
remaining balance of the net proceeds from the BHC Sale is  insufficient to
repay the entire outstanding principal balance of the MEDIQ Note.  There can be
no assurance that the Company will have sufficient cash to repay the
outstanding principal balance of the MEDIQ Note or that other sources of cash
will be available to the Company in the event the Company was to receive an
adverse decision on such matter.  In such event, the Company may be unable to
fulfill its debt obligations and also sustain operations at a level at which
the Company could continue as a going concern.

         As a result of the Company's continued negative operating results and
reduced collections of accounts receivable from certain government-funded
payors, as well as other administrative delays by third party payors (including
reimbursement review of certain Medicare claims in Southern California, as
described above), the Company has been experiencing difficulty generating
sufficient cash flows from operations to meet its obligations and sustain its
operations without the use of available cash.  In an effort to improve this
situation, the Company has pursued opportunities to sell its freestanding
facilities and is taking steps to reduce operating expenses, attempting to
raise additional capital, and working to improve its cash flows.  The Company
has sold six of its seven freestanding facilities.  See "Recent Developments."
With respect to its efforts to reduce operating expenses, the Company reduced
its office lease expense by decreasing the amount of its leased space and has
reduced personnel expenses by leasing its employees and eliminating staff. The
Company's liquidity could also be improved by: (i) the collection of additional
outstanding receivables; (ii) increasing profits through acquisitions; (iii)
significant reductions in the operating losses of the Company's remaining
businesses; (iv) significant additional reductions in overhead; and (v)
obtaining additional capital and/or financing sources.  However, there can be
no assurance that any of such events will occur or, if they do occur, that the
impact on cash flows will be sufficient to enable the Company to continue its
operations.  In the event that the Company is unable to enhance its liquidity,
the Company may be required to renegotiate the terms of its financial
obligations, significantly curtail its level of operations or otherwise
significantly reduce operating expenses.

         The Company has had discussions with potential investors with the
objective of raising additional capital.  To date, such efforts have been
unsuccessful.  The Company believes that it may be unable to obtain additional
capital without obtaining modifications to its financial obligations to MEDIQ.

         The Company has commenced discussions with representatives of MEDIQ
with the objective of renegotiating the terms of the MEDIQ Note.  To date, such
discussions have not resulted in any modification to the Company's financial
obligations to MEDIQ.  As a result, there can be no assurance that the Company
will be successful in restructuring such obligations, or that the Company will
be successful in raising additional capital.

         As of September 30 , 1996, the Company had a liability to third party
payors of approximately $2,500,000, of which approximately $1,730,000 relates
to sold facilities.  This liability relates to outstanding Medicare cost report
settlements from fiscal years 1995 and 1996 and outstanding Medicaid cost
reports from fiscal years 1992 through 1996 at two closed facilities.





                                       32
<PAGE>   33


         As a result of the sale by the Company of five of its hospitals  to
BHC on May 31 , 1996, the Company filed terminating Medicare and Medicaid cost
reports with each hospital's fiscal intermediary on October 31, 1996.

         The terminating cost reports filed by the Company included claims for
approximately $1,492,000 in Medicare depreciation recapture.  The BHC Agreement
provides that this recapture amount be allocated between the Company (85%) and
the purchaser (15%).  The Company estimates that its share of the Medicare
recapture amounts to be collected will be approximately $1,270,000, of which
the Company has recorded approximately 50%, and that it will receive final
settlements on these claims within one to three years from the date of filing.

         The Company expects the costs associated with discontinuing the
operations of SCC to be nominal.  The Company believes that the loss of SCC's
reduced revenues following increased delays in claims processing by the
Medicare fiscal intermediary will be offset by reduced personnel and overhead
costs.  The Company will continue to employ administrative personnel to pursue
SCC claims and will redeploy two employees with employment contracts through
July 1998 elsewhere within the Company.

         In addition, the Company estimates that it will take three to four
months to process SCC's outstanding accounts receivable, including the appeals
for previously denied claims, at a cost approximating $100,000.  There can be
no assurance that the appeal process will result in a significant percentage of
reversals, additional denials will not be received by SCC, actual bad debt
experience will not exceed the Company's estimates or that the review of SCC's
claims will not result in potential liability for the Company.

         This report includes forward-looking statements based on management's
current plans and expectations, relating to, among other matters, the
anticipated use of proceeds from the sale of freestanding facilities, the
proposed business activities of the Company, estimates of amounts that are not
yet determinable and the proposed activities of the Company relating to
improving its liquidity.  Such statements involve risks and uncertainties which
may cause actual future activities and results of operations to be materially
different from that suggested in this report, including, among others, the use
of available cash resources to fund continued operating losses, the amount and
timing of receipt of government reimbursement and the results of the review of
SCC's claims by the Medicare fiscal intermediary, risks associated with
industry consolidation and acquisitions, the need to manage growth, the
possible need to use the net cash proceeds from the sale of freestanding
facilities for the retirement of certain indebtedness and competition.





                                      33
<PAGE>   34




ITEM 8.  FINANCIAL STATEMENTS

<TABLE>
<S>                                                                                                   <C>
Independent Auditors' Report                                                                          35

Consolidated Statements of Operations -
  Three Years Ended September 30, 1996                                                                36

Consolidated Balance Sheets -
  September 30, 1996 and 1995                                                                         37

Consolidated Statements of Stockholders' (Deficit) Equity -
  Three Years Ended September 30, 1996                                                                38

Consolidated Statements of Cash Flows -
  Three Years Ended September 30, 1996                                                                39-40

Notes to Consolidated Financial Statements                                                            41-54
</TABLE>





                                       34
<PAGE>   35


                          Independent Auditors' Report

Board of Directors and Stockholders
MHM Services, Inc.
Vienna, Virginia

We have audited the accompanying consolidated balance sheets of MHM Services,
Inc. and subsidiaries as of September 30, 1996 and 1995, and the related
consolidated statements of operations, stockholders' (deficit) equity, and cash
flows for each of the three years in the period ended September 30, 1996.  Our
audits also included the financial statement schedule listed in the Index at
Item 14.  These financial statements and the financial statement schedule are
the responsibility of the Company's management.  Our responsibility is to
express an opinion on the financial statements and the financial statement
schedule 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, such consolidated financial statements present fairly, in all
material respects, the financial position of MHM Services, Inc. and
subsidiaries as of September 30, 1996 and 1995, and the 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.
Also, in our opinion, the financial statement schedule, when considered in
relation to the basic consolidated financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.

The accompanying consolidated financial statements have been prepared assuming
that the Company will continue as a going concern.  The Company has incurred
aggregated net losses of $20,448,000 for the three years ended September 30,
1996 and has a stockholders' deficiency of $3,582,000 as of September 30, 1996
and is experiencing difficulty in generating sufficient cash flows to meet its
obligations and sustain its operations, as discussed in Note 2 to the
consolidated financial statements.  Such conditions raise substantial doubt as
to the Company's ability to continue as a going concern.  Management's plans
concerning these matters are also described in Note 2 to the consolidated
financial statements.  The consolidated financial statements do not include any
adjustments that might result from the outcome of this uncertainty.


