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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934



For The Fiscal Year Ended December 31, 2004



Commission File Number 000-50940



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ROTECH HEALTHCARE INC.

(Exact Name of Registrant as Specified in Its Charter)



|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Delaware                                                       |  | 030408870                        
|(State or Other Jurisdiction of Incorporation or Organization) |  | (IRS Employer Identification No.)
|                                                               | 
|2600 Technology Drive, Suite 300, Orlando, Florida             |  | 32804                            
|(Address of Principal Executive Offices)                       |  | (Zip Code)                       



(407) 822-4600

(Registrants Telephone Number, Including Area Code)



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



Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.0001 par value per share



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



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



Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).    Yes ̈No x



As of June 30, 2004, the aggregate market value of the common equity held by non-affiliates of the registrant was approximately $616,526,158. The determination of stock ownership by non-affiliates is based upon the registrants
knowledge of stock ownership as of June 30, 2004 and is made solely for purposes of responding to the requirements of the form and the registrant is not bound by this determination for any other purpose. As of June 30, 2004, the registrant did not
have any securities registered pursuant to Section 12(b) or 12(g) of the Act and, therefore, has only limited knowledge of the common equity held by stockholders who may be deemed affiliates at that time. The aggregate market value is based upon the
closing sales price of the registrants common stock of $24.50, as reported by the Pink Sheets LLC on June 30, 2004.



As of March 18, 2005, the registrant had 25,376,995 shares of common stock outstanding.



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DOCUMENTS INCORPORATED BY REFERENCE: The information called for by Part III, to the extent not provided therein or elsewhere in this report, is incorporated by reference to the Definitive Proxy Statement for the 2005 Annual Meeting of
Stockholders of the registrant which will be filed with the Securities and Exchange Commission not later than 120 days after December 31, 2004.



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ROTECH HEALTHCARE INC.

Form 10-K

For the Fiscal Year Ended December 31, 2004



Index



|           |  |          |  |                                                                                                              |  |     
|---------- |  | -------- |  | ------------------------------------------------------------------------------------------------------------ |  | ----
|           |  |          |  |                                                                                                              |  | Page
|PART I     |  |          |  | 3                                                                                                           
|           |  | ITEM 1.  |  | BUSINESS                                                                                                     |  | 3   
|           |  | ITEM 2.  |  | PROPERTIES                                                                                                   |  | 30  
|           |  | ITEM 3.  |  | LEGAL PROCEEDINGS                                                                                            |  | 31  
|           |  | ITEM 4.  |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                          |  | 31  
|           |  |         
|PART II    |  |          |  | 32                                                                                                          
|           |  | ITEM 5.  |  | MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES |  | 32  
|           |  | ITEM 6.  |  | SELECTED FINANCIAL DATA                                                                                      |  | 35  
|           |  | ITEM 7.  |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                        |  | 39  
|           |  | ITEM 7A. |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                   |  | 54  
|           |  | ITEM 8.  |  | FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA                                                                  |  | 54  
|           |  | ITEM 9.  |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE                         |  | 54  
|           |  | ITEM 9A. |  | CONTROLS AND PROCEDURES                                                                                      |  | 54  
|           |  | ITEM 9B. |  | OTHER INFORMATION                                                                                            |  | 55  
|           |  |         
|PART III   |  |          |  | 56                                                                                                          
|           |  | ITEM 10. |  | DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT                                                           |  | 56  
|           |  | ITEM 11. |  | EXECUTIVE COMPENSATION                                                                                       |  | 56  
|           |  | ITEM 12. |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS               |  | 60  
|           |  | ITEM 13. |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                               |  | 60  
|           |  | ITEM 14. |  | PRINCIPAL ACCOUNTING FEES AND SERVICES                                                                       |  | 60  
|           |  |         
|PART IV    |  |          |  | 61                                                                                                          
|           |  | ITEM 15. |  | EXHIBITS AND FINANCIAL STATEMENT SCHEDULES                                                                   |  | 61  
|           | 
|SIGNATURES |  | 63      



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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS



This report contains certain statements that constitute forward-looking
statements. These forward-looking statements include all statements regarding the intent, belief or current expectations regarding the matters discussed in this report (including statements as to beliefs, expectations,
anticipations, intentions or similar words) and all statements which are not statements of historical fact. These forward-looking statements involve known and unknown risks, uncertainties, contingencies and other factors that
could cause results, performance or achievements to differ materially from those stated in this report. The following are some but not all of such risks, uncertainties, contingencies, assumptions and other factors, many of which are beyond our
control, that could cause results, performance or achievements to differ materially from those anticipated: general economic, financial and business conditions; issues relating to reimbursement by government and third party payors for our products
and services; the costs associated with government regulation of the health care industry; the effects of competition and industry consolidation; the costs and effects of legal proceedings; and other risks and uncertainties described under
Risk Factors. In the event that we seek a listing for our common stock on a securities exchange or automated quotation system, there can be no assurances that we will be able to obtain such a listing. Should one or more of these risks or
uncertainties materialize or should underlying assumptions prove incorrect, our actual results, performance or achievements could differ materially from those expressed in, or implied by, such forward-looking statements. Readers are cautioned not to
place undue reliance on these forward-looking statements, which speak only as of the date thereof. When you consider these forward-looking statements, you should keep in mind these risk factors and other cautionary statements in this report,
including in Managements Discussion and Analysis of Financial Condition and Results of Operations, Business and Market for Registrants Common Stock, Related Stockholder Matters and Issuer Purchases of Equity
Securities. We do not undertake any obligation to publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.



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PART I



Rotech Healthcare Inc.
was established upon the transfer to us of substantially all of the assets of our predecessor, Rotech Medical Corporation, when it emerged from bankruptcy on March 26, 2002. The financial statements included herein reflect these transactions
effective as of March 31, 2002. As a result, references to we, our, and us refer to the operations of Rotech Healthcare Inc., a Delaware corporation, and its subsidiaries for all periods subsequent to March 31,
2002 and the business and operations of our predecessor, Rotech Medical Corporation, a Florida corporation, and its subsidiaries for all periods prior to April 1, 2002. Financial data for the year-ended December 31, 2002 have been presented for the
three months ended March 31, 2002 and the nine months ended December 31, 2002, rather than for the year-ended December 31, 2002, because we had only nine months of operating results since our predecessor emerged from bankruptcy in such fiscal year.
In connection with our predecessors emergence from bankruptcy, we reflected the terms of the plan of reorganization in our consolidated financial statements by adopting the fresh-start reporting provisions of the American Institute of
Certified Public Accountants Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code. Under fresh-start reporting, a new reporting entity is deemed to be created and the recorded amounts of
assets and liabilities are adjusted to reflect their estimated fair values. For accounting purposes, the fresh-start adjustments have been reflected in the operating results of our predecessor for the three months ended March 31, 2002.



ITEM 1.    BUSINESS



We are one of the largest providers of home medical equipment and related products and services in the United States, with a comprehensive offering of respiratory therapy and durable home medical equipment and related services. We provide
equipment and services in 48 states through approximately 475 operating centers located primarily in non-urban markets. We provide our equipment and services principally to older patients with breathing disorders, such as chronic obstructive
pulmonary diseases, or COPD (which include chronic bronchitis and emphysema), obstructive sleep apnea and other cardiopulmonary disorders.



Our revenues are principally derived from respiratory equipment rental and related services (86.6% of net revenues for the year ended December 31, 2004),
which include rental of oxygen concentrators, liquid oxygen systems, portable oxygen systems, ventilator therapy systems, nebulizer equipment and sleep disorder breathing therapy systems, and the sale of nebulizer medications. We also generate
revenues through the rental and sale of durable medical equipment (12.4% of net revenues for the year ended December 31, 2004), including hospital beds, wheelchairs, walkers, patient aids and ancillary supplies. We derive a majority of our revenues
from reimbursement by third-party payors, including Medicare, Medicaid, the Veterans Administration (VA) and private insurers.



For the year ended December 31, 2004, we generated net revenues of $534.5 million and net earnings of $38.2 million. For the same period, net cash
provided by operating activities was $134.0 million and net cash used in investing activities and net cash used in financing activities were $54.0 million and $36.1 million, respectively. Earnings from continuing operations before interest, income
taxes, depreciation and amortization (EBITDA) for the year ended December 31, 2004 was $177.4 million. See Selected Financial Data, item (6) on page 37 for a detailed definition of EBITDA.



Our Service Lines



Respiratory Therapy



We provide a range of respiratory therapy equipment, including oxygen concentrators, liquid oxygen systems, portable oxygen systems, ventilator therapy
systems, nebulizer equipment, and sleep disorder breathing therapy systems, for rental or sale. Patients in need of respiratory equipment and services suffer from breathing disorders, such as COPD, obstructive sleep apnea and other cardiopulmonary
disorders. Individuals diagnosed with COPD or similar diseases are often elderly, and generally will require treatment for the rest of their lives.



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The majority of our respiratory therapy equipment is rented and reimbursed on a monthly basis. We also generate revenue from the sale of inhalation
medications, including albuterol and ipratropium. We provide driver technicians who deliver and/or install the respiratory care equipment, instruct the patient in its use, refill the high pressure and liquid oxygen systems as necessary and provide
continuing maintenance of the equipment. Respiratory therapy is monitored by licensed respiratory therapists and other clinical staff as prescribed by physicians. We currently employ approximately 451 full time respiratory therapists. Respiratory
therapy equipment rental and related services represented 86.6% of our net revenues for the year ended December 31, 2004.



Our home respiratory care equipment includes three types of oxygen systems:



| |  |  | stationary concentrators, which extract oxygen from room air and generally provide the least expensive supply of oxygen for patients who require a continuous supply of oxygen, are
not ambulatory and who do not require excessive flow rates;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | liquid oxygen systems, which store oxygen under pressure in a liquid form and act as both stationary and portable systems; and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------



| |  |  | high pressure oxygen cylinders, which are typically portable systems that permit greatly enhanced patient mobility.
| | - |  | -------------------------------------------------------------------------------------------------------------------



Other home respiratory care equipment includes non-invasive positive pressure
ventilators (NPPV), nebulizer devices, bilevel positive airway pressure and continuous positive airway pressure (CPAP) devices. NPPVs are used by individuals who suffer from certain other respiratory conditions by mechanically assisting the
individual to breathe. Nebulizer devices aerosolize our nebulizer medications and allow the medications to be inhaled directly into the patients lungs. CPAP devices deliver pressure into a patients airway through a specially designed
nasal mask or pillow to prevent airway collapse during sleep.



Durable Medical Equipment



We provide a
comprehensive line of durable medical equipment, such as hospital beds, wheelchairs, walkers, patient aids and other ancillary supplies, for rental or sale, to serve the specific needs of our patients. Typically, lower cost items, such as patient
aids and walkers, are sold and higher cost items, such as hospital beds and wheelchairs, are rented. We consider durable medical equipment to be a complementary offering to respiratory therapy equipment and related services.



Our Operations



Organization



We have approximately 475 operating centers, which now operate through three divisions. Each of these divisions is managed by a team of division managers
who provide management services to our operating centers in four service categories: operations, sales, billing and collection and clinical. These managers provide key support services to our operating centers, including billing, purchasing,
equipment maintenance and repair and warehousing. Each operating center delivers equipment and services to patients in their homes and other care sites through the operating centers delivery fleet and qualified personnel. Operational control,
purchasing and operating policies for our divisions are administered centrally at our principal offices in Orlando, Florida through our Chief Operating Officer, clinical functions are administered through our Chief Clinical Officer who reports to
our Chief Operating Officer, while sales functions are administered through our Chief Sales Officer, and financial control, billing and collection services are provided through our Chief Financial Officer. We believe that this management structure
provides control and consistency among our divisions and operating centers and allows us to implement standard policies and procedures across a large number of geographically remote operating centers.



Operating Systems and Controls



Our operating systems provide management with information to measure and
evaluate key components of our operations. We have a proprietary billing system that is scalable and is used for substantially all of our billing



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sources, including Medicare, our largest source of revenues. All Medicare claims are aggregated, processed, archived and transmitted to Medicare on a daily
basis. The process is highly automated and has proven to be reliable and cost-effective.



Our billing and collection departments work closely with personnel at operating center locations and third-party payors and are responsible for the review of patient coverage, the adequacy and timeliness of
documentation and the follow-up with third-party payors to expedite reimbursement payments. We communicate with our operating centers through an intranet-based system that provides our managers with detailed information that allows us to address
operating efficiencies. We believe this reporting capability allows our managers to operate their businesses more effectively and allocate their resources more appropriately.



We will continue to improve our operating efficiencies in order to position ourselves for future growth by utilizing our
proprietary information technology platform, as well as third-party software products, to improve our billing, compliance and inventory systems. In 2004, we reduced the number of billing centers from 13 to 11. We will continue to review the number
of billing centers in 2005. The reduction of billing centers allows for increased control with fewer individuals administering the process, reduces our lease costs and facilitates the further implementation of compliance controls. In addition, we
are continuing to develop our information technology platform that we use to track inventory on a store-by-store basis. We believe that this may help to analyze whether our inventory is being used at its most efficient levels by tracking the useful
life, maintenance and location of the equipment at all times.



Payors



We derive the majority of our revenues
from reimbursement by third party payors. We accept assignment of insurance benefits from patients and, in most instances, invoice and collect payments directly from Medicare, Medicaid and private insurance carriers, as well as directly from
patients under co-insurance provisions. The following table sets forth our payor mix:



|                                                                                           |  |                        |   |  |                                 |   |  |                                  |   |  |                            |   |  |                            |   |  |      |  
|------------------------------------------------------------------------------------------ |  | ---------------------- | - |  | ------------------------------- | - |  | -------------------------------- | - |  | -------------------------- | - |  | -------------------------- | - |  | ---- | -
|                                                                                           |  | Predecessor Company    |   |  | Successor Company               |  
|                                                                                           |  | Year EndedDecember 31, |   |  | Three MonthsEnded March 31,2002 |   |  | Nine MonthsEndedDecember 31,2002 |   |  | Year EndedDecember 31,2003 |   |  | Year EndedDecember 31,2004 |  
|                                                                                           |  | 2000                   |   |  | 2001                            |   |  |                                  |   | 
|Medicare, Medicaid and other federally funded programs (primarily Veterans Administration) |  | 64.7                   | % |  | 67.0                            | % |  | 67.9                             | % |  | 69.1                       | % |  | 71.1                       | % |  | 71.0 | %
|Commercial payors                                                                          |  | 27.3                   | % |  | 25.8                            | % |  | 25.6                             | % |  | 25.1                       | % |  | 24.3                       | % |  | 25.5 | %
|Private Payors                                                                             |  | 8.0                    | % |  | 7.2                             | % |  | 6.5                              | % |  | 5.8                        | % |  | 4.6                        | % |  | 3.5  | %



We contract with
insurers and managed care entities on a local, regional and national basis. We generally contract with those insurers and managed care entities having a significant patient population in the areas served by us, typically on a fee-for-service basis.
We have not historically contracted with insurers or managed care entities on a national basis, however, we are currently a party to a service agreement with a national managed care company and are pursuing additional managed care relationships on a
national level. Pursuant to our contracts with the Veterans Administration (VA), we provide equipment and services to persons eligible for VA benefits in the regions covered by the contracts. The VA contracts typically provide for an annual term,
subject to four or five one-year renewal periods unless terminated or not renewed by the VA.



Our Company History



Rotech Healthcare Inc. was incorporated in the State of Delaware on March 15, 2002. Rotech Medical Corporation, our predecessor, was founded in 1981. In October 1997, Rotech Medical Corporation was acquired



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by Integrated Health Services, Inc. (IHS), a large, publicly-held provider of post-acute and related specialty health care services and products. Following
the acquisition, Rotech Medical Corporation operated as a wholly-owned subsidiary of IHS. On February 2, 2000, IHS and substantially all of its subsidiaries, including Rotech Medical Corporation filed voluntary petitions for relief under Chapter 11
of the United States Bankruptcy Code with the United States Bankruptcy Court in the District of Delaware. The principal reason for the commencement of Rotech Medical Corporations Chapter 11 case was that Rotech Medical Corporation had jointly
guaranteed approximately $2.3 billion of obligations of IHS, under credit agreements with IHS senior creditors. IHS defaulted on its obligations under those agreements in 1999. Rotech Medical Corporations plan of reorganization was
confirmed on February 13, 2002 (and became final on February 25, 2002) and became effective on March 26, 2002. As a result of the reorganization, substantially all of Rotech Medical Corporations assets, business and operations were transferred
to us, an independent company. On December 20, 2004, the Bankruptcy Court entered a final decree closing Rotech Medical Corporations bankruptcy case.



Senior Secured Credit Facilities



On March 26, 2002, we entered into senior secured credit facilities for up to $275 million, with UBS Warburg LLC and Goldman Sachs Credit Partners L.P.,
as arrangers, Goldman Sachs Credit Partners, L.P., as syndication agent, UBS AG, Stamford Branch, as administrative agent, and a syndicate of other financial institutions. The senior secured credit facilities consist of:



| |  |  | a $75 million five-year revolving credit facility; and
| | - |  | ------------------------------------------------------



| |  |  | a $200 million six-year term loan facility.
| | - |  | -------------------------------------------



The amount available for borrowings under the revolving credit facility is the lesser of (a) the total commitment amount of the revolving credit facility
minus the aggregate outstanding balance of revolving credit loans (including obligations in respect of letters of credit) and (b) certain percentages of our and our domestic subsidiaries eligible accounts receivable, eligible inventory and
eligible property, plant and equipment, minus the aggregate outstanding balance of revolving credit loans (including obligations in respect of letters of credit) and the term loans.



The term loan was drawn in full on the consummation of our predecessors plan of reorganization, which occurred
contemporaneously with the sale of our 91⁄2% senior subordinated notes due 2012. The term loan is amortized with 1% of the term loan payable in each of the first five years and 95% of the initial aggregate term loan to be payable in year six,
2008. During the first quarter of 2004, we made payments on our term loan in the amount of $25.3 million. In August 2004, we repurchased $13 million of our 91⁄2% senior subordinated notes and paid a premium of $0.9 million associated with the
retirement of such notes. At December 31, 2004, the revolving credit facility had not been drawn upon, although standby letters of credit totaling $11.2 million have been issued under this credit facility.



Interest rates and fees



The interest rates per annum applicable to the senior secured credit
facilities is LIBOR or, at our option, the alternate base rate, which is the higher of (a) the rate of interest publicly announced by UBS AG as its prime rate in effect at its Stamford Branch, and (b) the federal funds effective rate from time to
time plus 0.50%, in each case, plus the applicable margin (as defined below). The applicable margin (a) with respect to the revolving credit facility, is determined in accordance with a performance grid based on our consolidated leverage ratio and
ranges from 3.25% to 2.25% in the case of Eurodollar rate advances and from 2.25% to 1.25% in the case of alternate base rate advances, and (b) with respect to the term loan facility, is 3.00% in the case of Eurodollar rate advances and 2.00% in the
case of alternate base rate advances. The default rate on the senior secured credit facilities is 2.00% above the otherwise applicable interest rate. We are also obligated to pay a commitment fee ranging, depending on usage, from 0.75% to 0.50% on
the unused portion of our revolving credit facility.



Covenants



The senior secured credit
facilities contain customary affirmative and negative covenants, including, without limitation, limitations on indebtedness; limitations on liens; limitations on guarantee obligations; limitations on



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mergers, consolidations, liquidations and dissolutions; limitations on sales of assets; limitations on leases; limitations on dividends and other payments in
respect of capital stock; limitations on investments, loans and advances; limitations on capital expenditures; limitations on optional payments and modifications of subordinated and other debt instruments; limitations on transactions with
affiliates; limitations on granting negative pledges; and limitations on changes in lines of business. Our senior secured credit facilities also contain customary financial covenants including, maintenance of the following ratios: (a) a consolidated
total leverage ratio, (b) a consolidated senior leverage ratio, (c) a consolidated interest coverage ratio and (d) a consolidated fixed charge coverage ratio.



Security and guarantees



Our obligations under the credit facilities are guaranteed by each of our direct and indirect domestic subsidiaries, excluding specified immaterial
subsidiaries. All obligations under the credit facilities and the guarantees are secured by a perfected first priority security interest in substantially all of our tangible and intangible assets, including intellectual property, real property and
all of the capital stock of each of our direct and indirect subsidiaries, excluding immaterial subsidiaries in the process of dissolution and other specified immaterial subsidiaries and limited, in the case of each foreign subsidiary, to 65% of the
value of the stock of such entity.