DELOITTE & TOUCHE LLP
Washington, D.C.
December 30, 1996





                                      35
<PAGE>   36



                               MHM SERVICES, INC.
                                AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>
<CAPTION>
                                                                             Year Ended September 30,               
                                                          -------------------------------------------------------------
                                                                   1996                 1995                1994    
                                                                 --------              --------          --------

<S>                                                             <C>                  <C>                 <C>
Net revenues                                                    $34,670,000          $41,109,000         $48,286,000

Costs and expenses:
  Operating                                                      25,765,000           28,918,000          33,895,000
  General and administrative                                      9,718,000           10,085,000          10,644,000
  Provision for bad debts                                         6,320,000            4,467,000           2,009,000
  Depreciation and amortization                                   1,034,000            1,603,000           1,617,000
  Loss on sale of freestanding facilities                         4,440,000                   --                  --
  Writedown of long-term assets                                     461,000            2,228,000                  --
  Restructuring charges                                                                       --             966,000
Other (credits) charges:
  Equity in earnings of Joint Venture                                    --             (835,000)           (292,000)
  Gain on sale of Joint Venture                                          --          ( 3,542,000)                 --
  Interest expense - MEDIQ                                        1,097,000            1,171,000             932,000
  Interest expense - other                                          290,000              366,000             389,000
  Other (income) expense - net                                     (233,000)            (223,000)            (33,000)
                                                                ------------         ------------        ------------

Loss before income taxes, extraordinary item and
  cumulative effect of a change in accounting principle         (14,222,000)         ( 3,129,000)         (1,841,000)

Income tax (benefit) expense                                       (308,000)             894,000            (525,000)
                                                                ------------         ------------        ------------

Loss before extraordinary item and cumulative
  effect of a change in accounting principle                    (13,914,000)          (4,023,000)         (1,316,000)
Extraordinary item-loss on early extinguishment of debt            (463,000)                                      --
Cumulative effect of a change in accounting principle
  (net of income taxes of $378,000)                                      --                   --            (732,000)
                                                                ------------         ------------        ------------

Net loss                                                       $(14,377,000)         $(4,023,000)        $(2,048,000)
                                                               =============         ============        ============

Loss per share:
Loss before extraordinary item and cumulative
  effect of a change in accounting principle                   $     ( 4.20)         $     (1.22)        $      (.40)
Extraordinary item                                                   (  .14)                  --                  --
Cumulative effect of a change in
  accounting principle                                                   --                   --                (.23)
                                                               -------------         ------------        ------------
Net loss                                                       $      (4.34)         $     (1.22)        $      (.63)
                                                               =============         ============        ============

Weighted average shares outstanding                               3,310,000            3,310,000           3,267,000
                                                               =============         ============        ============ 
</TABLE>

                 See Notes to Consolidated Financial Statements





                                       36
<PAGE>   37



                              MHM SERVICES, INC.
                               AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
                                                                                               September 30,        
                                                                                        --------------------------
                                                                                    1996                       1995
                                                                                    ----                       ----
                                                              Assets
                                                              ------
<S>                                                                         <C>                        <C>
Current assets:
   Cash and cash equivalents                                                $  3,611,000               $  3,084,000
   Accounts receivable, less allowances of $4,404,000 - 1996;
    $1,299,000 - 1995                                                          1,680,000                  7,618,000
   Prepaid expenses                                                              237,000                    397,000
   Income taxes refundable                                                       662,000                         --
   Other receivable                                                              660,000                         --
   Other current assets                                                          258,000                    976,000
                                                                            ------------               ------------

         Total current assets                                                  7,108,000                 12,075,000

Property, plant and equipment, net                                               538,000                 12,581,000
Goodwill, net of accumulated amortization of $188,000 - 1996;
   $2,467,000 - 1995                                                           1,375,000                  4,519,000
Notes receivable                                                               1,229,000                    196,000
Other intangibles, net                                                           230,000                    587,000
Other assets                                                                     348,000                    325,000
                                                                            ------------               ------------

Total assets                                                                $ 10,828,000               $ 30,283,000
                                                                            ============               ============
<CAPTION>
                                          Liabilities and Stockholders' (Deficit) Equity
                                          ----------------------------------------------
<S>                                                                          <C>                       <C>
Current liabilities:
   Accounts payable                                                          $   805,000               $  1,672,000
   Accrued payroll , vacation, severance, and related taxes                      503,000                    866,000
   Accrued expenses - MEDIQ                                                      321,000                    377,000
   Other accrued expenses                                                      1,441,000                  1,814,000
   Income taxes payable                                                          131,000                    204,000
   Current maturities of long-term debt                                          960,000                  1,219,000
                                                                            ------------               ------------
                                                                                             
         Total current liabilities                                             4,161,000                  6,152,000
                                                                                             
Long-term debt, less current maturities:                                                     
   MEDIQ                                                                       9,967,000                 10,733,000
   Other                                                                         257,000                  2,422,000
                                                                                             
Other liabilities                                                                 25,000                    181,000
                                                                                             
Commitments and contingencies                                                                
                                                                                             
Stockholders' (deficit) equity:                                                              
   Preferred stock ($.01 par value; authorized:                                               
     5,000,000; issued and outstanding: none)                                                 
   Common stock ($.01 par value; authorized, 15,000,000;                                      
      issued and outstanding: 3,310,000)                                          33,000                     33,000
   Additional paid-in capital                                                 41,699,000                 41,699,000
   Accumulated deficit                                                       (45,314,000)               (30,937,000)
                                                                            ------------               ------------
                                                                                             
         Total stockholders' (deficit) equity                                 (3,582,000)                10,795,000
                                                                            ------------               ------------
                                                                                             
Total liabilities and stockholders' (deficit) equity                        $ 10,828,000               $ 30,283,000
                                                                            ============               ============
</TABLE>

                 See Notes to Consolidated Financial Statements





                                      37
<PAGE>   38


                               MHM SERVICES, INC.
                                AND SUBSIDIARIES
           CONSOLIDATED STATEMENTS OF STOCKHOLDERS' (DEFICIT) EQUITY


<TABLE>
<CAPTION>
                                           Common Stock                        
                                      -------------------------     Additional
                                      Shares                         Paid-in        Accumulated
                                      Issued             Amount      Capital         Deficit        Total
                                      ------             ------    -------------   -------------    -----
 <S>                                  <C>               <C>         <C>            <C>             <C>
 Balance October 1, 1993              2,980,000         $30,000     $40,382,000    $(24,866,000)   $15,546,000

 Issuance of common stock -
   Acquisition of HCI                   330,000           3,000       1,317,000              --      1,320,000

 Net loss                                    --              --              --      (2,048,000)    (2,048,000)   
                                      ---------         -------     -----------    -------------   ------------

 Balance September 30, 1994           3,310,000          33,000      41,699,000     (26,914,000)    14,818,000

 Net Loss                                    --              --              --      (4,023,000)    (4,023,000)   
                                      ---------         -------     -----------    -------------   ------------

 Balance September 30, 1995           3,310,000          33,000      41,699,000     (30,937,000)    10,795,000

 Net Loss                                    --              --              --     (14,377,000)   (14,377,000)                
                                      ---------         -------     -----------    -------------   ------------

 Balance September 30, 1996           3,310,000         $33,000     $41,699,000    $(45,314,000)   $(3,582,000)  
                                      =========         =======     ===========    =============   ============  
</TABLE>

                 See Notes to Consolidated Financial Statements





                                       38
<PAGE>   39



                               MHM SERVICES, INC.
                                AND SUBSIDIARIES
                    CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
                                                                                Year Ended September 30,
                                                             ------------------------------------------------------
                                                                     1996               1995             1994    
                                                             ------------------   --------------   ----------------

 <S>                                                              <C>                <C>              <C>
 Cash Flows From Operating Activities:
 -------------------------------------
 Net loss                                                         $(14,377,000)      $ (4,023,000)    $ (2,048,000)
 Adjustments to reconcile net loss to net cash
   used in operating activities:
         Depreciation and amortization                               1,034,000          1,603,000        1,617,000
         Provision for bad debts                                     6,320,000          4,467,000        2,009,000
         Provision (benefit) for deferred income taxes                 500,000           (215,000)        (330,000)
         Loss on sale of freestanding facilities                     4,440,000                 --               --
         Undistributed earnings from Joint Venture                          --           (835,000)        (292,000)
         Gain on sale of Joint Venture                                      --         (3,542,000)              --
         Writedown of long-term assets                                 461,000          2,228,000               --
         Net effect of change in accounting principle                       --                 --          732,000
         Other                                                                             57,000           85,000
         Increase (decrease) from changes in:
           Accounts receivable                                        (382,000)        (2,596,000)      (5,406,000)
           Income taxes refundable                                    (662,000)
           Prepaid and other current assets                            (42,000)           803,000         (206,000)
           Accounts payable                                           (867,000)          (514,000)       2,481,000
           Accrued payroll and related taxes                          (363,000)           118,000         (226,000)
           Accrued expenses - MEDIQ                                    (56,000)          (616,000)         (12,000)
           Other accrued expenses                                     (815,000)          (271,000)         985,000
           Income taxes payable                                        (73,000)           988,000         (973,000)
                                                                   -----------        -----------      ----------- 

 Net cash used in operating activities                              (4,882,000)        (2,348,000)      (1,584,000)
                                                                   -----------        -----------      ----------- 
 Cash Flows From Investing Activities:
 -------------------------------------
 Proceeds from sale of freestanding facilities and Joint
   Venture                                                           9,099,000          9,609,000               --
 Capital expenditures for property, plant and
   equipment                                                          (273,000)          (631,000)      (1,100,000)
 Distributions from (investment in) Joint Venture                           --          1,000,000       (1,920,000)
 Acquisitions of businesses                                           (150,000)          (100,000)              --
 Deferred costs                                                         69,000                 --               --
 Other assets                                                          (30,000)                --               --
 Other liabilities                                                      (6,000)          (589,000)         (34,000)
                                                                   -----------        -----------      ----------- 

 Net cash provided by (used in) investing activities                 8,709,000          9,289,000       (3,054,000)
                                                                   -----------        -----------      ----------- 
 Cash Flows From Financing Activities:
 -------------------------------------
 Borrowings                                                                 --          1,679,000        6,273,000
 Debt repayments                                                    (3,280,000)        (6,271,000)      (4,104,000)
 Other                                                                 (20,000)                --               --
                                                                   -----------        -----------      ----------- 
 Net cash (used in) provided by financing activities                (3,300,000)        (4,592,000)       2,169,000 
                                                                   -----------        -----------      ----------- 

 Increase (decrease) in cash and cash equivalents                      527,000          2,349,000       (2,469,000)

 Cash and cash equivalents:
   Beginning of year                                                 3,084,000            735,000        3,204,000 
                                                                  ------------       ------------     ------------
   End of year                                                    $  3,611,000       $  3,084,000     $    735,000 
                                                                  ============       ============     ============
</TABLE>





                                      39
<PAGE>   40


<TABLE>
 <S>                                                                <C>             <C>              <C>
 Supplemental disclosure of cash flow information:
   Interest paid                                                    $1,398,000      $  1,577,000     $  1,279,000 
                                                                    ==========      ============     ============ 
   Income taxes (refunded) paid, net                                $  (71,000)     $    121,000     $  1,078,000 
                                                                    ==========      ============     ============ 
 Supplemental disclosure of non-cash investing and
   financing activities:

   Property and equipment and other assets financed
    with capital leases and long-term debt                          $   63,000      $    487,000     $    120,000 
                                                                    ==========      ============     ============ 
   Acquisition - portion financed with long-term debt               $  338,000      $         --     $         --   
                                                                    ==========      ============     ============ 
   Note received from sale of freestanding facility                 $1,400,000      $         --     $         --   
                                                                    ==========      ============     ============ 
   Liabilities assumed - BHC                                        $1,160,000      $         --     $         --   
                                                                    ==========      ============     ============ 
   Issuance of stock - acquisition of HCI                           $       --      $         --     $  1,320,000 
                                                                    ----------      ------------     ============ 
</TABLE>

                 See Notes to Consolidated Financial Statements





                                       40
<PAGE>   41



                               MHM SERVICES, INC.
                                AND SUBSIDIARIES
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Consolidation - The accompanying consolidated financial statements include the
accounts of MHM Services, Inc. and its subsidiaries (the "Company").  All
significant intercompany accounts and transactions have been eliminated in
consolidation.  The Company offers, arranges for, and manages nonacute
healthcare services primarily in institutional settings.  In October 1986, the
Company was acquired by MEDIQ Incorporated ("MEDIQ").  Effective August 31,
1993, MEDIQ distributed to its shareholders the shares of the Company's common
stock (the "Distribution") (see Note 11). The Company's investment in the Joint
Venture was accounted for under the equity method (see Note 4).

For the years ended September 30, 1996, and 1995, approximately 70% of revenue
and for the year ended September 30, 1994, approximately 45% of revenue was
generated from Medicare/Medicaid payments.  The Company operates in the
following states:  Florida (17 facilities), Georgia (324 facilities), Indiana
(54 facilities), Massachusetts (84 facilities), New Jersey (2 facilities),
North Carolina (125 facilities), Ohio (5 facilities), Pennsylvania (3
facilities), Tennessee (24 facilities), Virginia (17 facilities) and Colorado
(1 freestanding facility.)

Patient Service Revenue Recognition - Net patient service revenues are reported
at the estimated net realizable amounts from patients and third party payors
for services rendered, including estimated retroactive adjustments under
reimbursement agreements with third party payors.  Retroactive adjustments are
accrued on an estimated basis in the period in which the related services are
rendered and adjusted in future periods as final settlements are determined.

Contract Management Revenue Recognition - Contract management revenues were
reported as earned based upon patient census data or on a cost plus fixed fee
basis (See Note 4).

Extended Care Services Revenue Recognition - Net revenues from extended care
services are reported at the estimated net realizable amounts from patients and
third party payors for services rendered, less amounts payable to professionals
for the provision of such services.

Charity Care - The Company has a policy of providing charity care at its
behavioral health facilities to patients who are unable to pay.  Such patients
are identified based on financial information obtained from the patient and
subsequent analysis.  Since the Company does not expect payment, estimated
charges for charity care are not included in revenues.  The amount of charity
care provided, at established rates, was $682,000, $1,081,000, and $625,000 for
1996, 1995 and 1994, respectively.

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 amounts 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 those estimates.  The more
significant estimates include the allowance for potential losses from
uncollectible accounts receivable, medicare depreciation recapture income,
estimates of assets and liabilities due from/to third party payors, and the
estimated net realizable value of certain promissory notes.





                                      41
<PAGE>   42


Cash Equivalents - Cash equivalents include all liquid investments with
purchased maturities of three months or less.

Accounts Receivable - The Company's accounts receivable from its freestanding
facilities and Extended Care Services Division are due from its patients and
other third party payors, primarily Medicare, Medicaid, Blue Cross and various
commercial insurance companies.  The Company maintains an allowance for
potential losses from uncollectible accounts.

Property, plant and equipment - Property, plant and equipment are stated at
cost.  Capital leases are recorded at the present value of future lease
payments.  The Company provides for depreciation and amortization on a
straight-line basis as follows:

                 Buildings and improvements                         30 years
                 Furniture, fixtures and equipment                  5-8 years
                 Equipment under capital lease                      5-8 years

Goodwill - Goodwill represents the excess of the purchase price over the fair
value of net assets acquired and is amortized on a straight-line basis over 20
to 40 years (see Note 7).

Carrying Value of Long-Term Assets - At September 30, 1996, the Company adopted
Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
of."  The Company evaluates the carrying value of long-term assets, including
property, plant and equipment, goodwill and other intangible assets, based upon
current and anticipated net income and undiscounted cash flows, and recognizes
an impairment when it is probable that such estimated future net income and/or
cash flows will be less than the carrying value of the asset.  Measurement of
the amount of impairment, if any, is based upon the difference between carrying
value and fair value.  The effect of adopting SFAS No. 121 was not significant.
(See Note 7)

Income Taxes - Effective October 1, 1993, the Company adopted on a prospective
basis the provisions of Statement of Financial Accounting Standards ("SFAS")
No. 109, "Accounting for Income Taxes".  The effect of adopting SFAS No. 109
was not significant.