Senior Subordinated Notes



In March 2002, we issued an aggregate principal amount of
$300 million of 91⁄2% senior subordinated notes due 2012 and received net proceeds of approximately $290 million, after deducting the initial purchasers discount and our estimated expenses. We distributed the net proceeds from the sale of
the notes to our predecessor as partial consideration in exchange for substantially all of the assets used in connection with its business and operations as part of the restructuring and related transactions involving our predecessor and us.
Subsequently, our predecessor distributed the net proceeds to its former creditors as provided in its plan of reorganization. We did not retain any of the proceeds from the sale of the notes for use in our business.



Government Regulation



The health care industry is subject to extensive regulation by a number of governmental entities at the federal, state and
local levels. The industry is also subject to frequent regulatory changes. Our business is impacted not only by those laws and regulations that are directly applicable to us, but also by certain laws and regulations that are applicable to our
managed care and other patients. State laws also govern, among other things, pharmacies, nursing services, distribution of medical equipment and certain types of home health activities and apply to those locations involved in such activities.
Certain of our employees are subject to state laws and regulations governing the ethics and professional practice of respiratory therapy, pharmacy and nursing. If we fail to comply with the laws and regulations applicable to our business, we could
suffer civil and/or criminal penalties and we could be excluded from participating in Medicare, Medicaid and other federal and state health care programs.



The federal government has made a policy decision to significantly increase the financial resources allocated to enforcing the health care fraud and abuse
laws. Private insurers and various state enforcement agencies also have increased their level of scrutiny of health care claims in an effort to identify and prosecute fraudulent and abusive practices in the health care area.



Medicare and Medicaid Reimbursement. As part of the Social Security
Amendments of 1965, Congress enacted the Medicare program which provides for hospital, physician and other statutorily-defined health benefits for qualified individuals, including persons over 65 and the disabled. The Medicaid program, also
established by Congress in 1965, is a joint federal and state program that provides certain statutorily-defined health benefits to financially needy individuals who are blind, disabled, aged or members of families with dependent children. In



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addition, Medicaid may cover financially needy children, refugees and pregnant women. In 2004, Medicare, Medicaid and other federally funded programs
(primarily Veterans Administration contracts) accounted for approximately 71.0% of our revenues.



Medicare Laws and Regulations. The Balanced Budget Act of 1997, or BBA 97, granted authority to the Secretary of the Department of Health and Human
Services, or DHHS, to increase or reduce the reimbursement for home medical equipment, including oxygen, by 15% each year under an inherent reasonableness procedure. On February 11, 2003, the Centers for Medicare and Medicaid Services, or CMS, made
effective an interim final rule implementing the inherent reasonableness authority, which allows the agency and carriers to adjust payment amounts by up to 15% per year for certain items and services covered by Part B when the existing payment
amount is determined to be grossly excessive or deficient. The regulation lists factors that may be used by CMS and the carriers to determine whether an existing reimbursement rate is grossly excessive or deficient and to determine what is a
realistic and equitable payment amount. Also, under the regulation, CMS and the carriers will not consider a payment amount to be grossly excessive or deficient and make an adjustment if they determine that an overall payment adjustment of less than
15% is necessary to produce a realistic and equitable payment amount. In addition to its inherent reasonableness authority, CMS has the discretion to reduce the reimbursement for home medical equipment, or HME and other non-HME services to an amount
based on the payment amount for the least costly alternative treatment that meets the Medicare beneficiarys medical needs. Least costly alternative, or LCA, determinations are applied to particular products and services by CMS and its carriers
through the informal notice and comment process used in establishing local coverage policies for HME. This process need not be followed for LCA determinations made on individual claims. Using either its inherent reasonableness or least costly
alternative authority, CMS and the carriers may reduce reimbursement levels for certain items and services covered by Part B, including products and services we offer, which could have a material adverse effect on our results of operations.



On December 8, 2003, the President signed into law the
Medicare Prescription Drug, Improvement and Modernization Act of 2003, or MMA. The MMA significantly changes how Medicare Part B pays for our products, including HME items, such as oxygen, oxygen equipment and nebulizers, as well as inhalation drugs
dispensed through nebulizers, in the following ways:



(1) Reductions and Payment Freeze for HME. Currently, Medicare payments to us for our HME products are based on the lesser of the actual charge for the item or the applicable Medicare fee schedule amount. Under MMA, from 2004 through
2008, most payments for HME are set at the 2003 level and therefore, are frozen, unless the item becomes subject to further reductions based on Federal Health Benefits Program median payment amounts as described below, or are subject to
competitive bidding. As of January 1, 2005, the fee schedule amounts for certain items of HME, including wheelchairs and nebulizers, were further reduced, based on the percentage difference between the amount of payment otherwise determined for 2002
and the median amount of payment under the Federal Employee Health Benefits Program, or FEHBP, as determined by the Office of Inspector General of DHHS, or OIG. The FEHBP adjusted payments are to remain frozen through 2008 unless the
particular item becomes subject to competitive bidding.



The fee schedule amounts for oxygen and oxygen equipment are also to be calculated using this methodology. A September 2004 OIG report entitled Medicare Payment Rates for Home Oxygen Equipment
surveyed FEHBP prices for oxygen equipment and found that the median 2002 prices were considerably lower than Medicare payments for those items. According to the report, the 2002 median FEHBP payments for five oxygen codes showed that the FEHBP
median payments for stationary home oxygen equipment were approximately 15.5% less than Medicare payments for stationary home oxygen equipment and approximately 11.3% less than Medicare payments for portable home oxygen equipment. On February 4,
2005, CMS published notice CMS-1299-N announcing a delay in the implementation of the 2005 Medicare oxygen payment rates. The notice states that CMS was informed by the OIG that it will need to collect additional information before the FEHBP median
prices for oxygen are finalized. Until such prices are established, Medicare claims for oxygen equipment furnished on or after January 1, 2005 will be paid based on the 2004 monthly payment amounts. CMS is expected to calculate and implement the
lower 2005



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payment amounts upon receipt of the additional information from the OIG. CMS has stated that no retroactive adjustments are to be made once the new payment
amounts are set. Reductions in payment rates for 2005 established by CMS for the non-oxygen HME items subject to the FEHBP provisions range between 4% and 16%. The non-oxygen HME items subject to the Medicare price cuts accounted for approximately
2% of our recorded revenues in 2004. If the proposed reductions in the Medicare fee schedules for home oxygen equipment (as set forth in the September 2004 OIG report discussed above) together with the additional reimbursement reductions mandated by
the MMA in 2005 for other home medical equipment (excluding inhalation drugs) had been implemented in 2004, we believe it would have resulted in a reduction in our 2004 recorded revenues in the range of approximately $30 million to $35 million. At
this time, we cannot determine the outcome of the 2005 Medicare oxygen payment rates, the date on which the new payment amounts will become effective or the ultimate impact on our business.



(2) Implementation of Competitive Bidding for HME.
Starting in 2007, Medicare will begin to phase in a nationwide competitive bidding program to replace the existing fee schedule payment methodology. The program will begin in 10 high-population metropolitan service areas, or MSAs, expanding to 80
MSAs in 2009 and additional areas thereafter. Under competitive bidding, suppliers compete for the right to provide items to beneficiaries in a defined region. Only a limited number of suppliers will be selected in any given MSA, resulting in
restricted supplier choices for beneficiaries. MMA permits certain exemptions from competitive bidding, including exemptions for rural areas and areas with low population density within urban areas that are not competitive, unless there is a
significant national market through mail-order for the particular item. A large number of our facilities are located in such areas. However, the criteria for how the exemption will be applied have not yet been determined. Therefore, the impact on
our business is uncertain. Also, MMA requires that contracts may only be awarded to suppliers that meet certain quality and financial standards and that the amounts paid to suppliers under the contracts must be less than the amount paid under the
current system. Beginning in 2009, CMS may use information on payments from the competitive bidding program to adjust payments in regions not subject to competitive bidding. The proposed regulations implementing the competitive bidding program are
expected to be published in the summer of 2005 and finalized by the summer of 2006. The inherent reasonableness interim final regulation (see above) remains in effect after MMA, but the legislation precludes the use of inherent reasonableness
authority for devices subject to competitive bidding. At this time, we do not know which of our products will be subject to inherent reasonableness and/or competitive bidding, nor can we predict the impact that inherent reasonableness and
competitive bidding will have on our business.



(3) Reduction in Payments for Inhalation Drugs. MMA also revises the payment methodology for certain drugs, including inhalation drugs dispensed through nebulizers. Prior to MMA, Medicare paid for these drugs based on average
wholesale price, or AWP, as reported by drug manufacturers. Beginning January 1, 2004, Medicare payments were reduced for most of our Part B inhalation drugs to 80% of AWP from 95% of AWP, a reduction of approximately 15 percent. This reduction in
Medicare payment rates for inhalation drugs reduced our revenues and operating income by approximately $24 million in 2004. As of January 1, 2005, as required by MMA, payment amounts for most drugs are based on the average sales price, or ASP.
Beginning in 2006, payment amounts for most drugs are to be based on either ASP or competitive bidding for drugs administered by physicians. ASP is defined statutorily as the volume weighted average of manufacturers average sales prices,
calculated by adding the manufacturers average sales prices for the drug in the fiscal quarter to the number of units sold and then divided by the total number of units sold for all national drug codes assigned to the product. Under the ASP
methodology, Medicare generally will pay 106% of ASP for multiple source drugs and 106% of the lesser of ASP or wholesale acquisition cost for single source drugs. In addition, if the ASP exceeds the widely available market price by more than 5%,
CMS may substitute the widely available market price for the ASP. ASP payment rates are calculated using the most recent manufacturer data available. Manufacturer ASP data submissions are due to CMS not later than 30 days after the last day of each
calendar quarter. Quarterly updates are to be implemented to reflect these quarterly submissions by manufacturers. Third quarter 2004 data was used to calculate the ASP payment amounts for the first quarter of 2005. ASP payment amounts for our
products may fluctuate from quarter to quarter. We cannot predict whether manufacturers quarterly data submissions will result in further reductions in payment amounts and what impact such payment reductions would have on our results of
operations in 2005 and beyond.



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The ASP payment amounts for the first and second quarters of 2005 for many drugs are
significantly less than the payment amounts for these drugs in 2004. For example, the payment rates, as posted by CMS, for two prevalent inhalation drugs, albuterol sulfate and ipratropium bromide, were reduced from $0.39 and $2.82 per milligram in
2004 to $0.065 and $0.287 for the first quarter of 2005, respectively. For the second quarter of 2005, payment rates, as posted by CMS, for albuterol sulfate and ipratropium bromide were changed to $0.090 and $0.202, respectively. Given the overall
reduction in payment for inhalation drugs dispensed through nebulizers, CMS established a $57 dispensing fee for inhalation drugs shipped to a beneficiary during a 30-day period or $80 for a 90-day period. In calculating these 2005 dispensing fees,
CMS took into account data submitted by members of the public as well as an October 2004 report by the United States Government Accountability Office, or GAO, regarding inhalation drugs dispensed through nebulizers. The GAO recommended that CMS
evaluate the costs of dispensing inhalation therapy drugs and modify the existing dispensing fee, if warranted, to ensure that it reflects the costs necessary for dispensation of inhalation therapy drugs. In the FY 2005 physician fee schedule final
rule setting the ASP payment amounts and the dispensing fees, CMS noted that there may have been differences in surveyed costs and services between the GAO survey and other survey data submitted by commenters, including the American Association for
Homecare. CMS indicated its intent to explore further the variability in costs of furnishing inhalation drugs and the services being provided before making any determination with respect to an appropriate dispensing fee, if any, after 2005, and that
the agency intends to proceed through notice and comment rulemaking in order to establish a new dispensing fee, if any, for 2006. We cannot predict the outcome of any future rulemaking by CMS. If the dispensing fees are reduced or eliminated in 2006
or beyond, this could have a material adverse effect on our revenues, profitability and results of operations.



Medicare-reimbursed inhalation drug therapies provided by us in 2004 accounted for approximately 17% of our recorded revenues. The 2005
dispensing fees offset to some extent the reductions in payment rates for inhalation drugs established under the ASP methodology. While we have been able, based upon the increased dispensing fees, to continue offering inhalation drugs to Medicare
patients in 2005, the pricing changes resulting from the ASP payment rates are expected to result in a material reduction in the revenues and profitability of our inhalation drug business and we cannot predict whether it will continue to be
economically feasible for us to continue to provide inhalation drugs in the future.



(4) Implementation of Certain Clinical Conditions and Quality Standards. MMA requires that new clinical conditions of coverage be
developed for HME, with those products perceived as having a higher utilization to be given priority for implementation. Although not yet implemented, the quality standards are to be developed by CMS and applied by independent accreditation
organizations. As an entity that bills Medicare and receives payment from the program, we will be subject to these standards. At this time, we cannot predict the extent of the clinical and quality standards or the full impact they will have on our
business.



Professional Licensure



Nurses, pharmacists and other health care professionals employed by us are
required to be individually licensed or certified under applicable state law. We take steps to assure that our employees possess all necessary licenses and certifications, and we believe that our employees comply in all material respects with
applicable licensure or certification laws.



Pharmacy
Licensing and Registration



State laws require that each
of our pharmacy locations be licensed as an in-state pharmacy to dispense pharmaceuticals in that state and that companies delivering pharmaceuticals into a particular state be licensed to do so in that state. Most states, and the Federal Food and
Drug Administration (FDA), adopt and enforce the official standards of the US Pharmacopeia (USP) as the official compendia of drug standards. State lawmakers regularly propose and, at times, enact new legislation establishing
changes in the practice of pharmacy laws and regulations. In addition, the USP is frequently supplemented and amended to create new standards for drugs. We continuously monitor state activities and the USP, but there can be no assurance that we will
be able to



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immediately comply with all new laws, regulations or standards. We have policies in place that we believe substantially comply with all state licensing and
pharmacy laws currently applicable to our business, and we are engaged in activities designed to achieve compliance with these polices. We cannot ensure full compliance at all times, however, as licenses may lapse and laws may change. Many states
enforce their pharmacy laws, including the USP, through periodic facility inspections. The FDA generally defers to state pharmacy boards during routine inspections of pharmacies, but will intervene and exercise its enforcement authority if it
determines that any of a pharmacys activities are more akin to those of a manufacturer or if FDA determines that the public health is at risk. Failure to comply with applicable regulatory requirements can result in enforcement action,
including fines, injunctions, seizures, and civil or criminal penalties. If we are unable to obtain and maintain our licenses in one or more states, or if such states place burdensome restrictions or limitations on pharmacies, our ability to operate
in such states would be limited, which could adversely impact our business and results of operations.



Food, Drug and Cosmetic Act



Under the Federal Food Drug and Cosmetic Act (FFDCA), the FDA imposes stringent regulations on the distribution, labeling, and other aspects
of our medical gas and pharmacy operations. In particular, the FDA imposes rigorous regulations on medical gas distributors under its current Good Manufacturing Practice (cGMP) requirements. Federal and state laws also require that we
follow specific labeling, reporting and record-keeping requirements for pharmaceutical products that we distribute. Federal law exempts many pharmaceuticals and medical devices from federal labeling and packaging requirements so long as they are not
adulterated or misbranded and are dispensed in accordance with and pursuant to a valid prescription.



Some of our pharmacists provide compounded preparations of drug products that are not commercially available, based upon a patients individual need
and at a physicians specific request. While the FDA asserts that it has jurisdiction over pharmacy compounding, to the extent that compounding practices are considered to be within the practice of pharmacy, however, these activities are
regulated primarily under state law. In May 2002, FDA issued a Compliance Policy Guide for Staff and Industry, Section 460.200, setting forth FDAs enforcement policy on pharmacy compounding. We believe that our compounding activities are
consistent with the practice of pharmacy under state law and as provided in the FDAs Compliance Policy Guide. However, some of the activities that we consider to be compounding, the FDA may consider to constitute the manufacturing of a new
drug, because the FDA may define the scope of drug manufacturing activities more broadly than we or the state pharmacy boards do. If FDA determines that our compounding activities are more consistent with the activities of a drug manufacturer, we
could be subject to enforcement action.



Claims Audits



Durable medical equipment regional carriers are private
organizations that contract to serve as the governments agents for the processing of certain claims for items and services provided under Part B of the Medicare program. These carriers and Medicaid agencies periodically conduct pre-payment and
post-payment reviews and other audits of claims submitted. Medicare and Medicaid agents are under increasing pressure to scrutinize health care claims more closely. In addition, the industry in which we operate is generally characterized by long
collection cycles for accounts receivable due to complex and time-consuming documentation and claims processing and other requirements for obtaining reimbursement from private and governmental third-party payors. Such protracted collection cycles
can lead to delays in obtaining reimbursement. Furthermore, reviews and/or similar audits or investigations of our claims and related documentation could result in denials of claims for payment submitted by us. The government could demand
significant refunds or recoupments of amounts paid by the government for claims which, upon subsequent investigation, are determined by the government to be inadequately supported by the required documentation.



The Anti-Kickback Statute



As a provider of services under the Medicare and Medicaid programs, we are
subject to the Medicare and Medicaid fraud and abuse laws (sometimes referred to as the Anti-Kickback statute). At the federal level, the Anti-Kickback statute prohibits any person from knowingly and willfully soliciting, receiving,
offering or



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providing any remuneration, including a bribe, kickback or rebate, directly or indirectly, in return for or to induce the referral of patients, or the
furnishing, recommending, or arranging for products or services covered by federal health care programs. Federal health care programs have been defined to include plans and programs that provide health benefits funded by the federal government,
including Medicare and Medicaid, among others. Violations of the Anti-Kickback statute may result in civil and criminal penalties including fines of up to $25,000 per violation, civil monetary penalties of up to $50,000 per violation, assessments of
up to three times the amount of the prohibited remuneration, imprisonment, and exclusion from participation in the federal health care programs. The Office of the Inspector General of the DHHS has published regulations that identify a limited number
of specific business practices that fall within safe harbors which are deemed not to violate the Anti-Kickback statute. Although we attempt to structure our business relationships to meet safe harbor requirements, it is possible that not all of our
business relationships comply with the elements of one or more safe harbors. Conformity with the safe harbors is not mandatory and failure to meet all of the requirements of an applicable safe harbor does not make conduct per se illegal. The Office
of Inspector General is authorized to issue advisory opinions regarding the interpretation and applicability of the federal Anti-Kickback statute, including whether an activity constitutes grounds for the imposition of civil or criminal sanctions.
We have not, however, sought such an opinion.



In addition, a
number of states in which we operate have anti-fraud and anti-kickback laws similar to the Anti-Kickback Statute that prohibit certain direct or indirect payments if such arrangements are designed to induce or encourage the referral of patients or
the furnishing of goods or services. Some states anti-fraud and anti-kickback laws apply only to goods and services covered by Medicaid. Other states anti-fraud and anti-kickback laws apply to all health care goods and services,
regardless of whether the source of payment is governmental or private. Further, many states prohibit revenue sharing or fee splitting arrangements between physicians and other third parties. Possible sanctions for violation of these restrictions
include exclusion from state-funded health care programs, loss of licensure and civil and criminal penalties. Such statutes vary from state to state, are often vague and have seldom been interpreted by the courts or regulatory agencies.



Physician Self-Referrals



Certain provisions of the Omnibus Budget Reconciliation Act of 1993,
commonly known as Stark II, prohibit us, subject to certain exceptions, from submitting claims to the Medicare and Medicaid programs for designated health services if we have a financial relationship with the physician making
the referral for such services or with a member of such physicians immediate family. The term designated health services includes several services commonly performed or supplied by us, including durable medical equipment, home
health services and parenteral and enteral nutrition. In addition, financial relationship is broadly defined to include any ownership or investment interest or compensation arrangement involving remuneration between us and the physician
at issue. Violations of Stark II may result in loss of Medicare and Medicaid reimbursement, civil penalties and exclusion from participation in the Medicare and Medicaid programs. A person who engages in a scheme to circumvent the Stark Laws
referral prohibition may be subject to penalties as well.



On
January 4, 2001, CMS issued the first of two phases of final regulations (Phase I) to clarify the meaning and application of Stark II. On March 26, 2004, CMS released the second phase of the final regulations (Phase II). The
Phase I and Phase II final regulations address the primary substantive aspects of the prohibition and various exceptions. The Phase I regulations defined previously undefined key terms, clarified prior definitions, and created exceptions for certain
indirect compensation arrangements, fair market value transactions, arrangements involving non-monetary compensation up to $300, and risk-sharing arrangements, among others. For certain indirect compensation relationships,
the regulations permit providers to bill for items provided in connection with an otherwise prohibited referral, if the provider does not know, and does not act in reckless disregard or deliberate ignorance of, the identity of the referring
physician. Phase I of the final regulations became effective on January 4, 2002, except with respect to enforcement of the prohibitions application to certain percentage physician compensation arrangements, which effectiveness was delayed
several times by CMS. In the Phase II final regulations, which became effective on July 26, 2004, CMS addressed remaining Stark exceptions not addressed in the Phase I regulationprimarily related to compensation



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arrangements, but also addressed certain exceptions related to ownership and investment interests, reporting requirements and sanctions. CMS also finalized
its approach to percentage compensation arrangements, permitting them in certain circumstances.