Malpractice Insurance Coverage - Medical malpractice claims are covered by an
occurrence-basis medical malpractice insurance policy.

Earnings (Loss) Per Share - Earnings (loss) per share is computed using the
weighted average number of shares outstanding during the year.  Stock options
have not been included because their effect would be antidilutive.

Fair Value of Financial Instruments - The fair value of cash, accounts
receivable, accounts payable and accrued expenses are equivalent to their
carrying value because of the short-term maturity of those  instruments.  The
fair values of the Company's long-term debt (see Note 11) are considered to be
equivalent to their carrying values based upon consideration of borrowings with
similar credit ratings, collateral and maturities.





                                       42
<PAGE>   43



Reclassifications - Certain items in the prior years' financial statements have
been reclassified to conform with the 1996 presentation.

NOTE 2 - LIQUIDITY

The accompanying consolidated financial statements have been prepared on a
going concern basis which contemplates the continuation of operations,
realization of assets and liquidation of liabilities in the ordinary course of
business.  The Company has incurred aggregated net losses of $20,448,000 for
the three years ended September 30, 1996, and has a stockholders' deficiency of
$3,582,000 as of September 30, 1996.  The Company is experiencing difficulty in
generating sufficient cash flows to meet its obligations and sustain its
operations.  Such conditions raise substantial doubt about the Company's
ability to continue as a going concern.  The consolidated financial statements
do not include any adjustments that might result should the Company be unable
to continue as a going concern.

Based upon the adverse impact on the Company's operating results of
cost-reduction pressures on in-patient care and the Company's belief that such
pressures would be likely to continue to have an adverse impact on future
results, the Company has focused its strategy on pursuing opportunities to grow
its Extended Care Services Division.  As a result, the Company sold six of its
seven owned and/or operated freestanding behavioral health facilities which
represented 51% of net revenues in 1996.  In a continuing effort to improve
this situation for both the immediate future and the long-term, the Company is
taking steps to reduce operating expenses, finance its working capital
requirements, restructure debt, raise additional capital and improve its cash
flows.  Nevertheless, there can be no assurance that the Company's efforts will
result in positive effects on the Company's financial condition.

NOTE 3 - CHANGE IN ACCOUNTING PRINCIPLE

Effective October 1, 1993, the Company changed its method of accounting for
certain preopening costs and certain costs incurred in securing management
contracts.  Prior to the change, these costs were deferred and amortized over
the estimated periods of benefit, ranging from three to five years.  Based on
trends in industry practice, management reevaluated such policy.  In light of
the type and nature of the costs involved and changes in the Company's
business, management concluded that it was preferable to expense these costs as
incurred.

The cumulative effect of the change in accounting principle on years prior to
1994 was $1,110,000 ($732,000 net of income taxes) which was recorded in the
operating results for the year ended September 30, 1994.  The effect of the
change on the year ended September 30, 1994, was an increase in net loss before
the cumulative effect of the change in accounting principle of $312,000.

NOTE 4 - JOINT VENTURE

Effective August 1, 1994, the Company formed a joint venture ("Joint  Venture")
to combine its contract management business with that of Horizon Mental Health
Services, Inc. ("Horizon") of Denton, Texas.  The Joint Venture, which was
owned 27.5% by the Company and 72.5% by Horizon, managed both companies'
hospital behavioral health care contracts.  The operating results of the
contract management





                                      43
<PAGE>   44


business were included in the Company's results of operations through the
commencement of the Joint Venture on August 1, 1994.

The terms of the Joint Venture provided for the Company's continued ownership
of its management contracts and the assignment to the Joint Venture of the
operating responsibilities and revenues related to such contracts.  The
Company's investment in the Joint Venture represented $1,920,000 of cash for
working capital purposes.  The Company allocated goodwill attributable to the
contract management business in the amount of $4,090,000 (net of accumulated
amortization).  The original amount of goodwill allocated to the contract
management business and the freestanding hospitals was determined based upon
projected income and cash flows of the contract management business and the
freestanding hospitals and the facts and circumstances that existed at the time
of the acquisition of the Company by MEDIQ in 1986.  The amount of goodwill
related to the contract management business was reduced to estimated fair value
in 1992 in connection with the recognition of the impairment in the value of
goodwill.  No gain or loss resulted from the Joint Venture transaction.

On March 20, 1995, Horizon completed its initial public offering, and, in
accordance with the terms of the Joint Venture Agreement, acquired the
Company's interest in the Joint Venture for approximately $9,600,000 (net of
related expenses).  The sale resulted in a gain of approximately $500,000 (net
of income taxes of $3,000,000).  In connection with the sale, the Company
assigned to Horizon all of its rights and interests in its management
contracts.

In connection with the commencement of the Joint Venture, the Company recorded
a restructuring charge of $966,000, representing expenses solely related to the
contract management business.  The restructuring charge includes $496,000 for
employee severance and related costs for the termination of 22 employees
involved directly in the activities of the contract management business,
$150,000 for the write off of fixed assets and other assets used in the
contract management business and $230,000 for resulting excess office space
under lease through 1998.  The fixed assets consisted principally of furniture
and fixtures and computer equipment.  Also included in the charge was $90,000
for legal and consulting services related specifically to the restructuring,
which were substantially incurred prior to July 31, 1994.  The amount of actual
termination benefits subsequently paid and charged against the liability and
the actual number of employees terminated did not differ significantly from
original estimates.  During 1995, the restructuring was completed and the
remaining charges were paid.

In connection with the Joint Venture, commencing in August 1994, the Company
began operating Mountain Crest Hospital, a 60-bed psychiatric facility in Fort
Collins, Colorado, under a sublease agreement with Horizon expiring in December
2000.

NOTE 5 - SALE OF FREESTANDING FACILITIES

On April 5, 1996, the Company sold Oakview Treatment Center to a non-profit
corporation affiliated with a privately-owned operator of two psychiatric
hospitals for $50,000 in cash and $2,150,000,  evidenced by two promissory
notes payable to the Company.  For financial statement purposes, the notes were
recorded at an estimated net realizable value of $1,400,000.  The notes are
payable in monthly installments of principal and interest (at prime) based on a
15 year amortization, with the remaining principal due in five years (or
earlier under certain circumstances).  In connection with obtaining a waiver
from MEDIQ of an event of default provision of the MEDIQ Note relating to the
sale of the





                                       44
<PAGE>   45



assets of a significant subsidiary, the Company pledged one of the notes
receivable (with a principal balance of $1,875,000) as collateral for the
Company's obligations under the MEDIQ Note (see Note 11).

On May 31, 1996, the Company sold certain assets, consisting principally of
five of its freestanding behavioral healthcare facilities, to Behavioral
Healthcare Corporation, pursuant to an Asset Purchase Agreement (the "BHC
Agreement"), dated as of January 24, 1996, and amended as of April 11, 1996, by
and between the Company and BHC (the "BHC Sale").  The facilities were sold to
BHC for approximately $10,209,000, consisting of $9,049,000 in cash and
$1,160,000 in assumed liabilities of the freestanding facilities (reflecting
post-closing adjustments by both parties).

The Company used a portion of the proceeds from the BHC Sale for (i) the
repayment of the principal amount outstanding under the Company's revolving
credit facility ($2,515,000, including related early termination fees of
$174,000); (ii) the extinguishment of a portion of the indebtedness not assumed
by BHC at the closing of the sale ($692,000, including early termination fees
of $139,000), which consisted primarily of indebtedness secured by certain of
the assets (particularly a facility and certain equipment) acquired by BHC; and
(iii) the funding of the Company's obligation to complete repairs to two of the
freestanding facilities sold to BHC in the amount of $284,000 (of which
$216,000 remains in escrow).

The pretax loss on the sale of six of its seven freestanding behavioral health
facilities in 1996 was $4,440,000 consisting primarily of the write off of
intangibles related to the facilities of $3,184,000, loss on the sale of
certain property, plant, and equipment aggregating $319,000, transaction
expenses of $568,000, severance expenses of $349,000, and other expenses of
$680,000, offset by estimated Medicare depreciation recapture income of
approximately $660,000.

NOTE 6 - ACQUISITIONS

MHM Counseling Services - In December 1995, the Company's Extended Care
Services Division acquired the behavioral healthcare clinic operations of
National Mentor, Inc. located in Charlestown and Taunton, Massachusetts.  The
Company changed the name of the clinics to MHM Counseling Services.  The
purchase price included cash of $150,000 and a $338,000 term loan payable in 36
monthly installments. The operating results of the acquired business are
included in the Company's consolidated results of operations from the date of
acquisition.

Supportive Counseling Care - In July 1995, the Company acquired certain assets
of Supportive Counseling Care ("SCC") of Manhattan Beach, California, a
provider of behavioral healthcare services to extended care facilities, for
$500,000, and entered into a 40 year management contract to provide
administrative services to SCC.  The purchase  price was allocated primarily to
intangible assets.  The operating results of the acquired business are included
in the Company's consolidated results of operations from the date of
acquisition.  This business was discontinued in December 1996 (See Note 7).

HCI Services - On November 18, 1993, the Company acquired substantially all of
the assets and assumed certain liabilities of ICH Services, L.L.C. (successor
to HCI Services) ("HCI") of Atlanta, Georgia, a provider of specialized medical
and behavioral health services under annual contracts with extended care
facilities, for 330,000 shares of the Company's common stock, with a fair
market value of $1,320,000.  Additional consideration in cash or additional
shares of the Company's common stock, at





                                      45
<PAGE>   46


the option of the seller, will be payable after the third anniversary of the
acquisition in an amount equal to twenty percent of the appraised fair market
value of HCI as of November 18, 1996.  (See Note 18).

Upon the acquisition, HCI's contracts were identified as intangible assets. The
contracts, which had one-year terms with annual renewals and could be canceled
upon 30 days' notice, were between HCI and the extended care facilities and
permitted HCI to provide services to residents through licensed professionals.
HCI did not receive any compensation from the facility or the resident and its
activities were limited to scheduling visits to the facility and billing third
party payors on behalf of the independent professional.  HCI derived revenues
based on a percentage of the revenues received by the professionals who
provided medical services.  Such services were provided only as needed by the
resident.  The residents were not required by the extended care facility or HCI
to utilize HCI's professionals.  In addition, the historical results of such
contracts had negative operating profits and cash flows.  Based upon
management's analysis, including the factors described above, the Company did
not assign any value to the contracts.  Accordingly, the excess of the purchase
price over the fair values of the net assets acquired, in the amount of
$1,207,000, was recorded as goodwill, which is amortized over 20 years.  The
operating results are included in the Company's consolidated results of
operations from the date of acquisition.

NOTE 7 - WRITEDOWN OF LONG-TERM ASSETS

In November 1996, the Company decided that its SCC operation was to be
discontinued because of its continuing losses.  The Company shut down
operations in early December 1996.  Fixed assets of approximately $12,000 will
either be sold or redeployed elsewhere in the Company.  As a result, the
carrying value of all other assets related to SCC, primarily intangibles, have
been written off resulting in a charge of $461,000 in the year ended September
30, 1996.

In fiscal 1995, the Company determined that the recoverability of certain of
the assets, including property, plant and equipment and goodwill, related to
one of the Company's freestanding facilities was impaired, other than
temporarily.  Accordingly, the carrying value of such assets was reduced to the
estimated fair value, resulting in a charge of $2,228,000 based upon an
independent appraisal.

The Company completed the sale of six of its seven freestanding behavioral
health facilities in 1996 and recorded a loss of $4,440,000 consisting
primarily of write off of intangibles related to the facilities of $3,184,000,
loss on the sale of certain property, plant  and equipment aggregating
$319,000, transaction expenses of $568,000, severance expenses of $349,000, and
other expenses of $680,000, offset by estimated Medicare depreciation recapture
income of approximately $660,000.

NOTE 8 - THIRD PARTY PAYORS

The Company has agreements with third party payors that provide for payments
for patient services at amounts which differ from its established rates.  A
summary of the payment arrangements with major third party payors follows.

Medicare - In-patient nonacute services, certain outpatient services and
defined capital costs related to Medicare beneficiaries are paid primarily on a
cost reimbursement basis.  The Company is reimbursed





                                       46
<PAGE>   47



for cost reimbursable items at a tentative rate with final settlement
determined after submission of annual cost reports by the Company and audits
thereof by the Medicare fiscal intermediary.

Other Third Party Payors - The Company has also entered into payment agreements
with certain commercial insurance carriers, health maintenance organizations
and preferred provider organizations.  The basis for payment to the Company
under these agreements includes prospectively determined rates per discharge,
discounts from established charges and prospectively determined daily rates.
Services rendered to Blue Cross subscribers are paid based upon the provisions
of individual plans and include payment of predetermined rates or a percentage
of charges.

NOTE 9 - PROPERTY, PLANT AND EQUIPMENT

<TABLE>
<CAPTION>
                                                                        September 30,
                                                          -------------------------------------------
                                                               1996                    1995
                                                          ----------------        -------------------

  <S>                                                       <C>                      <C>
  Land                                                      $       --               $ 1,663,000
  Buildings and improvements                                    18,000                13,213,000
  Furniture, fixtures and equipment                            836,000                 5,176,000
  Equipment under capital lease                                314,000                   679,000
                                                               -------                ----------

                                                             1,168,000                20,731,000
  Less accumulated depreciation and amortization               630,000                 8,150,000
                                                             ---------                ----------

                                                            $  538,000               $12,581,000
                                                            ==========               ===========
</TABLE>

See Note 5 for description of sale of freestanding facilities.

Depreciation and amortization expense related to property, plant and equipment
was $735,000, $1,272,000 and $1,195,000 for 1996, 1995 and 1994, respectively.

NOTE 10 - OTHER ACCRUED EXPENSES

Other accrued expenses included the following:

<TABLE>
<CAPTION>
                                                                        September 30,
                                                          -----------------------------------------
                                                               1996                    1995
                                                          ----------------        -----------------

<S>                                                         <C>                       <C>
Accrued rent                                                $  218,000                $  290,000
Accrued refunds                                                345,000                    64,000
Accrued professional fees                                      196,000                   176,000
Other accrued expenses                                         682,000                 1,284,000
                                                            ----------                ----------

                                                            $1,441,000                $1,814,000
                                                            ==========                ==========
</TABLE>

NOTE 11 - LONG-TERM DEBT

In connection with the Distribution, the Company executed a five-year note (the
"MEDIQ Note") for the balance of unpaid management fees and intercompany
interest in the original principal amount of $11,500,000, which bears interest
at a rate of prime plus 1.5% (9.75% at September 30, 1996), with monthly
payments of interest only through September 1995 and then monthly principal and
interest payments for the following three years (principal payments of $767,000
were made in 1996, and





                                      47
<PAGE>   48


principal payments of $766,000 are due in 1997), based on a fifteen year
amortization period, with the balance due on August 31, 1998.