In addition, a number of the states in which we operate have similar or broader prohibitions on physician self-referrals. Finally, enforcement activity
and resulting case law developments have increased the legal risks of physician compensation arrangements that do not satisfy the terms of an exception to Stark II, especially in the area of joint venture arrangements with physicians.



False Claims



We are subject to state and federal laws that govern the submission of
claims for reimbursement. The federal False Claims Act imposes civil liability on individuals or entities that submit false or fraudulent claims for payment to the government. Violations of the False Claims Act may result in treble damages, civil
monetary penalties for each false claim submitted and exclusion from the Medicare and Medicaid programs. In addition, we could be subject to criminal penalties under a variety of federal statutes to the extent that we knowingly violate legal
requirements under federal health programs or otherwise present false or fraudulent claims or documentation to the government.



The False Claims Act also allows a private individual to bring a qui tam suit on behalf of the government against a health care provider for violations of
the False Claims Act. A qui tam suit may be brought by, with only a few exceptions, any private citizen who has material information of a false claim that has not yet been previously disclosed. Even if disclosed, the original source of the
information leading to the public disclosure may still pursue such a suit. Although a corporate insider is often the plaintiff in such actions, an increasing number of outsiders are pursuing such suits.



In a qui tam suit, the private plaintiff is responsible for initiating a
lawsuit that may eventually lead to the government recovering money of which it was defrauded. After the private plaintiff has initiated the lawsuit, the government must decide whether to intervene in the lawsuit and become the primary prosecutor.
In the event the government declines to join the lawsuit, the private plaintiff may choose to pursue the case alone, in which case the private plaintiffs counsel will have primary control over the prosecution (although the government must be
kept apprised of the progress of the lawsuit and will still receive at least 70% of any recovered amounts). In return for bringing the suit on the governments behalf, the statute provides that the private plaintiff is to receive up to 30% of
the recovered amount from the litigation proceeds if the litigation is successful. The number of qui tam suits brought against health care providers has increased dramatically. In addition, at least five statesCalifornia, Illinois, Florida,
Tennessee and Texashave enacted laws modeled after the False Claims Act that allow those states to recover money which was fraudulently obtained by a health care provider from the state (e.g., Medicaid funds provided by the state).



Health Insurance Portability and Accountability Act of 1996



The Health Insurance Portability and Accountability Act
of 1996, or HIPAA, mandates, among other things, the establishment of regulatory standards addressing the electronic exchange of health information, standards for the privacy and security of health information and standards for assigning unique
health identifiers to health care providers. Sanctions for failure to comply with HIPAA standards include civil and criminal penalties.



Two standards have been promulgated under HIPAA with which we currently are required to comply. The Standards for Electronic Transactions require the use
of standardized transactions and code sets for common health care transactions involving the exchange of certain types of information, including health care claims or equivalent encounter information, plan eligibility, referral certification and
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enrollment and disenrollment, payment and remittance advice, health plan premium payments, and coordination of benefits. The Standards for Privacy of
Individually Identifiable Information restricts use and disclosure of certain individually identifiable health information, called protected health information, or PHI. These Privacy Standards not only require our compliance with
standards restricting the use and disclosure of PHI, but also require us to obtain satisfactory assurances that any business associate of ours who has access to our PHI similarly will safeguard such PHI. We believe that we are in compliance in all
material respects with both of these HIPAA standards.



Two
other standards have been promulgated under HIPAA, although compliance with these standards is not yet required. The Security Standards require us to implement certain security measures to protect electronic PHI. We are required to comply with these
standards by April 20, 2005. In addition, CMS published a final rule covering the assignment of Unique Health Identifiers for Health Care Providers. The rule calls for the adoption of the National Provider Identifier as the standard unique health
identifier for health care providers to use in filing and processing health care claims and other transactions. We are required to comply with these standards by May 23, 2007. We have evaluated these rules to determine the effects of the rules on
our business, and we believe that we will have taken the appropriate steps to ensure that we will comply with these standards in all material respects by their respective compliance deadlines.



HIPAA also has created health care related crimes, and granted authority to
the Secretary of the DHHS to impose certain civil penalties. Particularly, the Secretary may exclude from Medicare any individual with a direct or indirect ownership interest in an entity convicted of health care fraud or excluded from the program.
HIPAA encourages the reporting of health care fraud by allowing reporting individuals to share in any recovery made by the government. HIPAA also requires new programs to control fraud and abuse, and new investigations, audits and inspections.



Under HIPAA it is a crime to:



| |  |  | knowingly and willfully commit a federal health care offense relating to a health care benefit program; and
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | knowingly and willfully falsify, conceal or cover up a material fact or make any materially false or fraudulent statements in connection with claims and payment for health care
services by a health care benefit plan.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



These
provisions of HIPAA create criminal sanctions for situations that were previously handled exclusively through civil repayments of overpayments, off-sets and fines. We believe that our business arrangements and practices comply with HIPAA. However, a
violation could subject us to penalties, fines or possible exclusion from Medicare or Medicaid. Such sanctions could reduce our revenue or profits.



The False Statements statute prohibits knowingly and willfully falsifying, concealing or covering up a material fact by any trick, scheme or device or
making any materially false, fictitious or fraudulent statement in connection with the delivery of or payment for healthcare benefits, items or services. A violation of this statute is a felony and may result in fines and/or imprisonment.



Compliance Program



In addition to our Corporate Integrity Agreement with the Office of
Inspector General described below under the caption Corporate Integrity Agreement, we have several voluntary programs to monitor compliance with federal and state laws and regulations applicable to health care entities which are
designed to minimize the likelihood that we would engage in conduct or enter into contracts in violation of the fraud and abuse laws. While we believe that our compliance program meets the relevant guidance provided by the Office of Inspector
General of the DHHS, we cannot provide any assurance that current or future administrative or judicial interpretations of existing laws or legislative enactment of new laws will not have a material adverse effect on our business.





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Health Care Reform Legislation



Economic, political and regulatory influences are subjecting the health care industry in the United States to fundamental
change. Health care reform proposals have been formulated by the legislative and administrative branches of the federal government. In addition, some of the states in which we operate periodically consider various health care reform proposals. We
anticipate that federal and state government bodies will continue to review and assess alternative health care delivery systems and payment methodologies and public debate of these issues will continue in the future. Due to uncertainties regarding
the ultimate features of reform initiatives and their enactment and implementation, we cannot predict, which, if any, of such reform proposals will be adopted or when they may be adopted or that any such reforms will not have a material adverse
effect on our business and results of operations.



Health care
is an area of extensive and dynamic regulatory change. Changes in the law or new interpretations of existing laws can have a dramatic effect on permissible activities, the relative costs associated with doing business and the amount of reimbursement
by government and other third-party payors.



Corporate Integrity Agreement



Our predecessor, Rotech Medical Corporation, and the
Office of Inspector General of the DHHS entered into a Corporate Integrity Agreement as part of the process of settling the United States federal governments fraud claims against Rotech Medical Corporation in its bankruptcy proceeding. As the
successor to the business and operations of Rotech Medical Corporation, we are subject to the provisions of the Corporate Integrity Agreement.



Providers and suppliers enter into corporate integrity agreements as part of settlements with the federal government in order that the federal government
will waive its right to permissively exclude them from participating in federal health care programs.



The Corporate Integrity Agreement is for a term of five years beginning February 2002. Among other things, the Corporate Integrity Agreement requires us
to conduct internal claims reviews related to our Medicare billing. In the first and fourth years of the agreement, the internal claims reviews will also be reviewed by an Independent Review Organization (IRO). Under certain
circumstances, the internal claims reviews may also be reviewed by the IRO in the fifth year of the agreement. KPMG LLP acted as our IRO during the first year of the agreement. We must file reports of the reviews with the Office of Inspector General
of the DHHS.



In addition, the Corporate Integrity Agreement
imposes upon us (including in most instances our officers, directors, employees and others) various training requirements, as well as the need to have certain policies and procedures in place. It also requires that we have a Compliance Officer,
several Compliance Liaisons and a Compliance Committee. We believe we are in compliance with these requirements.



The Corporate Integrity Agreement also mandates that we have certain procedures in place with respect to our acquisition process. More specifically, we
are required to have an Acquisition Committee which approves all acquisitions before they are consummated. As part of the acquisition process, we will be required to conduct operational and file reviews of potential entities in which we might
acquire an interest. Assuming that we decide to acquire an entity, we will be required to provide a report to the Office of Inspector General of the DHHS indicating that we followed the acquisition procedures set forth in the Corporate Integrity
Agreement and specifying any corrective action that might be necessary post acquisition.



The Corporate Integrity Agreement restricts us from hiring any person or contractor who is ineligible to participate in federal health care programs, federal procurement or federal non-procurement programs or has been
convicted of a criminal offense related to the provision of health care items or services. We are obligated to conduct ongoing reviews of the qualifications of all of our employees and contractors. If a current employee or contractor is or becomes
an ineligible employee as contemplated by the Corporate Integrity Agreement, such individual must be relieved of any responsibility for, and removed from any involvement with, our business operations relating to federal health care programs.



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As part of the Corporate Integrity Agreement, we also have certain obligations with respect to repayment
of identified overpayments and reporting of Material Deficiencies we may learn of with respect to our relationship with federal health care programs. We also must submit annual reports to the Office of Inspector General of the DHHS
regarding our compliance with the Corporate Integrity Agreement generally. To the extent that we violate the terms of the Corporate Integrity Agreement, we may be subject to substantial penalties, including stipulated cash penalties ranging from
$1,000 per day to $2,500 per day for each day we are in breach of the agreement and, possibly, exclusion from federal health care programs.



Suppliers



We purchase our supplies from a variety of independent suppliers. We are not dependent upon any one supplier, and believe that our supplies can be
provided by several suppliers. We have long-standing relationships with most of our largest national suppliers in each product category. We typically focus on one or two suppliers in each product category in an effort to maximize delivery efficiency
and gross margins.



Sales



We believe that the sales and marketing skills of our employees are
instrumental to the success of our business. We provide marketing, training, product and service information to all of our technical personnel through our intranet and through seminars conducted on a company-wide basis so that they can communicate
effectively with physicians about our equipment and services. We emphasize the cross-marketing of all our equipment and services to physicians with which we have already developed professional relationships.



Quality Control



We are committed to providing consistently high quality equipment and services. Our quality control procedures and training
programs are designed to promote greater responsiveness and sensitivity to individual patient needs and to provide a high level of quality assurance and convenience to the patient and the referring physician. Licensed respiratory therapists and
registered nurses provide professional health care support.



The Joint Commission on Accreditation of Healthcare Organizations, or JCAHO, is a nationally recognized organization which develops standards for various health care industry segments and monitors compliance with those standards through
voluntary surveys of participating providers. Accreditation by JCAHO entails a lengthy review process that is conducted at least every three years. We believe that our accreditation by JCAHO is indicative of our commitment to providing consistently
high quality equipment and services. Currently, 100% of our operating centers are accredited by JCAHO.



Competition



The home
medical equipment market is highly competitive and divided among a large number of providers, some of which are national providers, but most of which are either regional or local providers. Our largest national home medical equipment provider
competitors are Apria Healthcare Group, Inc., Lincare Holdings, Inc., American Home Patient, Inc., Praxair, Inc. and Air Products and Chemicals, Inc. The rest of the market consists of several medium-size competitors, as well as numerous small
(under $5 million in revenues) local operations. We also face competition from other types of health care providers, including hospitals, home health agencies and health maintenance organizations. We believe that the most important competitive
factors in the regional and local markets are:



| |  |  | reputation with referral sources, including local physicians and hospital-based professionals;
| | - |  | ----------------------------------------------------------------------------------------------



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| |  |  | service quality and responsiveness;
| | - |  | -----------------------------------



| |  |  | overall ease of doing business;
| | - |  | -------------------------------



| |  |  | quality of patient care, including clinical expertise;
| | - |  | ------------------------------------------------------



| |  |  | range of home medical equipment and services; and
| | - |  | -------------------------------------------------



| |  |  | being a low cost provider.
| | - |  | --------------------------



We believe that it is important to be able to offer a broad range of complementary equipment and services to provide patients access through a single
source. We believe that we compete effectively with respect to all of the above factors and that we have an established record as a quality provider of a range of complementary home medical equipment and services.



Insurance



Our business is subject to general and professional liability, products liability, employment practices liability,
workers compensation, automobile liability, personal injury and other liability claims that are generally covered by insurance. We have insurance policies that contain various customary levels of deductibles and self-insured retentions and
provide us with protection against claims alleging bodily injury or property damage arising out of our operations. These insurance policies are subject to annual renewal. We believe that our insurance coverage is appropriate based upon historical
claims and the nature and risks of our business.



Employees



Currently, we have approximately 4,331 full time employees. Our employees
are not currently represented by a labor union or other labor organization. We believe our relations with our employees are good.



Principal Executive Office and Website Access To Information



Our principal executive offices are located at 2600 Technology Drive, Suite 300, Orlando, Florida, 32804 and our telephone number there is (407) 822-4600.
Our internet website address is www.rotech.com.



We make
available free of charge on or through our website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is
electronically filed with or furnished to the Securities and Exchange Commission (the SEC). Our reports are also available free of charge on the SECs website, www.sec.gov. Also available free of charge on our website are the
following corporate governance documents:



| |  |  | Certificate of Incorporation
| | - |  | ----------------------------



| |  |  | Bylaws
| | - |  | ------



| |  |  | Audit Committee Charter
| | - |  | -----------------------



| |  |  | Compensation Committee Charter
| | - |  | ------------------------------



| |  |  | Nominating and Corporate Governance Committee Charter
| | - |  | -----------------------------------------------------



| |  |  | Corporate Governance Guidelines
| | - |  | -------------------------------



| |  |  | Code of Ethics for Directors, Senior Executive, Financial and Accounting Officers
| | - |  | ---------------------------------------------------------------------------------



| |  |  | Policy Statement on Business Ethics and Conflicts of Interests
| | - |  | --------------------------------------------------------------



All of our reports and corporate governance documents may also be obtained without charge, upon written request directed to the Chief Legal Officer,
Rotech Healthcare Inc., 2600 Technology Drive, Suite 300, Orlando, Florida, 32804. Information contained on our website is not incorporated by reference into this annual report and is not a part of this annual report.



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Executive Officers



Our executive officers and their respective ages and positions are as follows:



|                 |  |     |  |                                                
|---------------- |  | --- |  | -----------------------------------------------
|Name             |  | Age |  | Position                                       
|Philip L. Carter |  | 56  |  | President, Chief Executive Officer and Director
|Michael R. Dobbs |  | 55  |  | Chief Operating Officer                        
|Barry E. Stewart |  | 50  |  | Chief Financial Officer and Treasurer          



Philip L.
Carter became President, Chief Executive Officer and a director of our company in December 2002. From March 2002 to November 2002, Mr. Carter was self-employed. From May 1998 to February 2002, Mr. Carter was the Chief Executive Officer and a
director of Apria Healthcare Group Inc. Prior to joining Apria Healthcare Group Inc., Mr. Carter had served as President and Chief Executive Officer of Mac Frugals Bargains Close-Outs Inc., a chain of retail discount stores, since 1995.



Michael R. Dobbs became Chief Operating Officer
of our company in January 2003. Prior to joining our company, Mr. Dobbs was an officer of Apria Healthcare Group Inc., serving as Executive Vice President, Logistics from January 1999 to January 2003 and as Senior Vice President, Logistics from June
1998 to January 1999. Prior to joining Apria Healthcare Group Inc., Mr. Dobbs served as Senior Vice President of Distribution for Mac Frugals Bargains Close-Outs Inc. from 1991 to 1998.



Barry E. Stewart, our Chief Financial Officer and Treasurer,
joined us in July 2004. Prior to joining our company, Mr. Stewart was Chief Financial Officer of Evolved Digital Systems, Inc. from 2001 to 2004, and Vice President of Finance of Community Health Systems, Inc. from 1996 to 2001. Prior to 1996, Mr.
Stewart served in various managing director positions with national commercial banks. Mr. Stewart currently serves as a director and the chairman of the audit committee of the board of directors for FloTek Industries, Inc., a publicly traded company
headquartered in Houston, Texas. Mr. Stewart is a licensed Certified Public Accountant.



Risk Factors



Health care is an area of
extensive and dynamic regulatory change that involves a number of risks. The following discussion highlights some of these risks. These and other risks discussed in this report could materially and adversely affect our business and financial
condition.



A substantial percentage of our revenue is
attributable to Medicare. Our business may be significantly impacted by changes in Medicare reimbursement policies and recent legislative changes aimed at reducing health care costs.



A substantial percentage of our revenue is attributable to Medicare and, to a lesser extent, Medicaid. The remainder of our
billings are paid by other third-party payors, including private insurers, and by the patients themselves. Medicare, Medicaid and other federally funded programs (primarily Veterans Administration contracts) accounted for approximately 67.9% of our
revenues for three months ended March 31, 2002, approximately 69.1% of revenues for the nine months ended December 31, 2002, approximately 71.1% of our revenues for the year ended December 31, 2003 and approximately 71.0% of our revenues for the
year ended December 31, 2004.



There have been a number of
legislative and regulatory proposals to change the health care system in ways that could impact our ability to sell our products and services profitably. In the United States, federal and state lawmakers regularly propose and, at times, enact new
legislation establishing significant changes in the healthcare system. Recent news headlines highlighted the need to control health care spending in the Medicare and Medicaid programs, and this pressure may continue to intensify over time. Recent
legislation continues to impact and reduce Medicare payment levels. Under the Medicare Prescription Drug, Improvement and Modernization Act of 2003, or MMA, additional reductions have been imposed. Changes under MMA include a reduction in payments
for certain types of home medical equipment, including wheelchairs, nebulizers and oxygen equipment, a freeze in payments for other home medical equipment from 2004 through 2008, competitive



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bidding requirements, new clinical conditions for payment and quality standards. In addition, as of January 1, 2005, MMA also reduced payments for inhalation
drugs delivered through nebulizer equipment to an amount based on 106% of average sales price. Reductions in Medicare reimbursement for oxygen, nebulizers and inhalation medications could have a material adverse effect on our revenues and
profitability. We cannot predict the impact that any federal legislation enacted in the future will have on our revenues and profitability.



Changes in the law or new interpretations of existing laws can have a dramatic effect on permissible activities, the relative costs associated with doing
business and the amount of reimbursement by government and other third-party payors. Reimbursement from Medicare and other government programs is subject to federal and state statutory and regulatory requirements, administrative rulings,
interpretations of policy, implementation of reimbursement procedures, renewal of Veterans Administration contracts, retroactive payment adjustments and governmental funding restrictions. Our levels of revenue and profitability, like those of other
health care companies, are affected by the continuing efforts of government payors to contain or reduce the costs of health care by lowering reimbursement rates.



A substantial percentage of our business is derived from the sale of Medicare-covered HME items, including oxygen, and
recent legislation reduces payment amounts for certain categories of HME.



Currently, Medicare payments to us for our HME products are based on the lesser of the actual charge for the item or the applicable Medicare fee schedule amount. Under MMA, from 2004 through 2008, most payments for
HME are set at the 2003 level and therefore, are frozen, unless the item becomes subject to further reductions based on Federal Health Benefits Program median payment amounts as described below, or are subject to competitive bidding. As
of January 1, 2005, the fee schedule amounts for certain items of HME, including wheelchairs and nebulizers, were further reduced, based on the percentage difference between the amount of payment otherwise determined for 2002 and the median amount
of payment under the Federal Employee Health Benefits Program, or FEHBP as determined by the Office of the Inspector General of DHHS, or OIG. The FEHBP adjusted payments are to remain frozen through 2008 unless the particular item
becomes subject to competitive bidding.