The MEDIQ Note provides for certain events of default, including the
"sale of all or substantially all of the assets" of the Company.  In an attempt
to preclude the possibility of a dispute as to whether the BHC Sale constitutes
the sale of all or substantially all of the assets of the Company for purposes
of the MEDIQ Note, the Company, prior to the sale, sent MEDIQ a letter
requesting a waiver of this provision in connection therewith.  MEDIQ sent the
Company a letter in which MEDIQ declined to grant such a waiver.  Since the
completion of the BHC Sale, the Company has not received any notice of default
under the MEDIQ Note.  The Company, based upon discussions with legal counsel,
does not believe the MEDIQ Note is in default.  Therefore, the MEDIQ Note is
classified as noncurrent at September 30, 1996.  In the event MEDIQ attempts to
accelerate the MEDIQ Note, the Company intends to aggressively defend its
position in any legal proceeding.  There can be no assurances that the Company
would be able to obtain a favorable decision in such a legal proceeding.

Other long-term debt is as follows:

<TABLE>
<CAPTION>
                                                                        September 30,
                                                          -----------------------------------------
                                                               1996                    1995
                                                          --------------          -----------------

<S>                                                         <C>                        <C>
Revolving credit facility (prime + 2%)                      $       --                 $1,679,000
Term loans                                                     289,000                    900,000
Capital lease obligations                                      162,000                    295,000
                                                            ----------                 ----------

                                                               451,000                  2,874,000
Less current maturities                                        194,000                    452,000
                                                            ----------                 ----------

                                                            $  257,000                 $2,422,000
                                                            ==========                 ==========
</TABLE>


On August 14, 1995, the Company entered into a new $5,000,000 revolving credit
facility with a commercial lender.  The facility bore interest at the prime
rate plus 2% (10.75% at September 30, 1995), was secured by accounts receivable
from the freestanding facilities and property, plant and equipment at two of
the freestanding facilities.  The Company repaid the outstanding balance of the
revolving credit facility with proceeds from the sale of the freestanding
facilities (see Note 5).

In March 1995, the Company utilized a portion of the proceeds from the sale of
its investment in the Joint Venture (see Note 4) to repay the $5,100,000
outstanding principal balance of another revolving credit facility, which was
scheduled to mature March 31, 1995.

At September 30, 1996, term loans include unpaid debt incurred related to the
acquisition in December, 1995 (MHM Counseling Services) of approximately
$254,000 which is being paid monthly (see Note 6) and unpaid debt incurred
related to the acquisition in July, 1995 (SCC - see Note 6) of approximately
$35,000.  The term loans at September 30, 1995, consisting of debt incurred in
connection with the acquisition  of a freestanding facility, were repaid in
connection with the sale of the freestanding facilities (see Note 5).

Capital lease obligations are payable in monthly installments, including
interest at rates approximating 10% through 2001.  The leases are
collateralized by certain furniture, fixtures and equipment, which have a net
book value of $143,000 at September 30, 1996. The Company repaid capital leases
of





                                       48
<PAGE>   49



approximately $237,000 (including early termination fees of $139,000) secured
by certain assets sold to BHC with a portion of the proceeds from the sale of
the freestanding facilities (see Note 5).

In 1996, the Company recorded an extraordinary item in the amount of $463,000,
consisting primarily of costs related to the early retirement of the Company's
long-term debt and the write off of associated loan acquisition costs.

Scheduled maturities of long-term debt (including the MEDIQ Note) are as
follows:

<TABLE>
           <S>                                                        <C>
           Year Ending September 30,
                  1997                                                $      960,000
                  1998                                                    10,131,000
                  1999                                                        73,000
                  2000                                                        15,000
                  2001                                                         5,000
                                                                      --------------
                  
                                                                      $   11,184,000
                                                                      ==============
</TABLE>

NOTE 12 - COMMITMENTS AND CONTINGENCIES

Leases - The Company leases certain equipment and office facilities under
noncancelable leases.  The future minimum lease payments required under
operating leases are as follows:



<TABLE>
           <S>                                                       <C>
           Year Ending September 30,
                  1997                                               $   955,000
                  1998                                                   930,000
                  1999                                                   756,000
                  2000                                                   149,000
                  2001                                                    26,000
                                                                     -----------
                  
                  Total minimum lease payments                       $ 2,816,000
                                                                     ===========
</TABLE>


Lease expense was $1,433,000, $2,053,000, and $1,240,000 for 1996, 1995 and
1994, respectively.  The terms of the lease for its facility in Fort Collins,
Colorado, expiring in December 2000, require additional rent based upon 6.5% of
the net revenues of the facility and 50% of excess cash flow (as defined in the
lease agreement).

Litigation - The Company is involved in various legal proceedings incidental to
its business, some of which may be covered by insurance.  The Company knows of
no litigation, either pending or threatened, which is likely to have a material
adverse effect on the Company's consolidated financial statements.

NOTE 13 - COMMON STOCK AND PREFERRED STOCK

The Company's stockholders approved, effective October 28, 1994, a restatement
of the Company's Certificate of Incorporation reducing the number of authorized
shares of common stock from 25,000,000 to 15,000,000 and preferred stock from
10,000,000 to 5,000,000.





                                      49
<PAGE>   50


NOTE 14 - INCOME TAXES

Income tax (benefit) expense consisted of the following:

<TABLE>
<CAPTION>
                                                                       Year Ended September 30,        
                                                            --------------------------------------------
                                                               1996             1995            1994   
                                                            ----------       ----------      -----------
         <S>                                                <C>              <C>              <C>
         Current:
           Federal                                          $(662,000)       $  670,000       $(213,000)
           State                                             (146,000)          439,000          18,000
                                                            ----------       -----------      ---------- 
                                                             (808,000)        1,109,000        (195,000)
                                                            ----------       -----------      ----------  
         Deferred:
           Federal                                            500,000          (200,000)       (334,000)
           State                                                   --           (15,000)          4,000
                                                            ----------       -----------      ----------  
                                                              500,000          (215,000)       (330,000)
                                                            ----------       -----------      ---------- 
         Total income tax (benefit) expense                 $(308,000)       $  894,000       $(525,000)
                                                            ==========       ===========      ==========
</TABLE>


The differences between the effective income tax (benefit) expense and the
income tax (benefit) expense computed using the U.S.  Federal income tax rate
were as follows:

<TABLE>
<CAPTION>
                                                                   Year Ended September 30,
                                                       ----------------------------------------------
                                                            1996             1995           1994
                                                       ----------------------------------------------

 <S>                                                     <C>               <C>             <C>
 Statutory benefit                                       $(4,888,000)      $(1,064,000)    $(626,000)
 State income taxes, net of federal (benefit) tax            (96,000)          280,000        15,000
 Valuation reserve                                         4,658,000                --            --
 Effect of disposition of Joint Venture                           --         1,206,000            -- 
 Writedown of long-term assets                                    --           300,000            -- 
 Goodwill amortization                                        18,000            65,000        83,000 
 Other items - net                                                --           107,000         3,000
                                                           ---------         ---------     ---------
 Income tax (benefit) expense                              $(308,000)         $894,000     $(525,000) 
                                                           =========         =========     =========
                                                                                                      
</TABLE>





                                       50
<PAGE>   51



Significant components of deferred tax assets and liabilities follows:

<TABLE>
<CAPTION>
                                                                            Year Ended September 30,
                                                                --------------------------------------------------
                                                                          1996                       1995
                                                                ----------------------        --------------------

 <S>                                                                    <C>                           <C>
 Assets
 ------
 Allowance for doubtful accounts                                         $1,136,000                   $  326,000
 Capital loss carryforward                                                  832,000                           --
 Net operating loss carryforwards                                         3,195,000                      632,000
 Writedown of long-term assets                                              157,000                      486,000
 Other                                                                      112,000                      302,000
 Valuation allowance                                                     (5,290,000)                    (632,000)
                                                                         ----------                    --------- 
                                                                            142,000                    1,114,000
 Liabilities
 -----------
 Prepaid expenses                                                            77,000                      119,000
 Depreciation and amortization                                               34,000                      278,000
 Other                                                                       31,000                      217,000
                                                                          ---------                     --------
                                                                            142,000                      614,000
                                                                             ------                     --------   
 Net deferred tax asset                                                 $       -0-                     $500,000
                                                                        ===========                     ======== 
</TABLE>

At September 30, 1996, for income tax purposes, the Company had federal and
state net operating loss carryforwards of approximately $6,900,000 and
$14,000,000, respectively, expiring through 2011 and federal capital loss
carryforwards of $2,400,000 expiring in 2001.  The change in valuation
allowance was $4,658,000 in 1996 and $151,000 in 1995.