The fee schedule
amounts for oxygen and oxygen equipment are also to be calculated using this methodology. A September 2004 OIG report entitled Medicare Payment Rates for Home Oxygen Equipment surveyed FEHBP prices for oxygen equipment and found
that the median 2002 prices were considerably lower than Medicare payments for those items. According to the report, the 2002 median FEHBP payments for five oxygen codes showed that the FEHBP median payments for stationary home oxygen equipment were
approximately 15.5% less than Medicare payments for stationary home oxygen equipment and approximately 11.3% less than Medicare payments for portable home oxygen equipment. On February 4, 2005, CMS published notice CMS-1299-N announcing a delay in
the implementation of the 2005 Medicare oxygen payment rates. The notice states that CMS was informed by the OIG that it will need to collect additional information before the FEHBP median prices for oxygen are finalized. Until such prices are
established, Medicare claims for oxygen equipment furnished on or after January 1, 2005 will be paid based on the 2004 monthly payment amounts. CMS is expected to calculate and implement the lower 2005 payment amounts upon receipt of the additional
information from the OIG. CMS has stated that no retroactive adjustments are to be made once the new payment amounts are set. Reductions in payment rates for 2005 established by CMS for the non-oxygen HME items subject to the FEHBP provisions range
between 4% and 16%. The non-oxygen HME items subject to the Medicare price cuts accounted for approximately 2% of our recorded revenues in 2004. If the proposed reductions in the Medicare fee schedules for home oxygen equipment (as set forth in the
September 2004 OIG report discussed above) together with the additional reimbursement reductions mandated by the MMA in 2005 for other home medical equipment (excluding inhalation drugs) had been implemented in 2004, we believe it would have
resulted in a reduction in our 2004 recorded revenues in the range of approximately $30 million to $35 million. At this time, we cannot determine the outcome of the 2005 Medicare oxygen payment rates, the date on which the new payment amounts will
become effective or the ultimate impact thereof on our business. Reductions in reimbursement for Medicare-covered HME items, including oxygen, could have a material adverse effect on our revenues, profitability and results of operations.



A significant percentage of our business is derived from the sale of
Medicare-covered respiratory medications, and recent legislation imposes significant reductions in Medicare reimbursement for such inhalation drugs.



MMA also revises the payment methodology for certain drugs, including inhalation drugs dispensed through nebulizers. Prior to MMA, Medicare paid for these
drugs based on AWP, as reported by drug manufacturers.



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Beginning January 1, 2004, Medicare payments were reduced for most of our Part B inhalation drugs to 80% of AWP from 95% of AWP, a reduction of approximately
15 percent. This reduction in Medicare payment rates for inhalation drugs reduced our revenues and operating income by approximately $24 million in 2004. As of January 1, 2005, payments for drugs delivered through nebulizer equipment are based on
106% of ASP. ASP is defined statutorily as the volume weighted average of manufacturers average sales prices, calculated by adding the manufacturers average sales prices for the drug in the fiscal quarter to the number of units sold and
then divided by the total number of units sold for all national drug codes assigned to the product. Under the ASP methodology, Medicare generally will pay 106% of ASP for multiple source drugs and 106% of the lesser of ASP or wholesale acquisition
cost for single source drugs. In addition, if the ASP exceeds the widely available market price by more than 5%, CMS may substitute the widely available market price for the ASP. ASP payment rates are calculated and updated quarterly using the most
recent manufacturer data available. Manufacturer ASP data submissions are due to CMS not later than 30 days after the last day of each calendar quarter. Quarterly updates are to be implemented to reflect these quarterly submissions by manufacturers.
Third quarter 2004 data was used to calculate the ASP payment amounts for the first quarter of 2005. ASP payment amounts for our products may fluctuate from quarter to quarter, and if these payment amounts are reduced in future quarters, this could
have a material adverse effect on our revenues, profitability and results of operations in 2005 and beyond.



The ASP payment amounts for the first and second quarters of 2005 for many drugs are significantly less than the payment amounts for these drugs in 2004.
For example, the payment rates, as posted by CMS, for two prevalent inhalation drugs, albuterol sulfate and ipratropium bromide, were reduced from $0.39 and $2.82 per milligram in 2004 to $0.065 and $0.287 for the first quarter of 2005,
respectively. For the second quarter of 2005, payment rates, as posted by CMS, for albuterol sulfate and ipratropium bromide were changed to $0.090 and $0.202, respectively. Given the overall reduction in payment for inhalation drugs dispensed
through nebulizers, CMS established a $57 dispensing fee for inhalation drugs shipped to a beneficiary during a 30-day period or $80 for a 90-day period. CMS intends to revisit the payment amount for the dispensing fees during 2005 and to proceed
through notice and comment rulemaking in order to establish an appropriate dispensing fee, if any, for 2006. We cannot predict the outcome of any future rulemaking by CMS.These dispensing fees may be reduced or eliminated in 2006 or beyond,
and such reductions or eliminations, if they occur, could have a material adverse effect on our revenues, profitability and results of operations. Medicare-reimbursed inhalation drug therapies provided by us in 2004 accounted for approximately 17%
of our recorded revenues. While we have been able, based upon the increased dispensing fees, to continue offering inhalation drugs to Medicare patients in 2005, the pricing changes resulting from the ASP payment rates are expected to result in a
material reduction in the revenues and profitability of our inhalation drug business and we cannot predict whether it will continue to be economically feasible for us to continue to provide inhalation drugs in the future.



Federal law establishing a competitive bidding process under Medicare
could negatively affect our business and financial condition.



In 1999-2001, CMS conducted competitive bidding demonstrations for certain Medicare services. Under MMA, starting in 2007, Medicare will begin a nationwide competitive bidding program in ten high-population metropolitan services areas
(MSAs) for certain high cost and high utilization items. The program will expand to cover 80 MSAs in 2009 and additional areas thereafter. Competitive bidding will require suppliers to compete for the rights to provide items to beneficiaries in a
defined region. Only a limited number of suppliers will be selected in any given MSA, resulting in restricted supplier choices for beneficiaries. Competitive bidding may result in lower reimbursement or the loss of our ability to provide services in
certain regions. MMA permits certain exemptions from competitive bidding, including exemptions for rural areas and areas with low population density within urban areas that are not competitive, unless there is a significant national market through
mail-order for the particular item. A large number of our facilities are located in such areas. However, the criteria for how the exemption will be applied have not yet been determined. The proposed regulations implementing the competitive bidding
program are expected to be published in the summer of 2005 and finalized by the summer of 2006. Therefore, at this time, the impact on our business is uncertain.





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Regulatory changes subject the Medicare reimbursement rates for our equipment and services to
potential discretionary adjustment by the Centers for Medicare and Medicaid Services.



The Balanced Budget Act of 1997, or BBA 97, granted authority to the Secretary of the Department of Health and Human Services, or DHHS, to increase or reduce the reimbursement for home medical equipment, including
oxygen, by 15% each year under an inherent reasonableness procedure. On February 11, 2003, CMS made effective an interim final rule implementing the inherent reasonableness authority, which allows the agency and carriers to adjust payment amounts by
up to 15% per year for certain items and services covered by Part B when the existing payment amount is determined to be grossly excessive or deficient. The regulation lists factors that may be used by CMS and the carriers to determine whether an
existing reimbursement rate is grossly excessive or deficient and to determine what is a realistic and equitable payment amount. Also, under the regulation, CMS and the carriers will not consider a payment amount to be grossly excessive or deficient
and make an adjustment if they determine that an overall payment adjustment of less than 15% is necessary to produce a realistic and equitable payment amount. In addition to its inherent reasonableness authority, CMS has the discretion to reduce the
reimbursement for home medical equipment and other non-HME services to an amount based on the payment amount for the least costly alternative treatment that meets the Medicare beneficiarys medical needs. Least costly alternative, or LCA,
determinations are applied to particular products and services by CMS and its carriers through the informal notice and comment process used in establishing local coverage policies for HME. This process need not be followed for LCA determinations
made on individual claims. Using either its inherent reasonableness or least costly alternative authority, CMS and the carriers may reduce reimbursement levels for certain items and services covered by Part B, including products and services we
offer, which could have a material adverse effect on our revenues, profitability and results of operations.



Future reductions in reimbursement rates under Medicaid could negatively affect our business and financial condition.



Due to budgetary shortfalls, many states are considering, or have enacted,
cuts to their Medicaid programs. These cuts have included, or may include, elimination or reduction of coverage for some or all of our equipment and services, amounts eligible for payment under co-insurance arrangements, or payment rates for covered
items. Continued state budgetary pressures could lead to further reductions in funding for the reimbursement for our equipment and services which, in turn, could have a material adverse effect on our financial position and operating results.



In addition to cost containment initiatives associated with
Medicare and Medicaid, we are affected by continuing efforts by private third-party payors to control their costs. If we lower our prices due to pricing pressures from private third-party payors, our results of operations and financial condition
would likely deteriorate.



Private payors continually seek
to control the cost of providing health care services through direct contracts with health care providers, increased oversight and greater enrollment of patients in managed care programs and preferred provider organizations. These private payors are
increasingly demanding discounted fee structures and the assumption by the health care provider of all or a portion of the financial risk. Reimbursement payments under private payor programs may not remain at current levels and may not be sufficient
to cover the costs allocable to patients eligible for reimbursement pursuant to such programs, and we may suffer deterioration in pricing flexibility, changes in payor mix and growth in operating expenses in excess of increases in payments by
private third-party payors. We may be compelled to lower our prices due to increased pricing pressures, which could cause our results of operations and financial condition to deteriorate.



Failure to maintain current levels of collectibility of our accounts receivable would likely have a significant negative
impact on our profitability and cash flow.



Billing and
collection for our services is a complex process requiring constant attention and involvement by senior management and ongoing enhancements to information systems and billing center operating procedures.



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We are paid for our services by various payors, including patients, insurance companies, Medicare,
Medicaid and others, each with distinct billing requirements. We recognize revenue when we provide services to patients. However, our ability to collect these receivables is dependent on our submissions to payors of accurate and complete
documentation. In order for us to bill and receive payment for our services, the physician and the patient must provide appropriate billing information. Following up on incorrect or missing information generally slows down the billing process and
the collection of accounts receivable. Failure to meet the billing requirements of the different payors could result in a decline of our revenues, profitability and cash flow.



Further, even if our billing procedures comply with all third-party payor requirements, some of our payors may experience
financial difficulties or may otherwise not pay accounts receivable when due, which would result in increased write-offs or provisions for doubtful accounts. There can be no assurance that we will be able to maintain our current levels of
collectibility or that third-party payors will not experience financial difficulties. If we are unable to collect our accounts receivable on a timely basis, our revenues, profitability and cash flow likely will decline.



In addition, in connection with our ongoing consolidation of billing centers,
we have experienced in the past short-term disruptions in our operations and collection efforts. If we experience such disruptions in the future, our revenues, profitability and cash flow may significantly decline.



We are subject to periodic audits by governmental and private payors.



We are subject to periodic audits by Medicare and
Medicaid programs, and the oversight agencies for these programs have rights and remedies they can assert against us if they determine we have overcharged the programs or failed to comply with program requirements. These agencies could seek to
require us to repay any overcharges or amounts billed in violation of program requirements, or could make deductions from future amounts otherwise due to us from these programs. We could also be subject to fines, criminal penalties or program
exclusions. Private payors also reserve rights to conduct audits and make monetary adjustments. See BusinessGovernment Regulation for a discussion of recent efforts by government payors to reduce health care costs.



Our business, including our participation in the Medicare and Medicaid
program, is subject to extensive laws and government regulations. Failure by us to comply with these laws and regulations could subject us to severe sanctions and have a significant negative impact on our operations.



We are subject to stringent laws and regulations at both the federal and
state levels, including with respect to:



| |  |  | billing practices including substantiation and record keeping requirements;
| | - |  | ---------------------------------------------------------------------------



| |  |  | prohibitions on fraud and abuse, kickbacks, rebates and fee splitting;
| | - |  | ----------------------------------------------------------------------



| |  |  | licensing and certification requirements;
| | - |  | -----------------------------------------



| |  |  | confidentiality, privacy and security issues in connection with medical records and patient information;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | relationships with physicians and other referral sources;
| | - |  | ---------------------------------------------------------



| |  |  | operating policies and procedures;
| | - |  | ----------------------------------



| |  |  | qualifications of health care and support personnel;
| | - |  | ----------------------------------------------------



| |  |  | quality of durable medical equipment and other medical equipment;
| | - |  | -----------------------------------------------------------------



| |  |  | handling, distribution and disposal of pharmaceutical products and medical waste;
| | - |  | ---------------------------------------------------------------------------------



| |  |  | quality assurance; and
| | - |  | ----------------------



| |  |  | occupational safety.
| | - |  | --------------------



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Existing United States laws governing Medicare and state health care programs such as Medicaid, as well
as similar laws enacted in many states, impose a broad variety of prohibitions on soliciting, receiving, offering or paying, directly or indirectly, any form of remuneration, payment or benefit for the referral of a patient for services or products
reimbursable by Medicare or a state health care program. The federal government has published regulations that provide exceptions or safe harbors for business transactions that will be deemed not to violate these prohibitions. Violation
of these prohibitions may result in civil and criminal penalties and exclusion from participation in Medicare and state health care programs.



The federal and state Stark Laws impose a broad range of restrictions upon referring physicians (and their immediate family) and providers of
certain designated health services under Medicare and state health care programs, including restrictions on financial relationships between the referring physicians and the providers of the designated health care services. Services which we provide
are classified as designated health services and fall within the regulatory scope of the Stark Laws. Significant criminal, civil and administrative penalties may be imposed for violation of these laws.



We are also subject to strict licensing and safety requirements by the
federal government and many states. Furthermore, many state laws prohibit physicians from sharing professional fees with non-physicians and prohibit non-physician entities, such as us, from practicing medicine and from employing physicians to
practice medicine.



In addition, both federal and state
government agencies have heightened and coordinated civil and criminal enforcement efforts as part of numerous ongoing investigations of health care companies, as well as their executives and managers. These investigations relate to a wide variety
of matters, including referral and billing practices.



Further,
amendments to the False Claims Act have made it easier for private parties to bring qui tam whistleblower lawsuits against companies. Some states have adopted similar state whistleblower and false claims provisions.



The Office of the Inspector General of the DHHS and the Department of
Justice, or DOJ, have, from time to time, established national enforcement initiatives that focus on specific billing practices or other suspected areas of abuse. Some of our activities could become the subject of governmental investigations or
inquiries. In 2002, we entered into a settlement agreement with the DOJ and the DHHS to settle claims against Rotech Medical Corporation relating to certain Medicare and Medicaid billings. In addition, we or our executives could be included in other
governmental investigations or named as defendants in private litigation, resulting in adverse publicity against us.



On April 30, 2003, federal agents served search warrants at our corporate headquarters and four other facilities in three states and were provided access
to a number of current and historical financial records and other materials. Since that time, we have received subpoenas on behalf of the United States Attorneys Office for the Northern District of Illinois requesting the same information
including information relating to Medicare billing and Department of Veterans Affairs contracting. We are cooperating fully with the investigation. However, we can give no assurances as to the duration of the investigation or as to whether or not
the government will institute proceedings against us or any of our employees or as to the violations that may be asserted.



If we fail to comply with the laws and regulations relevant to our business, we could be subject to civil and/or criminal penalties, demands from the
government for refunds or recoupment of amounts previously paid to us by the government, facility shutdowns and possible exclusion from participation in federal health care programs such as Medicare and Medicaid, any of which could have a
significant negative impact on our operations. Some statutory and regulatory provisions, principally in the area of billing, have not been interpreted by the courts and may be interpreted or applied in a manner that might adversely affect us.
Changes in health care laws or new interpretations of existing laws may have a dramatic effect on our business and results of operations.





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Failure to achieve and maintain effective internal controls in accordance with Section 404 of the
Sarbanes-Oxley Act could have a material adverse effect on our business, operating results and stock price.



We are in the process of documenting and testing our internal control procedures in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley
Act, which requires annual management assessments of the effectiveness of our internal controls over financial reporting and a report by our independent auditors addressing these assessments. During the course of our testing we may identify
deficiencies which we may not be able to remediate in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with the requirements of Section 404. In addition, if we fail to achieve and maintain the adequacy of our internal
controls, as such standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section
404 of the Sarbanes-Oxley Act. Moreover, effective internal controls, particularly those related to revenue recognition, are necessary for us to produce reliable financial reports and are important to helping prevent financial fraud. If we cannot
provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly.



If we lose relationships with managed care organizations and other
third-party payors, we could lose access to patients and our revenue would likely decline.



Managed care organizations and other third-party payors have continued to consolidate in order to enhance their ability to influence the delivery of
health care services and to build volume that justifies discounted prices. Consequently, the health care needs of a large percentage of the United States population are now provided by a small number of managed care organizations and third-party
payors. These organizations, including the Veterans Administration, generally enter into service agreements with a limited number of providers for needed services. To the extent such organizations terminate agreements with us and/or engage our
competitors, our business could be materially adversely affected. If we lose relationships with managed care organizations and other third-party payors, including the Veterans Administration, we could lose access to patients and our revenue would
likely decline.



If we fail to cultivate new or maintain
established relationships with the physician referral sources, our revenues may decline.



Our success, in part, is dependent upon referrals and our ability to maintain good relations with physician referral sources. Physicians referring patients to us are not our employees, and are free to refer their
patients to our competitors. If we are unable to successfully cultivate new referral sources and maintain strong relationships with our current referral sources, our revenues may decline.



Our medical gas and pharmacy operations are subject to extensive regulation by federal and state authorities.



Our medical gas and pharmacy operations are subject to
extensive regulation by FDA and other federal and state authorities. Federal and state authorities enforce these regulations through periodic and unannounced inspections. Our failure to maintain regulatory compliance could result in enforcement
action, including warning letters, fines, product recalls or seizures, temporary or permanent injunctions, and civil or criminal penalties which would materially harm our business, financial condition and results of operations.



A percentage of our business is derived from the sale of our compounded
respiratory medications. Pharmacy compounding is considered to be within the practice of medicine and is regulated primarily under state law. The line between the activities that constitute drug compounding and the activities that constitute drug
manufacturing (which is subject to rigorous regulations by the FDA under the FFDCA) is not clear, and the FDA may define the scope of drug manufacturing activities more broadly than we or the state pharmacy board do. If FDA determines that our
compounding activities are more consistent with the activities of a drug manufacturer, FDA could exercise its enforcement authority to temporarily or permanently suspend part or all of our compounding operations, seize part or all of our compounding
raw materials and compounded products, or require us to comply with the FFDCAs rigorous requirements for manufacturing a new drug.



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If we do not comply with laws and regulations governing the confidentiality of medical information, we
could be subject to criminal penalties and civil sanctions.



In 1996, the Health Insurance Portability and Accountability Act (HIPAA) was enacted, among other things, to establish uniform standards governing the conduct of certain electronic health care transactions and to protect the security and
privacy of individually identifiable health information maintained or transmitted by health care providers, health plans and health care clearinghouses.



Two standards have been promulgated under HIPAA with which we currently are required to comply. We must comply with the Standards for Electronic
Transactions, which establish standards for common health care transactions, such as claims information, plan eligibility, payment information and the use of electronic signatures; unique identifiers for providers, employers, health plans and
individuals; security; privacy; and enforcement. We were required to comply with these Standards by October 16, 2003. We also must comply with the Standards for Privacy of Individually Identifiable Information, which restricts our use and disclosure
of certain individually identifiable health information. We were required to comply with the Privacy Standards by April 14, 2003. We believe we are in compliance in all material respects with both of these HIPAA standards. Two other standards
relevant to our use of medical information have been promulgated under HIPAA, although our compliance with these standards is not yet required. The Security Standards will require us to implement certain security measures to safeguard certain
electronic health information by April 20, 2005. In addition, CMS published a final rule, which will require us to adopt a Unique Health Identifiers for use in filing and processing health care claims and other transactions by May 23, 2007. While
the government intended this legislation to reduce administrative expenses and burdens for the health care industry, our compliance with this law may entail significant and costly changes for us. If we fail to comply with these standards, we could
be subject to criminal penalties and civil sanctions.



Lack
of accreditation of our operating centers or failure to meet government standards for coverage could result in a decline in our revenues.



Currently, 100% of our operating centers are accredited by the Joint Commission on Accreditation of Healthcare Organizations, or JCAHO. If future reviews
by JCAHO do not result in continued accreditation of our operating centers, we would likely experience a decline in our revenues. Further, under MMA, any entity or individual that bills Medicare for home medical equipment and certain supplies and
has a supplier number for submission of claims will be subject to new quality standards as a condition of receiving payment from the Medicare program. New standards are to be developed by CMS and applied by independent accreditation organizations.
MMA also authorizes CMS to establish clinical conditions for payment for home medical equipment. These new supplier standards and clinical conditions for payment could limit or reduce the number of individuals who can sell or provide our products
and could restrict coverage for our products. In addition, because we have Medicare supplier numbers and are subject to any new supplier standards, our failure to meet any new supplier standards could affect our ability to bill and therefore could
have a material adverse effect on our business, financial condition and results of operations.