NOTE 15 - RELATED PARTY TRANSACTIONS

Accrued expenses - MEDIQ - Amounts payable to MEDIQ primarily represent unpaid
federal taxes for the period in which the Company was included in MEDIQ's
consolidated federal tax return and expenses incurred by MEDIQ on behalf of the
Company.  Pursuant to an informal arrangement between MEDIQ and the Company,
such amounts are expected to be paid with available working capital.

Interest Expense - MEDIQ - The Company incurred interest expense related to the
note payable to MEDIQ of $1,097,000, $1,171,000 and $932,000 in 1996, 1995 and
1994, respectively.

Services Agreement - MEDIQ - Since April 1, 1993, the Company has obtained
certain legal, accounting, tax and risk management services from MEDIQ at
prescribed rates pursuant to a services agreement.  The services agreement
terminated in 1996.  Fees for such services were $38,000, $140,000 and 
$138,000 for 1996, 1995 and 1994, respectively, and are included in general 
and administrative expenses.

Insurance - Prior to May 29, 1993, the Company obtained certain of its
insurance coverages through MEDIQ's insurance program.  Insurance expense under
these programs was $64,000 and $212,000 for 1995 and 1994, respectively.
Insurance expense for 1995 and 1994 included retroactive premium adjustments
based upon the development of outstanding claims.

Tax Allocation/Sharing Agreement - Pursuant to a tax allocation/sharing
agreement, the Company will reimburse MEDIQ for any future tax assessments
against MEDIQ resulting from the Company's operations, the Company will be
reimbursed by MEDIQ for any future tax benefit derived by MEDIQ resulting from
the Company's operations and the Company will be indemnified for certain tax
liabilities,





                                      51
<PAGE>   52


in each case, for periods during which the Company had been a member of MEDIQ's
consolidated group.

NOTE 16 - STOCK OPTION PLANS

In August 1993, the Company's Board of Directors adopted a Stock Option Plan
(the "Stock Option Plan") and a Stock Option Plan for Non-Employee Directors
(the "Directors' Stock Option Plan").  Under the Stock Option Plan, up to
350,000 shares of the Company's Common Stock may be subject to stock options
granted to officers and key employees of the Company.  Options may not be
granted for a term in excess of ten years from the date of grant.  As of
September 30, 1996, options to acquire 147,600 shares of stock were exercisable
under the Stock Option Plan and options to acquire 10,000 shares of stock were
exercisable under the Directors' Stock Option Plan.  Exercise prices  of stock
options granted represent fair market value of the Common Stock at date of
grant.  A summary of activity for 1996 and 1995 follows:

<TABLE>
<CAPTION>
                                           Number of                Option Price
                                             Shares                   Per Share  
                                           ----------               -------------

<S>                                         <C>                     <C>
October 1, 1994                              264,600                $3.75 to $5.25

Granted                                       64,000                $3.00
Terminated                                   (59,000)               $3.00 to $5.25
                                           ----------               --------------

September 30, 1995                           269,600                $3.00 to $5.25

Granted                                       61,500                $1.00 to $3.00
Terminated                                   (71,500)               $3.00 to $5.25
                                           ----------               --------------

September 30, 1996                           259,600                $1.00 to $4.25
                                           ==========               ==============
</TABLE>


The Company will be required to adopt Statement of Financial Accounting
Standards ("SFAS") No. 123, "Accounting for Stock Based Compensation", in
fiscal year 1997.  The Company will elect to continue to measure compensation 
cost using APB Opinion No. 25 and, accordingly, will provide the disclosures 
required by SFAS No. 123.

NOTE 17 - RETIREMENT PLAN

The Company has a 401(k) plan (the "Plan").  Employees are eligible to join the
Plan upon completion of one year of service during which they have worked a
minimum of 1,000 hours and are age 21 or older.  The Plan provides that the
Company will make a matching contribution equal to $0.50 for each $1.00
contributed by a participant not to exceed 3% of a participant's compensation.
The Company's matching contribution is made in cash to be used to purchase
shares of common stock of the Company for the accounts of the participants.
For the years ended September 30, 1996, 1995 and 1994, the Company's
contributions were $70,000, $81,000, and $11,000 respectively.





                                       52
<PAGE>   53



NOTE 18 - SUBSEQUENT EVENTS

Acquisition of Extended Care Operations in Massachusetts (Liberty Bay).
Effective as of December 1, 1996, the Company's Extended Care Services Division
acquired, pursuant to an Agreement (the "Liberty Bay Agreement") by and among
the Company, MHM Extended Care Services, Inc., Liberty Bay Colony Health
Services, Inc ("Liberty Bay") and Liberty Management Group, Inc. ("Liberty
Management"), certain assets and contractual rights from Liberty Bay which
constituted Liberty Bay's geropsychiatric management services operations in
Massachusetts.  Liberty Bay, a wholly-owned subsidiary of Liberty Management,
provided behavioral healthcare services on a contract basis to residents of
approximately 60 extended care facilities in Massachusetts.  The Company has
commenced integrating these operations with MHM Counseling Services and the
combined operations will operate under the name "MHM/Bay Colony Counseling
Services", and, as a result of the acquisition, will serve approximately 80
extended care facilities.

As consideration for the purchase, the Company paid Liberty Bay $150,000 in
cash and issued a promissory note in the principal amount  of $150,000 (the
"Liberty Bay Note").  The purchase price will be primarily allocated to
intangible assets.  The Liberty Bay Note provides for quarterly interest
payments at an annual rate of 9% and the payment of the principal amount in one
installment on December 1, 1999.  The Company also agreed to pay Liberty Bay
additional consideration consisting of 20% of "cash flow" (as such term is
defined in the Liberty Bay Agreement) from the acquired contracts over the five
year period commencing December 1, 1996.  Such additional consideration is
payable annually by the Company and is calculated on a contract-by-contract
basis.

Discontinuance of SCC Operations.  The Company expects the costs associated
with discontinuing the operations of SCC to be nominal.  The Company believes
that the loss of SCC's reduced revenues following increased delays in claims
processing by the Medicare financial intermediary will be offset by reduced
personnel and overhead costs.  The Company will continue to employ
administrative personnel to pursue SCC claims and will redeploy two employees
with employment contracts through July 1998 elsewhere within the Company.

In addition, the Company estimates that it will take three to four months to
process SCC's outstanding accounts receivable, including the appeals for
previously denied claims, at a cost approximating $100,000.  There can be no
assurance that the appeal process will result in a significant percentage of
reversals, additional denials will not be received by SCC, actual bad debt
experience will not exceed the Company's estimates or the review of SCC's
claims will not result in potential liability for the Company.

ICH Services Acquisition and Agreement.  In an effort to avoid the time,
expense and possibility of disagreement inherent to the appraisal process,
related to the additional consideration of the acquisition, the Company has had
discussions with ICH for the purpose of modifying the terms of the additional
consideration.  Although no definitive agreement has been reached to date, the
Company expects to execute such an agreement with the former ICH members in the
near future.  As proposed, such agreement, which would replace the existing
additional consideration provisions, would require the Company to issue an
aggregate of an additional 266,089 shares of Common Stock to the former ICH
members as soon as practicable after obtaining listing approval from the
American Stock Exchange for such shares and pay the former ICH members (in the
aggregate) approximately $52,562 in cash.  The





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<PAGE>   54


proposed amendment would also require the Company to pay to each former ICH
member on November 1, 1997, a one time adjustment payment equal to the positive
difference, if any, between (i) $3.56 per share multiplied by the number of
Company shares such former ICH member received as additional consideration and
(ii) the gross proceeds received by such former ICH member from the sale of all
of such former ICH member's shares of common stock of the Company received as
additional consideration.  The additional consideration will be recorded as
goodwill and amortized over 20 years.