If we fail to comply with our Corporate Integrity Agreement or the terms of our settlement with the federal government, we could be subject to severe sanctions and be excluded from participating in federal and
state health care programs, as well as adverse publicity, which could result in a material decrease in our revenue and seriously undermine our ability to compete for business, negotiate acquisitions, hire new personnel and otherwise conduct our
business.



On February 11, 2002, our predecessor entered
into a Corporate Integrity Agreement with the DHHS. We have assumed the obligations under this agreement (and the settlement with the federal government). Pursuant to the terms of this agreement, we are obligated to implement procedures designed to
ensure compliance with the requirements of Medicare, Medicaid and all other federal health care programs. The Corporate Integrity Agreement is effective for five years. Among other things, the Corporate Integrity Agreement requires us to



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conduct internal claims reviews relating to our Medicare billing. In the first and fourth years of the agreement, the internal claim reviews must also be
reviewed by an Independent Review Organization (currently KPMG LLP). We must file reports of the reviews with the Office of Inspector General of the Department of Health and Human Services. As a result of these reviews we may be required to refund
certain payments to the federal government and/or be subject to penalties resulting from such overpayments. In addition, failure by us to comply with the Corporate Integrity Agreement could subject us to substantial monetary penalties, exclusion
from participation in federal health care programs, as well as adverse publicity, which could seriously undermine our ability to compete for business, negotiate acquisitions, hire new personnel and otherwise conduct our business, and could result in
a deterioration in our financial condition and results of operations. See BusinessCorporate Integrity Agreement for a more detailed description of the terms of the Corporate Integrity Agreement.



In June 2002, we uncovered a pattern of falsified bulk sales of equipment
to the Department of Veterans Affairs, as well as certain improperly recorded revenues from non-bulk VA service contracts.



In late June 2002, we discovered that an independent contractor (who was also a former employee) had falsified certain bulk sales to the Department of
Veterans Affairs (VA) by fabricating documentation for nonexistent sales of medical equipment in bulk to the VA. Upon learning of these falsified sales, we promptly:



| |  |  | brought the matter to the attention of the relevant government authorities;
| | - |  | ---------------------------------------------------------------------------



| |  |  | terminated the independent contractor;
| | - |  | --------------------------------------



| |  |  | retained a nationally recognized law firm and a government contracts consulting firm to conduct a comprehensive internal investigation; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | commenced working with our independent certified public accountants to determine the appropriate accounting treatment.
| | - |  | ----------------------------------------------------------------------------------------------------------------------



The investigation confirmed the existence of a pattern of falsified bulk
sales of equipment to the VA, as well as certain improperly recorded revenues from non-bulk VA service contracts. The total of the falsified sales was originally recorded to our books and records as net revenue of $30.4 million. Of this amount,
$14.8 million was recorded during the six-month period from October 1, 2001 to March 31, 2002. In addition, $8.1 million of receivables associated with non-bulk VA service contracts were reversed. In connection with the investigation, we recovered
approximately $12.5 million of medical equipment inventory, virtually all of which was in resalable condition. Although we have concluded our investigation, it is possible that our investigation did not uncover every instance of fraudulent activity.
In addition, we received informal requests for information on March 7, 2003 and on April 17, 2003, from the Division of Enforcement of the Securities and Exchange Commission related to our internal investigation regarding VA contracts, and provided
documents in response to such requests. At this time we have not received any further requests for information from the Securities and Exchange Commission, however, we can give no assurances as to whether or not the Securities and Exchange
Commission will request additional information or take any other action.



As a result of the investigation, we restated our consolidated financial statements for each of the years ended December 31, 1999, 2000 and 2001 and for the three months ended March 31, 2002. The restatement reflects
a net after-tax charge of $14.1 million over a three-year period.



We experience competition from numerous other home medical equipment providers, and this competition could result in a deterioration in our revenues and business.



The home medical equipment market is highly competitive and divided among a large number of providers, some of which are
national providers but most of which are either regional or local providers. Home respiratory companies compete primarily on the basis of service rather than price since reimbursement levels are established by Medicare and Medicaid or by the
individual determinations of private health plans. Our ability to compete successfully and to increase our referrals of new customers are highly dependent upon our reputation within each



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local health care market for providing responsive, professional and high-quality service, a professional staff with clinical and technical expertise and
achieving strong customer satisfaction.



Some of our
competitors may now or in the future have greater financial or marketing resources than we do. Our largest national home medical equipment provider competitors are Apria Healthcare Group, Inc., Lincare Holdings, Inc., American Home Patient, Inc.,
Praxair, Inc. and Air Products and Chemicals, Inc. The rest of the market consists of several medium-size competitors, as well as hundreds of smaller companies with under $5 million in revenues. Many of the smaller, owner-operated home medical
equipment providers have a level of service quality that is difficult to replicate. There are relatively few barriers to entry in local home health care markets. The competitive nature of the home medical equipment environment could result in a
deterioration in our revenues and our business.



Since our
financial statements reflect fresh-start reporting adjustments made upon our predecessors emergence from bankruptcy, information reflecting our results of operations and financial condition will not be comparable to prior periods of our
predecessor.



Upon our predecessors emergence from
bankruptcy, we adopted fresh-start reporting. Under fresh-start reporting, our reorganization value is allocated to our assets based on their respective fair values in conformity with the purchase method of accounting for business combinations. Any
portion not attributed to specific tangible or identified intangible assets is reported as an intangible asset referred to as reorganization value in excess of value of identifiable assetsgoodwill. In adopting fresh-start
reporting, we engaged an independent financial advisor to assist in the determination of the reorganization value or fair value of the entity. Within the implementation of fresh-start reporting, the book value of our fixed assets and amortization
schedules has changed. Accordingly, you will not be able to compare certain information reflecting our results of operations and financial condition to those of our predecessor for periods prior to its emergence from bankruptcy.



We are engaged in a series of initiatives to strengthen our organizational
structure and the failure to complete such initiatives could negatively affect our operating efficiencies and financial performance.



We have engaged in a series of activities to strengthen our organizational structure and reposition us for future growth. These actions include selective
reduction in headcount, renegotiation of certain vendor contracts, substantial reduction in the number of billing centers, discontinuation of certain product lines and branch locations, centralization of certain administrative functions (including
billing and purchasing), development and implementation of an advanced information and billing system, and enhancement of regulatory compliance programs. These activities are expected to continue for so long as management determines is necessary and
appropriate. Although we have been successful in implementing many of these measures, if we are unable to continue to do so on satisfactory terms or at all, our ability to execute our business strategy and achieve operating efficiency will be
adversely affected.



We have substantial outstanding
indebtedness, which could adversely affect our financial condition.



As of March 21, 2005, our total consolidated long-term debt (including current maturities) accounted for approximately 33.3% of our total capitalization.



The degree to which we are leveraged could have important consequences, because:



| |  |  | it could affect our ability to satisfy our obligations under our 91⁄2% senior subordinated notes due 2012;
| | - |  | --------------------------------------------------------------------------------------------------------



| |  |  | a substantial portion of our cash flow from operations will be required to be dedicated to interest and principal payments and may not be available for operations, working capital,
capital expenditures, expansion, acquisitions or general corporate or other purposes;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | our ability to obtain additional financing in the future may be impaired;
| | - |  | -------------------------------------------------------------------------



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| |  |  | we may be more highly leveraged than some of our competitors, which may place us at a competitive disadvantage;
| | - |  | ---------------------------------------------------------------------------------------------------------------



| |  |  | our flexibility in planning for, or reacting to, changes in our business and industry may be limited;
| | - |  | -----------------------------------------------------------------------------------------------------



| |  |  | it may make us more vulnerable in the event of a downturn in our business, our industry or the economy in general; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------



| |  |  | we are vulnerable to interest rate fluctuations because a portion of our debt is subject to variable interest rates.
| | - |  | --------------------------------------------------------------------------------------------------------------------



Our ability to make payments on and to refinance our debt, will depend on our
ability to generate cash in the future. This, to a certain extent, is subject to general economic, business, financial, competitive, legislative, regulatory and other factors that are beyond our control.



Our business may not generate sufficient cash flow from operations and future
borrowings may not be available to us under credit facilities in an amount sufficient to enable us to pay our debt, or to fund our other liquidity needs. We may need to refinance all or a portion of our debt, on or before maturity. We may not be
able to refinance any of our debt, including any credit facilities and the notes, on commercially reasonable terms or at all.



Our business and growth strategies will require additional capital, which we may not be able to raise on terms satisfactory to us, if at all.



Our business requires us to make significant capital
expenditures relating to the purchase and maintenance of the medical equipment used in our business. In the year ended December 31, 2004, our capital expenditures were approximately $54.0 million, representing 10.1% of our net revenues. In addition,
we may pursue our growth strategy in part through acquisitions (as competitive and pricing pressures encourage consolidation and economies of scale) and the start-up of new locations. We may need to incur additional indebtedness and/or sell equity
securities, from time to time, to fund such capital expenditures. Sufficient financing may not be available to us on terms satisfactory to us, if at all.



In the event that we acquire companies, we may incur unknown liabilities for their past practices, we may be unable to successfully integrate such
companies into our operations and our results of operations could deteriorate.



If we acquire additional companies, there can be no assurance that we will be able to integrate such companies successfully or manage our expanded operations effectively and profitably. The process of integrating
newly acquired businesses may be costly and disruptive. Our operational, financial and management systems may be incompatible with or inadequate to cost-effectively integrate and manage the acquired systems. As a result, billing practices could be
interrupted and cash collections on the newly acquired business could be delayed pending conversion of patient files onto our billing systems and receipt of provider numbers from government payors. The integration may place significant demands on
our management, diverting their attention from our existing operations. If we are not successful in integrating acquired businesses, our results of operations would likely decline.



We may acquire businesses with unknown or contingent liabilities, including liabilities for failure to comply with health
care laws and regulations. We have policies to conform the practices of acquired facilities to our standards and applicable law and generally intend to seek indemnification from prospective sellers covering these matters. We may, however, incur
material liabilities for past activities of acquired businesses.



If we do not enhance and maintain effective and efficient information systems, our operations may be disrupted and our anticipated operating efficiency may not be realized.



Our operations are dependent on the enhancement and uninterrupted
performance of our information systems. Failure to enhance and maintain reliable information systems or disruptions in our information systems



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could cause disruptions in our business operations, including billing and collections, loss of existing patients and difficulty in attracting new patients,
patient and payor disputes, regulatory problems, increases in administrative expenses or other adverse consequences, any or all of which could disrupt our operations and prevent us from achieving operating efficiency.



We are highly dependent on our key personnel.



Our performance is substantially dependent on the performance and continued
efforts of our senior management team. The loss of the services of any of our executive officers or other key employees could result in a decline in our business, results of operations and financial condition. In particular, the loss of the services
of our Chief Executive Officer, Philip L. Carter, could have a material adverse effect on our business and results of operations. We do not carry key person life insurance on any of our personnel. Our future success is dependent on the ability of
our managers and sales personnel to manage and promote our business, operations and growth. Any inability to manage our operations effectively could have a material adverse effect on our business, sales, results of operations and financial
condition.



If we are not able to hire qualified management
and other personnel, or if costs of compensation or employee benefits increase substantially, our ability to deliver equipment and services effectively could suffer and our profitability would likely decline.



The success of our business depends upon our ability to attract and retain
highly motivated, well-qualified management and other personnel. Our highest cost is in the payment of salaries to our approximately 4,331 full time employees. We face significant competition in the recruitment of qualified employees, which has
caused increased salary and wage rates. If we are unable to recruit or retain a sufficient number of qualified employees, or if the costs of compensation or employee benefits increase substantially, our ability to deliver services effectively could
suffer and our profitability would likely decline.



Increases in our costs could erode our profit margins and substantially reduce our net income and cash flows.



Cost containment in the health care industry, fueled, in part, by federal and state government budgetary shortfalls, is likely to result in constant or
decreasing reimbursement amounts for our equipment and services. As a result, we must control our operating cost levels, particularly labor and related costs. We compete with other health care providers to attract and retain qualified or skilled
personnel. We also compete with various industries for lower-wage administrative and service employees. Since reimbursement rates are established by fee schedules mandated by Medicare, Medicaid and private payors, we are not able to offset the
effects of general inflation in labor and related cost components, if any, through increases in prices for our equipment and services. Consequently, such cost increases could erode our profit margins and reduce our net income.



We may write-off intangible assets, such as goodwill.



Goodwill represents the excess of cost over fair value of assets acquired
and liabilities assumed of purchased operations. As of December 31, 2003, this goodwill was approximately $11.3 million. As a result of the implementation of fresh-start reporting, the assets and liabilities of Rotech Medical Corporation
were revalued, which resulted in approximately $668.3 million for reorganization value in excess of fair value of identifiable assetsgoodwill and $20.0 million in identifiable intangible assets as of December 31, 2004. Any future acquisitions
by us will likely result in the recognition of additional intangible assets.



On an ongoing basis, we evaluate whether facts and circumstances indicate any impairment of value of intangible assets. As circumstances after an acquisition can change, the value of intangible assets may not be
realized by us. If we determine that a significant impairment has occurred, we would be required to write-off the impaired portion of the unamortized intangible assets, which could have a material adverse effect on our results of operations in the
period in which the write-off occurs.





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We may be subject to claims arising from investigations and legal proceedings, which could have a
significant negative impact on our results of operations and profitability.



The nature of our business subjects us to litigation in the ordinary course of our business. In addition, we are from time to time involved in other legal
proceedings. Although the claims made against our predecessor prior to the date it filed for bankruptcy protection have been satisfied in accordance with the terms of its plan of reorganization or in connection with settlement agreements that were
approved by the Bankruptcy Court prior to its emergence from bankruptcy (including all federal claims) or claims covered by our predecessors settlement agreements with IHS and/or its successors, any pending or future proceeding may have a
significant negative impact on our results of operations and profitability. States in other bankruptcy cases have challenged whether their claims could be discharged in a federal bankruptcy proceeding if they never made an appearance in the case.
Therefore, our predecessors emergence from bankruptcy may not result in a discharge of all state claims against us with respect to periods prior to the date it filed for bankruptcy protection. Any such claim not discharged could result in a
decline in our financial condition and profitability.



If
the coverage limits on our insurance policies are inadequate to cover our liabilities or our insurance costs continue to increase, our financial condition and results of operations would likely decline.



Participants in the health care industry, including us, are subject to
substantial claims and litigation in the ordinary course, often involving large claims and significant defense costs. As a result of the liability risks inherent in our lines of business we maintain liability insurance intended to cover such claims.
Our insurance policies are subject to annual renewal. The coverage limits of our insurance policies may not be adequate, and we may not be able to obtain liability insurance in the future on acceptable terms or at all. In addition, we have been
advised by our insurance broker that our insurance premiums will be subject to increases in the future, which increases may be material. If the coverage limits are inadequate to cover our liabilities or our insurance costs continue to increase, our
financial condition and results of operations would likely decline.



The lack of an established trading market for our common stock is likely to make it more difficult to dispose of or to obtain accurate quotations as to the market value of our common stock and may increase volatility.



There is no established trading market for our common stock and there can be
no assurance that a public market for our common stock will develop or be sustained. Our common stock currently trades in interdealer and over-the-counter transactions, and price quotations are provided in the pink sheets. Our common
stock is not listed on any securities exchange or automated quotation system. Accordingly, it is likely that an investor will find it more difficult to dispose of or to obtain accurate quotations as to the market value of our common stock and the
price of our common stock may experience additional volatility. If market conditions and other factors are satisfactory, we currently intend to apply to list our common stock for trading on a securities exchange or automated quotation system prior
to the end of the second quarter of 2005. However, there can be no assurance that we will receive approval to list our common stock on any securities exchange or automated quotation system in any particular time frame or at all.



|ITEM 2. | PROPERTIES
|------- | ----------



We lease our offices and facilities. Our corporate headquarters currently consists of 31,223 square feet (of which we sublease 10,165 square feet) in an
office building located at 2600 Technology Drive, Orlando, Florida, 32804. It is leased to us for a seven-year period ending August 18, 2008 at a current base rate of $49,903 per month (including sales tax), plus operating costs (which have
historically been approximately $4,000 per month (including sales tax)). In addition to our corporate headquarters, we lease office facilities for approximately 475 locations. These facilities are primarily used for general office work and the
dispatching of registered respiratory therapists, registered nurses, registered pharmacists and delivery personnel. Our office facilities vary in size from approximately 500 to 60,000 square feet. The total space leased for these offices is
approximately 2.24 million square feet at an average price of $8.15 per square foot. All of such office space is leased pursuant to operating leases. We believe that our office locations and other facilities are suitable and adequate for our planned
needs.



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ITEM 3.    LEGAL PROCEEDINGS



Due to the nature of our business, we are involved from time to time in lawsuits that arise in the ordinary course of our business. We do not believe that any lawsuit that we (or our predecessor) are a party to, if
resolved adversely, would have a material adverse effect on our financial condition or results of operations.



On April 30, 2003, federal agents served search warrants at our corporate headquarters and four other facilities in three states and were provided access
to a number of current and historical financial records and other materials. We have also received subpoenas on behalf of the United States Attorneys Office for the Northern District of Illinois relating to the same information including
information relating to Medicare billing and VA contracting. We are cooperating fully with the investigation; however, we can give no assurances as to the duration of the investigation or as to whether or not the government will institute
proceedings against us or any of our employees or as to the violations that may be asserted. In addition, we received informal requests for information on March 7, 2003 and April 17, 2003 from the Division of Enforcement of the Securities and
Exchange Commission related to matters that were the subject of our internal investigation regarding VA contracts discussed above under the caption Risk FactorsIn June 2002, we uncovered a pattern of falsified bulk sales of equipment to
the Department of Veterans Affairs, as well as certain improperly recorded revenues from non-bulk VA service contracts, and we have provided documents in response to such requests. As a health care provider, we are subject to extensive
government regulation, including numerous laws directed at preventing fraud and abuse and laws regulating reimbursement under various government programs. The marketing, billing, documentation and other practices of health care companies are all
subject to government scrutiny. To ensure compliance with Medicare and other regulations, regional carriers often conduct audits and request patient records and other documents to support claims submitted by us for payment of services rendered to
patients. Similarly, government agencies periodically open investigations and obtain information from health care providers pursuant to legal process. Violations of federal and state regulations can result in severe criminal, civil and
administrative penalties and sanctions, including disqualification from Medicare and other reimbursement programs.



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



No matters were submitted to a vote of our stockholders during the fourth quarter of the fiscal year covered by this report.



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PART II



ITEM 5.    MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER REPURCHASES OF EQUITY SECURITIES



There is no established trading market for our common stock. Our common stock currently trades in interdealer and
over-the-counter transactions and price quotations are provided in the pink sheets by Pink Sheets LLC under the symbol ROHI.PK which can be found on their website at www.pinksheets.com. Upon effectiveness of our
predecessors plan of reorganization on March 26, 2002, all of our outstanding common stock was distributed to our predecessor for further distribution to its senior creditors as contemplated by the plan of reorganization. Our common stock was
issued pursuant to an exemption from the registration requirements of the Securities Act provided by Section 1145 of the Bankruptcy Code. Although we received no cash proceeds from the initial distribution of our common stock pursuant to the plan of
reorganization, we received substantially all of the assets of our predecessor in consideration of the issuance of such stock. If market conditions and other factors are satisfactory, we currently intend to apply to list our common stock for trading
on a securities exchange or automated quotation system prior to the end of the second quarter of 2005. However, there can be no assurance that we will receive approval to list our common stock on any securities exchange or automated quotation system
in any particular time frame or at all.



The following table
sets forth the high and low sale prices of our common stock as reported by Pink Sheets LLC for the periods indicated:



|               |  |      |       |     |   |      
|-------------- |  | ---- | ----- | --- | - | -----
|               |  | High |       | Low
|Fiscal 2003    |  |      |       |     |   |      
|First Quarter  |  | $    | 17.80 |     | $ | 13.80
|Second Quarter |  | $    | 23.05 |     | $ | 12.00
|Third Quarter  |  | $    | 25.75 |     | $ | 21.50
|Fourth Quarter |  | $    | 31.25 |     | $ | 20.50
|Fiscal 2004    |  |      |       |     |   |      
|First Quarter  |  | $    | 24.00 |     | $ | 20.25
|Second Quarter |  | $    | 26.50 |     | $ | 20.75
|Third Quarter  |  | $    | 24.60 |     | $ | 18.75
|Fourth Quarter |  | $    | 28.20 |     | $ | 20.00



The above quotations
reported by Pink Sheets LLC reflect interdealer prices, which may not include retail mark-ups, mark-downs or commissions and may not necessarily represent actual transactions.



As of March 18, 2005, there were 25,376,995 shares of our common stock outstanding and approximately 8 holders of record of
common stock. This number was derived from our stockholder records and does not include beneficial owners of our common stock whose shares are held in the names of various dealers, clearing agencies, banks, brokers and other fiduciaries.



We did not pay any cash dividends on our common stock for the fiscal years
ended December 31, 2003 and December 31, 2004, and it is unlikely that we will pay any cash dividends on our common stock in the forseeable future. The payment of cash dividends on our common stock will depend on, among other things, our earnings,
capital requirements and financial condition, and general business conditions. We are restricted from paying dividends on our common stock or from acquiring our capital stock by certain debt covenants contained in our senior secured credit
facilities and the indenture governing our 91⁄2% senior subordinated notes due 2012.



Each share of our Series A convertible redeemable preferred stock has a stated value of $20 and entitles the holder to an annual cumulative dividend equal to 9% of its stated value, payable semi-annually at the
discretion of our board of directors in cash or in additional shares of Series A convertible redeemable preferred stock. In the event dividends are declared by our board of directors but not paid for six (6) consecutive periods, the holders of



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the Series A convertible redeemable preferred stock are entitled to vote as a separate class to elect one director to serve on our board of directors.
Effective December 5, 2003, our board of directors adopted a policy of declaring dividends to the holders of the Series A convertible redeemable preferred stock under the Rotech Healthcare Inc. Employees Plan on an annual basis, with each such
declaration to be made at the annual meeting of the board of directors with respect to dividends payable for the preceding year. Such policy commenced at the 2004 annual meeting of the board of directors and, in order to account for the period from
the inception of the Rotech Healthcare Inc. Employees Plan to such date, the first declaration of dividends covered the preceding two years. In June 2004, dividends in the amount of $0.9 million were declared on our Series A convertible redeemable
preferred stock and such dividends were paid during the first quarter of 2005.



Effective October 12, 2004, we repurchased 804 shares of our Series A convertible redeemable preferred stock for approximately $0.02 million in order to fund the cash payment of benefits under the Rotech Healthcare
Inc. Employees Plan to certain plan participants that are no longer employed by us.



Equity Compensation Plan Information



The
following table summarizes information, as of December 31, 2004, with respect to shares of our common stock that may be issued under our existing equity compensation plans.



|                                                           |  |                                                                                             |  |                                                                             |       |                                                                                                                                           |         |    
|---------------------------------------------------------- |  | ------------------------------------------------------------------------------------------- |  | --------------------------------------------------------------------------- | ----- | ----------------------------------------------------------------------------------------------------------------------------------------- | ------- | ---
|Plan Category                                              |  | Number of securitiesto be issued uponexercise ofoutstanding options,warrants and
rights (a) |  | Weighted-averageexercise price ofoutstandingoptions, warrantsand
rights (b) |       | Number of securitiesremaining availablefor future issuanceunder equitycompensation
plans(excluding securitiesreflected in column (a)) (c) |        
|Equity compensation plans approved by security holders     |  | 3,214,375                                                                                   |  | $                                                                           | 19.04 |                                                                                                                                           | 486,878 | (1)
|Equity compensation plans not approved by security holders |  |                                                                                            |  |                                                                             |      |                                                                                                                                           | 168,000 | (2)
|                                                           |  |                                                                                             |  |                                                                             |       |                                                                                                                                           |         |    
|Total                                                      |  | 3,214,375                                                                                   |  | $                                                                           | 19.04 |                                                                                                                                           | 654,878 |    

---

|(1) |  | Based on (i) 4,025,000 shares of common stock reserved for issuance to employees, officers, non-employee directors and consultants upon exercise of incentive and non-statutory
options under our stock option plan and (ii) 323,747 shares of common stock issued upon exercise of options under our stock option plan. Options exercisable for an aggregate of 235,159 shares of our common stock were forfeited in 2004. Options
exercisable for an aggregate of 440,000 shares of our common stock were granted in 2004.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) |  | Effective as of August 1, 2004, we established the Rotech Healthcare Inc. Nonemployee Director Restricted Stock Plan which is intended to attract, retain and provide incentives to
nonemployee directors of our company. The plan is administered by the compensation committee of our board of directors. The terms of the plan provide that on or following August 1, 2004 (the Effective Date), each nonemployee director
will receive (i) a restricted stock award of 8,000 shares of our common stock for his or her initial year as a nonemployee director, provided that such directorship commences on or after the Effective Date, (ii) a restricted stock award for 4,000
shares of our common stock for each year commencing on or after the Effective Date during which he or she continues to serve as a nonemployee director and (iii) in the event that the chairman of our board of directors is a nonemployee director, in
lieu of any other restricted stock award to be granted under the plan, the chairman will receive a restricted stock award for 12,000 shares of our common stock for each year he or she serves in such capacity. All shares of common stock issued to a
nonemployee director under the plan are issued pursuant to a restricted stock award agreement under which the shares are subject to transfer restrictions for a set period of time (generally, one year). Such restrictions will lapse in accordance with
the terms of the plan and the applicable restricted stock award agreement, including, but not limited to, upon a change of control (as defined in the restricted stock award agreements) of our company or the death or permanent and
total disability (as defined in the restricted stock award agreements) of the nonemployee director. 200,000 shares of our common stock have been authorized by our company for restricted awards to be made under the plan. As of December 31,
2004, restricted stock awards for an aggregate amount of 32,000 shares of common stock were granted to our non-employee directors. As of December 31, 2004, all of such shares remained subject to transfer restrictions. The number of shares available
for future awards under the plan, as of December 31, 2004, was 168,000.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Amended and Restated Bylaws



Effective as of March 31, 2005, we amended and restated our bylaws to provide, among other things, (i) clarification regarding the procedure by which any person other than our board of directors may call a special



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meeting of stockholders, (ii) that our board of directors may, in its sole discretion, determine that a meeting of stockholders may be held solely by means
of remote communication as authorized by Section 211(a)(2) of the Delaware General Corporation Law, (iii) for notice to stockholders by electronic transmission and permit action by consent of the board by electronic transmission, (iv) that no proxy
will be voted or acted upon after three (3) years from its date, unless the proxy provides for a longer period, (v) that the election of directors at all meetings of the stockholders may, in the discretion of our board, be by ballot or otherwise
(our bylaws previously limited the election of directors to be solely by ballot), (vi) that the authorized number of directors will be determined from time to time by resolution of our board of directors, provided that the board will consist of at
least three (3) members (our bylaws previously provided that seven (7) directors will constitute the board) and (vii) clarification that a majority of all of the members of a board committee shall constitute a quorum present for the transaction of
business. The foregoing description of the changes made to our bylaws is qualified in its entirety by reference to the full text of our amended and restated bylaws, a copy of which is filed as Exhibit 3.2 to this annual report on Form 10-K.



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ITEM 6.    SELECTED FINANCIAL DATA



You should read the following selected financial data along with the section captioned Managements discussion and analysis of financial condition and results of operations and the audited
consolidated financial statements and the related notes included in this report. The consolidated statement of operations data and consolidated balance sheet data for the years ended December 31, 2003 and December 31, 2004 have been derived from our
audited financial statements included in this report. The consolidated statement of operations data for the three months ended March 31, 2002 for our predecessor and the nine months ended December 31, 2002 for us, as the successor company, have been
derived from our audited financial statements included in this report. The consolidated balance sheet data for the year ended December 31, 2002 have been derived from our audited financial statements not included in this report. The statement of
operations data and balance sheet data for the years ended December 31, 2001 and December 31, 2000, have been derived from the audited financial statements of our predecessor not included in this report. Data have been presented for the three months
ended March 31, 2002 and nine months ended December 31, 2002, rather than for the year ended on such date, because we had only nine months of operating results in fiscal year 2002 since our predecessor, Rotech Medical Corporation, emerged from
bankruptcy on March 26, 2002. For all periods prior to April 1, 2002, the results of operations and other financial data set forth below refer to the business and operations of our predecessor which, upon emerging from bankruptcy, transferred
substantially all of its assets to us in a restructuring transaction accounted for as of March 31, 2002. For all periods subsequent to March 31, 2002, the results of operations and other financial data refer to our business and operations, as the
successor company to Rotech Medical Corporation.



|                                                                               |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|------------------------------------------------------------------------------ |  | ----------------------- | ------- | --- | --------------------------- | - | ------- | ---------------------------- |  | ---------------------- | -------- | - | ---- | - | ------- |  | - | ------- |  | - | ------- | -
|                                                                               |  | Predecessor Company     |         |     | Successor Company           |  
|                                                                               |  | Year ended December 31, |         |     | Three monthsended March 31, |   |         | Nine monthsendedDecember 31, |  | Year endedDecember 31, |         
|(dollars in thousands)                                                         |  | 2000                    |         |     | 2001                        |   |         | 2002                         |  |                        | 2002(1)  |   | 2003 |   | 2004    | 
|Statement of Operations Data:                                                  |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|Net revenues                                                                   |  | $                       | 568,704 | (2) |                             | $ | 614,487 |                              |  | $                      | 154,750  |   |      | $ | 463,025 |  | $ | 581,221 |  | $ | 534,503 |  
|Costs and expenses                                                             |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|Cost of net revenues:                                                          |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|Product and supply costs                                                       |  |                         | 116,063 |     |                             |   | 97,167  |                              |  |                        | 22,513   |   |      |   | 67,542  |  |   | 73,900  |  |   | 70,583  |  
|Patient service equipment depreciation                                         |  |                         | 36,723  |     |                             |   | 44,679  |                              |  |                        | 12,147   |   |      |   | 39,363  |  |   | 102,819 |  |   | 61,362  |  
|                                                                               |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|Total cost of net revenues                                                     |  |                         | 152,786 |     |                             |   | 141,846 |                              |  |                        | 34,660   |   |      |   | 106,905 |  |   | 176,719 |  |   | 131,945 |  
|Provision for doubtful accounts                                                |  |                         | 27,352  | (2) |                             |   | 20,917  |                              |  |                        | 3,661    |   |      |   | 11,481  |  |   | 20,033  |  |   | 15,214  |  
|Selling, general and administrative                                            |  |                         | 315,106 |     |                             |   | 329,516 |                              |  |                        | 84,996   |   |      |   | 274,300 |  |   | 311,075 |  |   | 273,825 |  
|Depreciation and amortization(3)                                               |  |                         | 50,614  |     |                             |   | 60,736  |                              |  |                        | 2,839    |   |      |   | 8,572   |  |   | 16,828  |  |   | 15,191  |  
|Interest (income) expense, net                                                 |  |                         | (46     | )   |                             |   | (322    | )                            |  |                        | (17      | ) |      |   | 33,093  |  |   | 41,402  |  |   | 33,696  |  
|Provision for settlement of government claims(4)                               |  |                         | 2,176   |     |                             |   | 2,516   |                              |  |                        |         |   |      |   |        |  |   |        |  |   |        |  
|Other income                                                                   |  |                         |        |     |                             |   |        |                              |  |                        |         |   |      |   |        |  |   |        |  |   | (2,516  | )
|Provision for inventory losses                                                 |  |                         | 211     |     |                             |   | 2,141   |                              |  |                        | 264      |   |      |   |        |  |   |        |  |   |        |  
|                                                                               |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|Total costs and expenses                                                       |  |                         | 548,199 |     |                             |   | 557,350 |                              |  |                        | 126,403  |   |      |   | 434,351 |  |   | 566,057 |  |   | 467,355 |  
|                                                                               |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|Earnings (loss) before reorganization items, income taxes, extraordinary items |  |                         | 20,505  |     |                             |   | 57,137  |                              |  |                        | 28,347   |   |      |   | 28,674  |  |   | 15,164  |  |   | 67,148  |  
|Reorganization items(5)                                                        |  |                         | 17,191  |     |                             |   | 17,107  |                              |  |                        | 182,291  |   |      |   | 3,899   |  |   |        |  |   |        |  
|                                                                               |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|Earnings (loss) before income taxes, extraordinary items                       |  |                         | 3,314   |     |                             |   | 40,030  |                              |  |                        | (153,944 | ) |      |   | 24,775  |  |   | 15,164  |  |   | 67,148  |  
|Federal and state income (benefit) taxes                                       |  |                         | 12,081  |     |                             |   | 30,324  |                              |  |                        | (203     | ) |      |   | 10,903  |  |   | 6,751   |  |   | 28,931  |  
|                                                                               |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|Earnings (loss) before extraordinary items                                     |  |                         | (8,767  | )   |                             |   | 9,706   |                              |  |                        | (153,741 | ) |      |   | 13,872  |  |   | 8,413   |  |   | 38,217  |  
|Extraordinary gain on debt discharge, net of taxes                             |  |                         |        |     |                             |   |        |                              |  |                        | 20,441   |   |      |   |        |  |   |        |  |   |        |  
|                                                                               |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  
|Net earnings (loss)(3)                                                         |  | $                       | (8,767  | )   |                             | $ | 9,706   |                              |  | $                      | (133,300 | ) |      | $ | 13,872  |  | $ | 8,413   |  | $ | 38,217  |  
|                                                                               |  |                         |         |     |                             |   |         |                              |  |                        |          |   |      |   |         |  |   |         |  |   |         |  



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|                                       |  |                     |           |                   |   |           |  |      |           |      |   |         |  |   |          
|-------------------------------------- |  | ------------------- | --------- | ----------------- | - | --------- |  | ---- | --------- | ---- | - | ------- |  | - | ---------
|                                       |  | Predecessor Company |           | Successor Company
|                                       |  | December 31,        |           | December 31,     
|(dollars in thousands)                 |  | 2000                |           | 2001              |   | 2002      |  | 2003 |           | 2004
|Balance Sheet Data                     |  |                     |           |                   |   |           |  |      |           |      |   |         |  |   |          
|Current assets                         |  | $                   | 161,685   |                   | $ | 174,630   |  | $    | 157,347   |      | $ | 131,303 |  | $ | 169,997  
|Working capital                        |  |                     | 136,134   |                   |   | 135,116   |  |      | 80,671    |      |   | 63,284  |  |   | 114,743  
|Total assets                           |  |                     | 1,238,643 |                   |   | 1,228,696 |  |      | 1,091,206 |      |   | 993,283 |  |   | 1,007,399
|Total debt, including current portion  |  |                     |          |                   |   |          |  |      | 478,513   |      |   | 368,000 |  |   | 335,878  
|Convertible redeemable preferred stock |  |                     |          |                   |   |          |  |      | 5,346     |      |   | 6,101   |  |   | 5,343    
|Stockholders equity                   |  |                     | 678,390   |                   |   | 688,096   |  |      | 508,526   |      |   | 517,598 |  |   | 561,521  



|                                            |  |                         |         |   |                              |   |         |                              |  |   |                         |   |  |      |         |   |      |   |          |   |  |   |         |  
|------------------------------------------- |  | ----------------------- | ------- | - | ---------------------------- | - | ------- | ---------------------------- |  | - | ----------------------- | - |  | ---- | ------- | - | ---- | - | -------- | - |  | - | ------- | -
|                                            |  | Predecessor Company     |         |   | Successor Company            |  
|                                            |  | Year ended December 31, |         |   | Three months ended March 31, |   |         | Nine monthsendedDecember 31, |  |   | Year ended December 31, |  
|(dollars in thousands)                      |  | 2000                    |         |   | 2001                         |   |         | 2002                         |  |   | 2002                    |   |  | 2003 |         |   | 2004 |  
|Selected Historical Financial Data:         |  |                         |         |   |                              |   |         |                              |  |   |                         |   |  |      |         |   |      |   |          |   |  |   |         |  
|EBITDA(6)                                   |  | $                       | 90,605  |   |                              | $ | 145,123 |                              |  | $ | (118,534                | ) |  | $    | 105,803 |   |      | $ | 176,213  |   |  | $ | 177,397 |  
|Capital expenditures                        |  |                         | 71,557  |   |                              |   | 79,765  |                              |  |   | 15,299                  |   |  |      | 47,273  |   |      |   | 41,993   |   |  |   | 54,003  |  
|Cash flows provided by operating activities |  |                         | 161,637 |   |                              |   | 116,127 |                              |  |   | 17,561                  |   |  |      | 97,988  |   |      |   | 148,279  |   |  |   | 133,994 |  
|Cash flows used in investing activities     |  |                         | (71,818 | ) |                              |   | (84,989 | )                            |  |   | (15,299                 | ) |  |      | (50,176 | ) |      |   | (45,022  | ) |  |   | (54,003 | )
|Cash flows used in financing activities     |  |                         | (74,982 | ) |                              |   | (39,121 | )                            |  |   | (5,545                  | ) |  |      | (21,487 | ) |      |   | (110,289 | ) |  |   | (36,148 | )