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

         There were no changes in nor disagreements with accountants on
accounting and financial disclosure.



                                    PART III

 The information required to be included herein has been incorporated herein by
reference to the Company's proxy statement for the Annual Meeting of
Stockholders to be held in 1997.





                                       54
<PAGE>   55




                                    PART IV

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

(a)(1)           The response to this portion of Item 14 is submitted as a
                 separate section of this report commencing on page 34.

(a)(2)           FINANCIAL STATEMENT SCHEDULES

                 Schedule II Valuation and Qualifying Accounts and Reserves

                 Other schedules are omitted because of the absence of
                 conditions under which they are required.

(a)(3)           EXHIBITS.  The Exhibits are listed in the Exhibit Index
                 appearing below.

(b)              REPORTS ON FORM 8-K:      The Company submitted a Current
                 Report on Form 8-K on September 6, 1996 with its restated
                 Articles of Incorporation and on September 13, 1996 to
                 announce a new Director, William P. Ferretti, to replace
                 Abraham D. Gosman.

(c)              EXHIBITS (numbered in accordance with Item 601 of Regulation
                 S-K).

Exhibit #                 Description and Method of Filing
-----------------------------------------------------------

2.1              Distribution Agreement by and between MHM and MEDIQ (1)
2.2              Agreement regarding L.L.C. dated August 1, 1994 (2)
2.3              Limited Liability Agreement dated August 1, 1994 (2)
3.1              Restated Articles of Incorporation of MHM (6)
3.2              Amended Bylaws of MHM (7)
4.1              Specimen MHM Common Stock Certificate (3)
10.1             Tax Indemnification Agreement, dated August 31, 1993 by and
                 between MHM and MEDIQ (1)
10.2             Services Agreement, dated August 31, 1993 by and between MHM
                 and MEDIQ (1)
10.3             Insurance Liability Agreement, dated August 31, 1993 by and
                 between MHM and MEDIQ (1)
10.4             Promissory Note of MHM to MEDIQ, dated August 31, 1993 (1)
10.5             MHM 1993 Stock Option Plan (1)
10.6             MHM 1993 Non-Employee Director Stock Option Plan (1)
10.7             MHM 1993 Bonus Plan (3)
10.8             MHM 1996 Non-Employee Directors' Stock Option Plan (4)
10.9             MHM Amendment to 1993 Stock Option Plan (4)
10.10            Agreement by and among the Company and ICH Services, L.L.C.,
                 dated November 18, 1993(5)
10.11            Agreement by and among the Company, MHM Extended Care
                 Services, Inc., and Liberty Management Group, Inc., and
                 Liberty Bay Colony Health Services, Inc. dated November 22,
                 1996 (10) 





                                      55
<PAGE>   56


      10.12      Form of Purchase Warrant Agreement between the Company and
                 Murray I.  Firestone (10)
      10.13      Form of Repurchase Agreement between the Company and Murray I.
                 Firestone dated July 7, 1995 (10)
      10.14      Amendment to Repurchase Agreement between the Company and
                 Murray I. Firestone dated August 22, 1995 (10)
      10.15      Asset Purchase Agreement between the Company and Behavioral
                 Healthcare Corporation (8)
      10.16      Asset Purchase Agreement between the Company and Oakview
                 Treatment Center (9)
      10.17      Sublease Agreement dated June 1996 between the Company and
                 Stanley Martin Companies, Inc. (10)
      10.18      Client Service Agreement and Addendum dated June 30, 1996
                 between the Company and Administaff Companies, Inc. (10)
      10.19      Client Service Agreement and Addendum dated June 30, 1996
                 between MHM Extended Care Services, Inc. and Administaff
                 Companies, Inc. (10)
      10.20      Client Service Agreement and Addendum dated June 30, 1996
                 between MHM of Colorado, Inc. and Administaff Companies, Inc.
      21         Subsidiaries of MHM (10)
      27         Financial Data Schedule (10)
----------------
(1)   Incorporated by reference to the Registrant's Form 10-K report for
      fiscal 1993, as amended.
(2)   Incorporated by reference to the Registrant's Form 10-Q report for the
      Quarter Ended June 30, 1994.
(3)   Incorporated by reference to the Registrant's Form 10 filed August 13,
      1993, as amended.
(4)   Incorporated by reference to the Registrant's 1996 Annual Meeting
      Proxy Statement.
(5)   Incorporated by reference to the Registrant's Form 8-K report, dated
      December 2, 1993.
(6)   Incorporated by reference to the Registrant's Form 8-K/A, dated May
      15, 1996.
(7)   Incorporated by reference to the Registrant's Form 10-K report for
      fiscal 1995, as amended.
(8)   Incorporated by reference to the Registrant's May 1, 1996 Special
      Meeting Proxy Statement.
(9)   Incorporated by reference to the Registrant's Form 8-K dated April 18,
      1996.
(10)  Filed herewith.





                                       56
<PAGE>   57



                                   SIGNATURES

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

Dated:                            MHM SERVICES, INC.
                                  
                                  
                                  
                                  By:    /s/ Michael S. Pinkert
                                         --------------------------------------
                                         Michael S. Pinkert, President
                                         and Chief Executive Officer
                                  
                                  
                                  By:    /s/ Carolyn Zimmerman
                                         --------------------------------------
                                         Carolyn Zimmerman, Vice President-
                                         Finance and Chief Financial Officer


         Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons, which include at
least a majority of the Board of Directors on behalf of the Registrant and in
the capacities and on the dates indicated.

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


/s/ Michael S. Pinkert                     President, Chief
--------------------------                 Executive Officer and 
Michael S. Pinkert                         Director              
                                                                 

/s/ William P. Ferretti                    Director
-----------------------                            
William P. Ferretti


/s/ Kenneth A. Kessler, M.D.               Director
----------------------------------                 
Kenneth A. Kessler, M.D.


/s/ H. Scott Miller                        Director
--------------------------                         
H. Scott Miller


/s/ Michael F. Sandler                     Director
--------------------------                         
Michael F. Sandler





                                      57
<PAGE>   58


                               MHM SERVICES, INC.
                                AND SUBSIDIARIES

                                  SCHEDULE II

                 VALUATION AND QUALIFYING ACCOUNTS AND RESERVES

                 YEARS ENDED SEPTEMBER 30, 1996, 1995 AND 1994
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                  COL A                                 COL B                  COL C           COL D          COL E
------------------------------------------------------------------------------------------------------------------------

                                             Balance at      Charged to     Charged to                       Balance
                                             Beginning of    Costs and        Other                           at End
         Description                           Period        Expenses        Accounts        Deductions      of Period
------------------------------------------------------------------------------------------------------------------------
 <S>                                             <C>            <C>          <C>              <C>            <C>
 Year ended September 30, 1996:
         Allowance for doubtful accounts         $ 1,299        $ 6,320                       $ 3,215        $ 4,404
                                                 -----------------------------------------------------------------------

 Year ended September 30, 1995:
         Allowance for doubtful accounts         $ 1,891        $ 4,467                       $ 5,059        $ 1,299
                                                 -----------------------------------------------------------------------

 Year ended September 30, 1994:
         Allowance for doubtful accounts         $ 1,690        $ 2,009      $   526 (1)      $ 2,334        $ 1,891
                                                 -----------------------------------------------------------------------
</TABLE>


(1) Represents the allowance for doubtful accounts related to the acquisition
    of HCI.






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