---

|(1) |  | We adopted fresh-start reporting upon our emergence from bankruptcy, effective as of March 31, 2002. Under fresh-start reporting, our reorganization value is allocated to our assets
based on their respective fair values in conformity with the purchase method of accounting for business combinations; any portion not attributed to specific tangible or identified intangible assets are reported as an intangible asset referred to as
reorganization value in excess of value of identifiable assetsgoodwill. In adopting fresh-start reporting, we engaged an independent financial advisor to assist in the determination of the reorganization value or fair value of the
entity. See Risk FactorsSince our financial statements reflect fresh-start reporting adjustments made upon our predecessors emergence from bankruptcy, information reflecting our results of operations and financial condition will
not be comparable to prior periods of our predecessor and note 2 to the audited financial statements for the three months ended March 31, 2002 and the nine months ended December 31, 2002 and the years ended December 31, 2003 and December 31,
2004.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In connection with our adoption of fresh-start reporting, we have obtained valuations of the patient service equipment and have reconsidered the estimated useful lives for this
equipment and our other fixed assets. The new basis of patient service equipment, furniture and office equipment, and vehicles at March 31, 2002 are being depreciated over their respective remaining useful lives. Purchases of such property and
equipment since March 31, 2002 are being depreciated over five years for patient service equipment, three years for computer equipment and five years for vehicles; leasehold improvements and furniture and equipment are unchanged. Prior to March 31,
2002, all such assets were depreciated over an average life of seven years. The effect of this change in estimate for the nine months ended December 31, 2002 was to increase depreciation by $1,271.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(2) |  | We experienced a deterioration in the aging of certain receivables during 2000 due to a variety of factors including the operational effects of the bankruptcy filing. Some of the
factors that negatively affected the billing and collections process include increased loss of office and other personnel, problems experienced in the closure and consolidation of billing locations and systems, and personnel shortages and the
competing time demands required in normalizing relations with payors and addressing a variety of vendor issues. In the fourth quarter of 2000, management performed a study and analysis of these issues and their effect, and performed a re-evaluation
of the allowance for doubtful accounts and contractual adjustments. Accordingly, we recorded an increase to the provision for bad debts of $5 million and an increase to contractual adjustments of $15 million in the fourth quarter of 2000.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) |  | In July 2001, the Financial Accounting Standards Board (FASB) issued Statement No. 142, Goodwill and Other Intangible Assets (Statement 142). Statement 142 requires that
goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that intangible assets with
estimable useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of. We adopted the provisions of Statement 142 effective January 1, 2002. Had Statement 142 been in effect for the years ended December 31, 2000 and 2001, amortization of goodwill would have been reduced by $41.0
million and $47.8 million, respectively, and net earnings for such periods would have increased by $35.4 million and $42.2 million, respectively.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Prior to March 31, 2002, property and equipment was stated at cost. Subsequent to March 31, 2002, property and equipment are stated at cost, adjusted for the impact
of fresh start reporting. Patient service equipment represents medical equipment rented or held for rental to in-home patients. Patient service equipment is accounted for using a composite method, due to its characteristics of high unit volumes of
relative low dollar unit cost items. Under the composite method, the purchase cost of monthly purchases of patient service equipment are capitalized and depreciated over five years using the straight-line convention, without specific physical
tracking of individual items. We believe the five year depreciation period provides a proper matching of the cost of patient service equipment with the patient
| |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | service revenues generated from use of the equipment, when considering the wear and tear, damage, loss and ultimately scrapping of patient service equipment
over its life. Other property and equipment is accounted for by a specific identification system. Depreciation for other property and equipment is provided on the straight-line method over the estimated useful lives of the assets, seven years for
furniture and office equipment, five years for vehicles, three years for computer equipment, and the shorter of the remaining lease term or the estimated useful life for leasehold improvements.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | During the second quarter ended June 30, 2003, management completed an assessment of the depreciation estimates made on April 1, 2002, related to long-lived assets acquired from our
predecessor, Rotech Medical Corporation. Based on information then available, we revised our estimate of useful lives for certain of these assets from an aggregate of four years from the date acquired from our predecessor, to depreciating the assets
over a period ending five years from the date the assets were originally acquired by our predecessor. The revised estimates on depreciable lives for approximately $138 million of rental property was necessary to more closely match the replacement
rates of rental property acquired with its specific useful remaining life. As a result of that change in depreciation estimate, we recognized approximately $42.5 million in additional depreciation expense for the year ended December 31, 2003 which
has been included as a component of cost of sales. This change in estimate resulted in a decrease to net income of approximately $23.8 million. Cost of net revenues as a percentage of net revenue was 30.4% for 2003 as compared to 22.9% for 2002.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | During 2004, we undertook a project to physically count the patient service equipment within all of our respective operating locations and to estimate the equipment utilized for
rental within patient homes. As a result of this project, we believe that certain of the equipment acquired from our predecessor company, Rotech Medical Corporation, is no longer in service or held by us or our patients. Such equipment is presumed
to have been fully depreciated prior to December 31, 2004. Accordingly, we have reduced the gross patient service equipment accounts and the related accumulated depreciation accounts by offsetting $52 million. This adjustment had no impact on our
results of operations in 2004.
| |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) |  | In February 2002, we settled all outstanding government litigation and pre-petition and certain post-petition claims arising from Medicare payments made to certain of our operating
centers as well as claims in unliquidated amounts for a cash settlement of $17 million. In addition, on February 13, 2002, IHS and its subsidiaries, including us, entered into a stipulation with the Centers for Medicare and Medicaid Services, or
CMS, whereby CMS was permitted to off-set certain underpayments to IHS with certain overpayments to us in exchange for a full release of all CMS claims against IHS and its subsidiaries, including us, to the effective date of the stipulation. The
Bankruptcy Court signed the stipulation on April 12, 2002.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | In 1999, we recorded a provision of $15 million based on a preliminary evaluation of the governments estimated claims. We revised this estimate and recorded an additional
provision of $2 million in 2001; related legal costs incurred were $2.2 million in 2000 and $0.5 million in 2001.
| |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(5) |  | During the years ended December 31, 2000 and December 31, 2001, the three months ended March 31, 2002, the nine months ended December 31, 2002 and the years ended December 31, 2003
and December 31, 2004, we recorded the following as reorganization items:
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|                                                                                                                                                                                     |  |                        |        |                             |   |                           |  |                        |         |      |   |       |  |   |   |  |   |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---------------------- | ------ | --------------------------- | - | ------------------------- |  | ---------------------- | ------- | ---- | - | ----- |  | - | - |  | - | -
|                                                                                                                                                                                     |  | Predecessor Company    |        | Successor Company          
|                                                                                                                                                                                     |  | Year endedDecember 31, |        | Three monthsended March 31, |   | Nine monthsendedMarch 31, |  | Year endedDecember 31,
|(dollars in thousands)                                                                                                                                                               |  | 2000                   |        | 2001                        |   | 2002                      |  | 2002                   |         | 2003 |   | 2004 
|Severance and terminations                                                                                                                                                           |  | $                      | 3,470  |                             | $ | 753                       |  | $                      | 837     |      | $ |      |  | $ |  |  | $ | 
|Legal, accounting and consulting fees                                                                                                                                                |  |                        | 325    |                             |   | 3,815                     |  |                        | 175     |      |   | 1,928 |  |   |  |  |   | 
|Loss on sale/leaseback of vehicles                                                                                                                                                   |  |                        |       |                             |   |                          |  |                        | 4,686   |      |   | 169   |  |   |  |  |   | 
|Priority tax claim allowed                                                                                                                                                           |  |                        |       |                             |   |                          |  |                        | 9,000   |      |   |      |  |   |  |  |   | 
|Contribution of convertible redeemable preferred stock to an employee profit sharing plan                                                                                            |  |                        |       |                             |   |                          |  |                        | 5,000   |      |   |      |  |   |  |  |   | 
|Administrative expense claims allowed                                                                                                                                                |  |                        |       |                             |   |                          |  |                        | 7,800   |      |   |      |  |   |  |  |   | 
|Fresh-start reporting adjustments                                                                                                                                                    |  |                        |       |                             |   |                          |  |                        | 153,197 |      |   |      |  |   |  |  |   | 
|Loss on closure of discontinued branch operations and discontinued product lines, long-term incentive compensation and other charges resulting
from reorganization and restructuring |  |                        | 13,396 |                             |   | 12,539                    |  |                        | 1,596   |      |   | 1,802 |  |   |  |  |   | 
|                                                                                                                                                                                     |  |                        |        |                             |   |                           |  |                        |         |      |   |       |  |   |   |  |   |  
|                                                                                                                                                                                     |  | $                      | 17,191 |                             | $ | 17,107                    |  | $                      | 182,291 |      | $ | 3,899 |  | $ |  |  | $ | 
|                                                                                                                                                                                     |  |                        |        |                             |   |                           |  |                        |         |      |   |       |  |   |   |  |   |  



| |  | For further information, see note 3 to the audited financial statements for the three months ended March 31, 2002 and the nine months ended December 31, 2002 and the years ended
December 31, 2003 and December 31, 2004.
| |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(6) |  | EBITDA is defined as earnings from continuing operations before interest, income taxes, depreciation and amortization. EBITDA is commonly used as an analytical
indicator within the health care industry, and also serves as a measure of leverage capacity and debt service ability. EBITDA should not be considered as a measure of financial performance under generally accepted accounting principles, and the
items excluded from EBITDA are significant components in understanding and assessing financial performance. EBITDA should not be considered in isolation or as an alternative to net income, cash flows generated by operating, investing or financing
activities or other financial statement data presented in the consolidated financial statements as an indicator of financial performance or liquidity.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | Because EBITDA is not a measurement determined in accordance with generally accepted accounting principles and is thus susceptible to varying calculations,
EBITDA as presented may not be comparable to other similarly titled measures of other companies. A reconciliation of net earnings to EBITDA for each period is presented below. EBITDA as defined herein reflects the effects of non-recurring items
(including provision for settlement of government claims, provision for inventory losses, reorganization items and extraordinary items) in amounts of $19,578, $21,764, $162,114, $3,899, $0 and $0 for the years ended December 31, 2000 and 2001, the
three-months ended March 31, 2002, the nine months ended December 31, 2002 and the years ended December 31, 2003 and 2004, respectively.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Reconciliation of Net Earnings (Loss) to EBITDA



|                              |  |                        |        |   |                             |   |         |                              |  |                         |          |   |      |   |         |  |   |         |  |   |        
|----------------------------- |  | ---------------------- | ------ | - | --------------------------- | - | ------- | ---------------------------- |  | ----------------------- | -------- | - | ---- | - | ------- |  | - | ------- |  | - | -------
|                              |  | Predecessor Company    |        |   | Successor Company          
|                              |  | Year endedDecember 31, |        |   | Three monthsended March 31, |   |         | Nine monthsendedDecember 31, |  | Year ended December 31,
|(dollars in thousands)        |  | 2000                   |        |   | 2001                        |   |         | 2002                         |  |                         | 2002     |   | 2003 |   | 2004   
|Net earnings (loss)           |  | $                      | (8,767 | ) |                             | $ | 9,706   |                              |  | $                       | (133,300 | ) |      | $ | 13,872  |  | $ | 8,413   |  | $ | 38,217 
|Income taxes (benefit)        |  |                        | 12,081 |   |                             |   | 30,324  |                              |  |                         | (203     | ) |      |   | 10,903  |  |   | 6,751   |  |   | 28,931 
|Interest expense (income)     |  |                        | (46    | ) |                             |   | (322    | )                            |  |                         | (17      | ) |      |   | 33,093  |  |   | 41,402  |  |   | 33,696 
|Depreciation and amortization |  |                        | 87,337 |   |                             |   | 105,415 |                              |  |                         | 14,986   |   |      |   | 47,935  |  |   | 119,647 |  |   | 76,553 
|                              |  |                        |        |   |                             |   |         |                              |  |                         |          |   |      |   |         |  |   |         |  |   |        
|EBITDA                        |  | $                      | 90,605 |   |                             | $ | 145,123 |                              |  | $                       | (118,534 | ) |      | $ | 105,803 |  | $ | 176,213 |  | $ | 177,397
|                              |  |                        |        |   |                             |   |         |                              |  |                         |          |   |      |   |         |  |   |         |  |   |        



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##### Table of Contents

|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, related notes and other financial
information appearing elsewhere in this report. In addition, see Information Regarding Forward-Looking Statements and BusinessRisk Factors. Our predecessor, Rotech Medical Corporation emerged from bankruptcy on March
26, 2002 and subsequently transferred substantially all of its assets to us in a restructuring transaction. The financial statements included herein reflect these transactions effective as of March 31, 2002. As used herein, unless otherwise
specified or the context otherwise requires, references to we, our and us refer to the business and operations of Rotech Healthcare Inc. and its subsidiaries for all periods subsequent to March 31, 2002 and to the
business and operations of Rotech Medical Corporation and its subsidiaries for all periods prior to April 1, 2002.



Overview



Background. We provide home medical equipment and related products and services in the United States, with a comprehensive offering of respiratory
therapy and durable home medical equipment and related services. We provide equipment and services in 48 states through approximately 475 operating centers located primarily in non-urban markets.



Our revenues are principally derived from respiratory equipment rental and
related services (86.6% of net revenues for the year-ended December 31, 2004), which include the rental of oxygen concentrators, liquid oxygen systems, portable oxygen systems, ventilator therapy systems, nebulizer equipment and sleep disorder
breathing therapy systems, and the sale of nebulizer medications. We also generate revenues from the rental and sale of durable medical equipment (12.4% of net revenues for the year-ended December 31, 2004), including hospital beds, wheelchairs,
walkers, patient aids and ancillary supplies.



We have engaged
in an ongoing series of activities to strengthen our organizational structure and reposition us for future growth. These actions have included selective reduction in headcount, renegotiation of certain vendor contracts, substantial reduction in the
number of billing centers, discontinuation of certain product lines and branch locations, centralization of certain administrative functions (including billing and purchasing), development and implementation of an advanced information and billing
system, and enhancement of regulatory compliance programs. We expect to continue to review our operations in order to improve operating efficiencies.



Reimbursement by Third Party Payors. We derive a majority of our revenues from reimbursement by third party payors, including Medicare, Medicaid,
the Veterans Administration and private insurers. In 2004, approximately 71.0% of our revenues were reimbursed under arrangements with Medicare, Medicaid and other federally-funded programs (primarily the Veterans Administration). Our business has
been, and may continue to be, significantly impacted by changes mandated by Medicare legislation. With the passage of the Medicare Prescription Drug, Improvement and Modernization Act of 2003, or MMA, a number of changes have been mandated to the
Medicare payment methodology and conditions for coverage for our products. These changes include a freeze in payments for home medical equipment from 2004 to 2008, competitive bidding requirements, new clinical conditions for payment and quality
standards. The impact of competitive bidding, new clinical conditions and quality standards are uncertain at this time. The MMA changes also include a reduction in payment rates for oxygen equipment and certain other items of home medical equipment
(including wheelchairs, nebulizers, hospital beds and air mattresses), based on the percentage difference between the amount of payment otherwise determined for 2002 and the median payment amount under the Federal Employee Health Benefits Program,
or FEHBP, as determined by the Office of the Inspector General of the Department of Health and Human Services, or OIG.



As of the time of filing this annual report, the reduction in payments for oxygen and oxygen equipment had not been finalized. A September 2004 OIG report
surveyed FEHBP prices for oxygen equipment and found that the median 2002 prices were considerably lower than Medicare payments for those items. On February 4, 2005,



39



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##### Table of Contents

CMS published notice CMS-1299-N announcing a delay in the implementation of the 2005 Medicare oxygen payment rates. The notice states that CMS was informed
by the OIG that it will need to collect additional information before the FEHBP median prices for oxygen are finalized. Until such prices are established, Medicare claims for oxygen equipment furnished on or after January 1, 2005 will be paid based
on the 2004 monthly payment amounts. CMS is expected to calculate and implement the lower 2005 payment amounts upon receipt of the additional information from the OIG. CMS has stated that no retroactive adjustments are to be made once the new
payment amounts are set. Reductions in payment rates for 2005 established by CMS for the non-oxygen HME items subject to the FEHBP provisions range between 4% and 16%. The non-oxygen HME items subject to the Medicare price cuts accounted for
approximately 2% of our recorded revenues in 2004. If the proposed reductions in the Medicare fee schedules for home oxygen equipment (as set forth in the September 2004 OIG report discussed above) together with the additional reimbursement
reductions mandated by the MMA in 2005 for other home medical equipment (excluding inhalation drugs) had been implemented in 2004, we believe it would have resulted in a reduction in our 2004 recorded revenues in the range of approximately $30
million to $35 million. At this time, we cannot determine the outcome of the 2005 Medicare oxygen payment rates, the date on which the new payment amounts will become effective or the ultimate impact on our business.



MMA also revises the payment methodology for certain drugs, including
inhalation drugs dispensed through nebulizers. Medicare-reimbursed inhalation drug therapies provided by us in 2004 accounted for approximately 17% of our recorded revenues. Prior to MMA, Medicare paid for these drugs based on average wholesale
price, or AWP, as reported by drug manufacturers. Beginning January 1, 2004, Medicare payments were reduced for most of our Part B inhalation drugs to 80% of AWP from 95% of AWP, a reduction of approximately 15 percent. This reduction in Medicare
payment rates for inhalation drugs reduced our revenues and operating income by approximately $24 million in 2004. As of January 1, 2005, payments for drugs delivered through nebulizer equipment are based on 106% of average sales price, or ASP. ASP
is defined statutorily as the volume weighted average of manufacturers average sales prices, calculated by adding the manufacturers average sales prices for the drug in the fiscal quarter to the number of units sold and then divided by
the total number of units sold for all national drug codes assigned to the product. Under the ASP methodology, Medicare generally will pay 106% of ASP for multiple source drugs and 106% of the lesser of ASP or wholesale acquisition cost for single
source drugs. In addition, if the ASP exceeds the widely available market price by more than 5%, CMS may substitute the widely available market price for the ASP. ASP payment rates are calculated and updated quarterly using the most recent
manufacturer data available. ASP payment amounts for our products may fluctuate from quarter to quarter, and if these payment amounts are reduced in future quarters, this could have a material adverse effect on our results of operations. The ASP
payment amounts for the first and second quarters of 2005 for many drugs, including inhalation drugs, are significantly less than the payment amounts for these drugs in 2004. For example, the payment rates, as posted by CMS, for two prevalent
inhalation drugs, albuterol sulfate and ipratropium bromide, were reduced from $0.39 and $2.82 per milligram in 2004 to $0.065 and $0.287 for the first quarter of 2005, respectively. For the second quarter of 2005, payment rates, as posted by CMS,
for albuterol sulfate and ipratropium bromide were changed to $0.090 and $0.202, respectively. Given the overall reduction in payment for inhalation drugs dispensed through nebulizers, CMS established a $57 dispensing fee for inhalation drugs
shipped to a beneficiary during a 30-day period or $80 for a 90-day period. These dispensing fees may be reduced or eliminated in 2006 or beyond, and such reductions or eliminations, if they occur, could have a material adverse effect on our
revenues, profitability and results of operations. While we have been able, based upon the increased dispensing fees, to continue offering inhalation drugs to Medicare patients in 2005, the pricing changes resulting from the ASP payment rates are
expected to result in a material reduction in the revenues and profitability of our inhalation drug business and we cannot predict whether it will continue to be economically feasible for us to continue to provide inhalation drugs in the future.
Reductions in Medicare reimbursement for oxygen, nebulizers and inhalation medications in 2005, many of which are expected to continue to exist for a number of years, could have a material adverse effect on our revenues, profitability and results of
operations.



Critical Accounting Policies



The preparation of our financial statements in accordance with generally
accepted accounting principles requires us to make assumptions that affect the reported amounts of assets, liabilities and disclosure of contingencies as of the date of the financial statements, as well as the reported amounts of revenues and
expenses during the reporting periods. Critical accounting policies are those that require the most complex or subjective



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judgments often as a result of the need to make estimates about the effects of matters that are inherently uncertain. Thus, to the extent that actual events
differ from our estimates and assumptions, there could be a material impact to our financial statements. We believe that the critical accounting policies for our company are those related to revenue recognition, accounts receivable, goodwill and
other intangibles.



The below listing is not intended to be a
comprehensive list of all our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles with limited or no need for managements judgment. There
are also areas in which managements judgment in selecting available alternatives may or may not produce a materially different result. For more information, see our audited consolidated financial statements and notes thereto.



Revenue Recognition and Accounts Receivable



Revenues are recognized when services and related products are provided to
patients and are recorded at amounts estimated to be received under reimbursement arrangements with third-party payors. Revenues derived from capitation arrangements are insignificant.



Our rental arrangements generally provide for fixed monthly payments established by fee schedules (subject to capped rentals
in some instances) for as long as the patient is using the equipment and medical necessity continues. Once initial delivery is made to the patient (initial setup), a monthly billing is established based on the initial setup service date. Subsequent
to our predecessors emergence from bankruptcy, at the end of each reporting period, we recognize rental arrangement revenues ratably over the monthly service period and defer revenue for the portion of the monthly bill which is unearned. No
separate revenue is earned from the initial setup process. We have no lease with the patient or third-party payor, no continuing service obligation (other than oxygen refills and servicing equipment based on manufacturers recommendations)
after the initial setup, and no refund obligation for the return of equipment after the monthly billing date.



Revenues for the sale of durable medical equipment and related supplies, including oxygen equipment, ventilators, wheelchairs, hospital beds and infusion
pumps, are recognized at the time of delivery. Revenues for the sale of nebulizer medications, which are generally dispensed by our pharmacies and shipped directly to the patients home, are recognized at the time of shipment.



Due to the nature of the industry and the reimbursement environment in which
we operate, certain estimates are required to record net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes
available. Specifically, the complexity of many third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are
typically identified and recorded at the point of cash application, claim denial or account review.



Management performs analyses to evaluate the net realizable value of accounts receivable. Specifically, management considers historical realization data,
accounts receivable aging trends, other operating trends and relevant business conditions. Because of continuing changes in the healthcare industry and third-party reimbursement, it is possible that managements estimates could change, which
could have an impact on operations and cash flows.



Net
Patient Service Revenues



We derive a significant portion
of our revenues from the Medicare and Medicaid programs and from managed care health plans. Payments for services we render to patients covered by these programs may be less than billed charges. For Medicare and Medicaid revenues, provisions for
contractual adjustments are made to reduce the charges to these patients to estimated receipts based upon the programs principles of payment or reimbursement (retrospectively determined). Final payment under these programs is subject to
administrative review and audit, and we currently make provisions for any adjustments which may result. Our provisions for contractual allowances under managed care health plans are based primarily on payment terms. We closely



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monitor our historical collection rates as well as changes in applicable laws, rules and regulations and contract terms to help assure that provisions are
made using the most accurate information we believe to be available. However, due to the complexities involved in these estimations, actual payments we receive could be different from the amounts we estimate and record.



Provision for Doubtful Accounts



Collection of receivables from third party payors and patients is our
primary source of cash and is critical to our operating performance. Our primary collection risks relate to patient accounts for which the primary insurance payor has paid, but patient responsibility amounts (generally deductibles and co-payments)
remain outstanding. We estimate provisions for doubtful accounts based primarily upon the age of patients account, the economic ability of patients to pay and the effectiveness of our collection efforts. We routinely review accounts receivable
balances in conjunction with our historical collection rates and other economic conditions which might ultimately affect the collectibility of patient accounts when we consider the adequacy of the amounts we record as reserves for doubtful accounts.
Significant changes in payer mix, business office operations, economic conditions or trends in federal and state governmental health care coverage could affect our collection of accounts receivable, cash flows and results of operations.



Reorganization Value in Excess of Value of Identifiable
AssetsGoodwill and Intangible Assets



Reorganization
value in excess of value of identifiable assetsgoodwill, represents the portion of our reorganization value at March 26, 2002 that could not be attributed to specific tangible or identified intangible assets recorded in connection with the
implementation of fresh-start reporting.



Goodwill and
intangible assets prior to March 26, 2002, represent the excess of cost over the fair value of assets acquired and liabilities assumed in business combinations. Prior to January 1, 2002, such assets were amortized on a straight-line basis over an
estimated life of approximately 20 years.



Effective January 1,
2002, we adopted the provisions of Financial Accounting Standards Board (FASB) Statement No. 142, Goodwill and Other Intangible Assets (Statement 142). Statement 142 requires that goodwill and intangible assets with indefinite useful lives no
longer be amortized, but instead be tested for impairment at least annually in accordance with the provisions of Statement 142. Management has determined that branch locations have similar economic characteristics and should be aggregated into one
reporting unit for assessing fair value. If the carrying amount of the goodwill and intangible asset exceeds its fair value, an impairment loss is recognized. Fair values for goodwill and intangible assets are determined based upon discounted cash
flows, market multiples or appraised values as appropriate. As a result of adopting Statement 142, goodwill and a substantial amount of our intangible assets are no longer amortized. Pursuant to Statement 142, goodwill and indefinite lived
intangible assets must be periodically tested for impairment. We performed our annual impairment testing during our fourth quarter of each year and concluded there was no impairment of successor company goodwill or identifiable intangibles in 2002,
2003, and 2004.



Property and Equipment



Prior to March 31, 2002, property and equipment was stated at cost.
Subsequent to March 31, 2002, property and equipment are stated at cost, adjusted for the impact of fresh start reporting. Patient service equipment represents medical equipment rented or held for rental to in-home patients. Patient service
equipment is accounted for using a composite method, due to its characteristics of high unit volumes of relative low dollar unit cost items. Under the composite method, the purchase cost of monthly purchases of patient service equipment are
capitalized and depreciated over five years using the straight-line convention, without specific physical tracking of individual items. We believe the five year depreciation period provides a proper matching of the cost of patient service equipment
with the patient service revenues generated from use of the equipment, when considering the wear and tear, damage, loss and ultimately scrapping of patient service equipment over its



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life. Other property and equipment is accounted for by a specific identification system. Depreciation for other property and equipment is provided on the
straight-line method over the estimated useful lives of the assets, seven years for furniture and office equipment, five years for vehicles, three years for computer equipment, and the shorter of the remaining lease term or the estimated useful life
for leasehold improvements.



Effective April 1, 2003, we
changed our estimated useful life on certain long-lived assets acquired from our predecessor, Rotech Medical Corporation. The estimated useful life of certain acquired rental property was changed from an aggregate of four years from the date
acquired from our predecessor to a five-year useful life from the original acquisition date by our predecessor. The change increased depreciation expense by $42.5 million and decreased net income by approximately $23.8 million, or $0.95 per basic
share and $0.94 per diluted share for the year ended December 31, 2003. The change was made to more closely match the replacement rates of rental property acquired with its specific remaining useful life.



During 2004, we undertook a project to physically count the patient service
equipment within all the respective operating locations and to estimate the equipment utilized for rental within patient homes. As a result of this project, we believe that certain of the equipment acquired from our predecessor company, Rotech
Medical Corporation, is no longer in service or held by us or our patients. Such equipment is presumed to have been fully depreciated prior to December 31, 2004. Accordingly, we have reduced the gross patient service equipment account and the
related accumulated depreciation by $52 million. This adjustment had no impact on our results of operations in 2004.



Capitalized Software



Included in property, equipment and improvements are costs related to internally-developed and purchased software that are capitalized and amortized over
periods from three to fifteen years. Capitalized costs include direct costs of materials and services incurred in developing or obtaining internal-use software and payroll and payroll-related costs for employees directly involved in the development
of internal-use software. The carrying value of capitalized software is reviewed if the facts and circumstances suggest that it may be impaired. Indicators of impairment may include a subsequent change in the extent or manner in which the software
is used or expected to be used, a significant change to the software is made or expected to be made or the cost to develop or modify internal-use software exceeds that expected amount. Management does not believe any impairment of our capitalized
software existed at December 31, 2004.



Income Taxes



We account for income taxes under the asset and liability
approach required by FASB Statement No. 109, Accounting for Income Taxes (Statement 109). For periods prior to March 31, 2002, under Statement 109, the current and deferred tax expense was allocated among the members of the IHS controlled corporate
group, including our predecessor.



Deferred tax assets and
liabilities are determined based upon differences between financial reporting and the tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse.
Valuation allowances are established when necessary to reduce deferred income tax assets to amounts expected to be realized.



Contingencies



Our business is subject to extensive laws and government regulations, including those related to the Medicare and Medicaid programs. We are also subject
to a Corporate Integrity Agreement with the DHHS. Non-compliance with such laws and regulations or the Corporate Integrity Agreement could subject us to severe sanctions, including penalties and fines.



FASB Statement No. 5, Accounting for Contingencies, provides guidance
on the application of generally accepted accounting principles related to these matters. We evaluate and record liabilities for contingencies based on known claims and legal actions when it is probable a liability has been incurred and the liability
can be reasonably estimated. We believe that our accrued liabilities related to such contingencies are appropriate and in accordance with generally accepted accounting principles.



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Fresh-Start Reporting



We adopted fresh-start reporting upon our emergence from bankruptcy, effective as of March 31, 2002. Under fresh-start reporting, our reorganization value
was allocated to our assets based on their respective fair values in conformity with a method similar in nature to the purchase method of accounting for business combinations. Any portion not attributed to specific tangible or identified intangible
assets are reported as an intangible asset referred to as reorganization value in excess of value of identifiable assetsgoodwill. In adopting fresh-start reporting, we engaged an independent financial advisor to assist in the
determination of the reorganization value or fair value of the entity. See BusinessRisk FactorsSince our financial statements reflect fresh-start reporting adjustments made upon our predecessors emergence from bankruptcy,
information reflecting our results of operations and financial condition will not be comparable to prior periods of our predecessor.



Results of Operations



The following table shows our results of operations for the three months ended March 31, 2002, the nine months ended December 31, 2002 and the combined
results for the predecessor company and us, as the successor company, for the year ended December 31, 2002. The calculation of the combined results for the year ended December 31, 2002 is based on an aggregation of the three months ended March 31,
2002 and the nine months ended December 31, 2002 and is for illustrative purposes only (see note 1 to the audited financial statements for the three months ended March 31, 2002 and the nine months ended December 31, 2002 and the years ended December
31, 2003 and December 31, 2004 included in this report).



|                                                                           |  |                                 |          |   |                                     |   |                            |  |   |          |  
|-------------------------------------------------------------------------- |  | ------------------------------- | -------- | - | ----------------------------------- | - | -------------------------- |  | - | -------- | -
|                                                                           |  | PredecessorCompany              |          |   | Rotech Healthcare Inc.              |   | Combined                   | 
|                                                                           |  | Three months endedMarch 31,2002 |          |   | Nine months ended December 31, 2002 |   | Year endedDecember 31,2002 | 
|Statement of Operations Data:                                              |  |                                 |          |   |                                     |   |                            |  |   |          |  
|Net Revenues                                                               |  | $                               | 154,750  |   |                                     | $ | 463,025                    |  | $ | 617,775  |  
|Costs and expenses:                                                        |  |                                 |          |   |                                     |   |                            |  |   |          |  
|Cost of net revenues:                                                      |  |                                 |          |   |                                     |   |                            |  |   |          |  
|Product and supply costs                                                   |  |                                 | 22,513   |   |                                     |   | 67,542                     |  |   | 90,055   |  
|Patient service equipment deprecation                                      |  |                                 | 12,147   |   |                                     |   | 39,363                     |  |   | 51,510   |  
|                                                                           |  |                                 |          |   |                                     |   |                            |  |   |          |  
|Total cost of net revenues                                                 |  |                                 | 34,660   |   |                                     |   | 106,905                    |  |   | 141,565  |  
|Provision for doubtful accounts                                            |  |                                 | 3,661    |   |                                     |   | 11,481                     |  |   | 15,142   |  
|Selling, general and administrative                                        |  |                                 | 84,996   |   |                                     |   | 274,300                    |  |   | 359,296  |  
|Depreciation and amortization                                              |  |                                 | 2,839    |   |                                     |   | 8,572                      |  |   | 11,411   |  
|Interest (income) expense, net                                             |  |                                 | (17      | ) |                                     |   | 33,093                     |  |   | 33,076   |  
|Provision for inventory losses                                             |  |                                 | 264      |   |                                     |   |                           |  |   | 264      |  
|                                                                           |  |                                 |          |   |                                     |   |                            |  |   |          |  
|Total costs and expenses                                                   |  |                                 | 126,403  |   |                                     |   | 434,351                    |  |   | 560,754  |  
|                                                                           |  |                                 |          |   |                                     |   |                            |  |   |          |  
|Earnings before reorganization items, income taxes and extraordinary items |  |                                 | 28,347   |   |                                     |   | 28,674                     |  |   | 57,021   |  
|Reorganization items                                                       |  |                                 | 182,291  |   |                                     |   | 3,899                      |  |   | 186,190  |  
|                                                                           |  |                                 |          |   |                                     |   |                            |  |   |          |  
|Earnings (loss) before taxes and extraordinary items                       |  |                                 | (153,944 | ) |                                     |   | 24,775                     |  |   | (129,169 | )
|Federal and state income taxes (benefit)                                   |  |                                 | (203     | ) |                                     |   | 10,903                     |  |   | 10,700   |  
|                                                                           |  |                                 |          |   |                                     |   |                            |  |   |          |  
|Earnings (loss) before extraordinary items                                 |  |                                 | (153,741 | ) |                                     |   | 13,872                     |  |   | (139,869 | )
|Extraordinary gain on debt discharge                                       |  |                                 | 20,441   |   |                                     |   |                           |  |   | 20,441   |  
|                                                                           |  |                                 |          |   |                                     |   |                            |  |   |          |  
|Net earnings (loss)                                                        |  | $                               | (133,300 | ) |                                     | $ | 13,872                     |  | $ | (119,428 | )
|                                                                           |  |                                 |          |   |                                     |   |                            |  |   |          |  



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The following table shows our results of operations and our results of operations as a percentage of net
revenues for the years ended December 31, 2002 (combined results), 2003 and 2004.



|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|------------------------------------------------------------------------------ |  | ----------------------------- | -------- | - | ------------------------------------------- | - | ------------------------------------------ | ------------- | - | ------------------------------ | ------------- |  | ------------------------------------------- | - |  | ------------------------------------------- | - |  | -------------------------- | - |  | ------- | - |  | ----- | -
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   | Percentage of Net Revenues     |               |  |                                             |  
|                                                                               |  | CombinedYearendedDec. 31,2002 |          |   | RotechHealthcare Inc.Year endedDec. 31,2003 |   | RotechHealthcare Inc.Year endedDec. 312004 |               |   | CombinedYear endedDec. 31,2002 |               |  | RotechHealthcare Inc.Year endedDec. 31,2003 |   |  | RotechHealthcare Inc.Year endedDec. 31,2004 |   |  | Percent Increase(Decrease) |  
|(dollars in thousands)                                                         |  |                               |          |   |                                             |   |                                            | 2003 vs. 2002 |   |                                | 2004 vs. 2003 | 
|Statement of Operations Data:                                                  |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Net revenues                                                                   |  | $                             | 617,775  |   |                                             | $ | 581,221                                    |               | $ | 534,503                        |               |  | 100.0                                       | % |  | 100.0                                       | % |  | 100.0                      | % |  | -5.9    | % |  | -8.0  | %
|Costs and expenses:                                                            |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Cost of net revenues:                                                          |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Product and supply costs                                                       |  |                               | 90,055   |   |                                             |   | 73,900                                     |               |   | 70,583                         |               |  | 14.6                                        |   |  | 12.7                                        |   |  | 13.2                       |   |  | -17.9   |   |  | -4.5  |  
|Patient service equipment deprecation                                          |  |                               | 51,510   |   |                                             |   | 102,819                                    |               |   | 61,362                         |               |  | 8.3                                         |   |  | 17.7                                        |   |  | 11.5                       |   |  | 99.6    |   |  | -40.3 |  
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Total cost of net revenues                                                     |  |                               | 141,565  |   |                                             |   | 176,719                                    |               |   | 131,945                        |               |  | 22.9                                        |   |  | 30.4                                        |   |  | 24.7                       |   |  | 24.8    |   |  | -25.3 |  
|Provision for doubtful accounts                                                |  |                               | 15,142   |   |                                             |   | 20,033                                     |               |   | 15,214                         |               |  | 2.5                                         |   |  | 3.4                                         |   |  | 2.8                        |   |  | 32.3    |   |  | -24.1 |  
|Selling, general and administrative                                            |  |                               | 359,296  |   |                                             |   | 311,075                                    |               |   | 273,825                        |               |  | 58.2                                        |   |  | 53.5                                        |   |  | 51.2                       |   |  | -13.4   |   |  | -12.0 |  
|Depreciation and amortization                                                  |  |                               | 11,411   |   |                                             |   | 16,828                                     |               |   | 15,191                         |               |  | 1.8                                         |   |  | 2.9                                         |   |  | 2.8                        |   |  | 47.5    |   |  | -9.7  |  
|Interest (income) expense, net                                                 |  |                               | 33,076   |   |                                             |   | 41,402                                     |               |   | 33,696                         |               |  | 5.4                                         |   |  | 7.1                                         |   |  | 6.3                        |   |  | 25.2    |   |  | -18.6 |  
|Other income                                                                   |  |                               |         |   |                                             |   |                                           |               |   | (2,516                         | )             |  | 0.0                                         |   |  | 0.0                                         |   |  | -0.5                       |   |  | 0.0     |   |  | 0.0   |  
|Provision for inventory losses                                                 |  |                               | 264      |   |                                             |   |                                           |               |   |                               |               |  | 0.0                                         |   |  | 0.0                                         |   |  | 0.0                        |   |  | -100.0  |   |  | 0.0   |  
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Total costs and expenses                                                       |  |                               | 560,754  |   |                                             |   | 566,057                                    |               |   | 467,355                        |               |  | 90.8                                        |   |  | 97.4                                        |   |  | 87.4                       |   |  | 0.9     |   |  | -17.4 |  
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Earnings (loss) before reorganization items, income taxes, extraordinary items |  |                               | 57,021   |   |                                             |   | 15,164                                     |               |   | 67,148                         |               |  | 9.2                                         |   |  | 2.6                                         |   |  | 12.6                       |   |  | -73.4   |   |  | 342.8 |  
|Reorganization items                                                           |  |                               | 186,190  |   |                                             |   |                                           |               |   |                               |               |  | 30.1                                        |   |  | 0.0                                         |   |  | 0.0                        |   |  | -100.0  |   |  | 0.0   |  
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Earnings before income taxes and extraordinary items                           |  |                               | (129,169 | ) |                                             |   | 15,164                                     |               |   | 67,148                         |               |  | -20.9                                       |   |  | 2.6                                         |   |  | 12.6                       |   |  | -111.7  |   |  | 342.8 |  
|Federal and state income taxes                                                 |  |                               | 10,700   |   |                                             |   | 6,751                                      |               |   | 28,931                         |               |  | 1.7                                         |   |  | 1.2                                         |   |  | 5.4                        |   |  | -36.9   |   |  | 328.5 |  
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Earnings (loss) before extraordinary items                                     |  |                               | (139,869 | ) |                                             |   | 8,413                                      |               |   | 38,217                         |               |  | -22.6                                       |   |  | 1.4                                         |   |  | 7.2                        |   |  | -106.0  |   |  | 354.3 |  
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Extraordinary gain on debt discharge, net of taxes                             |  |                               | 20,441   |   |                                             |   |                                           |               |   |                               |               |  | 3.3                                         |   |  | 0.0                                         |   |  | 0.0                        |   |  | -100.0  |   |  | 0.0   |  
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|Net earnings (loss)                                                            |  |                               | (119,428 | ) |                                             |   | 8,413                                      |               |   | 38,217                         |               |  | -19.3                                       |   |  | 1.4                                         |   |  | 7.2                        |   |  | -107.0  |   |  | 354.3 |  
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  
|EBITDA(1)                                                                      |  | $                             | (13,451  | ) |                                             | $ | 176,213                                    |               | $ | 177,397                        |               |  | -2.2                                        | % |  | 30.3                                        | % |  | 33.2                       | % |  | 1,409.8 | % |  | 0.1   | %
|                                                                               |  |                               |          |   |                                             |   |                                            |               |   |                                |               |  |                                             |   |  |                                             |   |  |                            |   |  |         |   |  |       |  

---

|(1) |  | See Selected Historical Consolidated Financial Data, item (6) on page 37 for a detailed definition of EBITDA and a reconciliation of net earnings to EBITDA. EBITDA is
commonly used as an analytical indicator within the health care industry, and also serves as a measure of leverage capacity and debt service ability. EBITDA should not be considered as a measure of financial performance under generally accepted
accounting principles, and the items excluded from EBITDA are significant components in understanding and assessing financial performance. EBITDA should not be considered in isolation or as an alternative to net income, cash flows generated by
operating, investing or financing activities or other financial statement data presented in the consolidated financial statements as an indicator of financial performance or liquidity. Because EBITDA is not a measurement determined in accordance
with generally accepted accounting principles and is thus susceptible to varying calculations, EBITDA as presented may not be comparable to other similarly titled measures of other companies.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Year ended December 31, 2004 as compared to year ended December 31, 2003



Total net revenues for the year ended December 31, 2004 decreased $46.7
million, or 8.0%, to $534.5 million, from the comparable period in 2003. The decrease was primarily attributable to a reduction in Medicare payment rates for inhalation drugs which reduced our revenues and operating income by approximately $24
million and the remainder was due to volume decreases, including decreases related to closing certain of our locations in 2003 due to various contract issues and failure to meet profitability targets.



Cost of net revenues for the year ended December 31, 2004 decreased $44.8
million, or 25.3% to $131.9 million, from the comparable period in 2003. The decrease in cost of net revenues is mainly attributable to the decrease in patient service equipment depreciation of $41.5 million. In 2003, we changed the estimated useful
lives of the patient service equipment which resulted in a significant increase in patient service equipment depreciation charged for 2003. Cost of net revenues as a percentage of net revenue was 24.7% for 2004 as compared to 30.4% for 2003.



The provision for doubtful accounts for the year ended
December 31, 2004 decreased by $4.8 million or 24.1% from the comparable period in 2003. The provision for doubtful accounts expense as a percentage of net revenues decreased to 2.8% for the year ended December 31, 2004 as compared to 3.4% for 2003.
The decrease in this expense is primarily attributed to efficiencies gained from consolidating our billing centers, improving our collection policies and procedures and from exiting certain contracts.



Selling, general and administrative expenses for the year ended December 31,
2004 decreased by $37.3 million, or 12.0%, to $273.8 million, from the comparable period in 2003. The primary factors in the decrease of selling, general and administrative expenses was an $11.5 million decrease in salary expense, an $11.3 million
decrease in insurance costs with the remainder attributable to a continued focus on cost controls. Selling, general and administrative expenses as a percentage of net revenues decreased to 51.2% for the year ended December 31, 2004 from 53.5% for
the year ended December 31, 2003.



Depreciation and
amortization for the year ended December 31, 2004 decreased $1.6 million, or 9.7%, to $15.2 million, from the comparable period in 2003. The primary reason for the decrease was a decline in capital purchases of non-patient service equipment.



Interest expense for the year ended December 31, 2004
decreased $7.7 million from the comparable period in 2003. The decrease is primarily attributable to debt payments in the amount of $25.3 million on our term loan and the repurchase, in August 2004, of $13 million of our 91/2% senior subordinated notes due 2012 with respect to which we paid a premium of $0.9 million associated with the
retirement of such notes.



Federal and state income
taxes for the year ended December 31, 2004 increased $22.2 million to $28.9 million, from the comparable period in 2003. The increase in federal and state income taxes was due to much higher earnings before income taxes in the year ended December
31, 2004.



For the year ended December 31, 2004, we generated
net earnings of $38.2 million as compared to net earnings of $8.4 million for 2003. The increase in earnings for the year ended December 31, 2004 resulted primarily from the decrease in total expenses of $98.7 million, offset by $46.7 million in
reduced revenue and $22.2 million in increased income taxes.



Year ended December 31, 2003 as compared to year ended December 31, 2002



Total net revenues for the year ended December 31, 2003 decreased $36.6 million, or 5.9%, to $581.2 million, from the comparable period in 2002. The
decrease was attributable to flat revenues in our respiratory therapy equipment and services products and a 25.0% decrease in our durable medical equipment revenues. The decrease in durable medical equipment revenues was due to our efforts to focus
on the more profitable respiratory therapy equipment rental and related services and provide durable medical equipment as a complementary offering to respiratory therapy services. In addition, we exited from certain contracts that we believed were
not profitable.



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Cost of net revenues for the year ended December 31, 2003 increased $35.2 million, or 24.8%, to $176.7
million, from the comparable period in 2002. The increase in cost of net revenues is attributable to the increase in patient service equipment depreciation of $51.3 million offset by a decrease in product and supply costs of $16.2 million. The
change in revenue composition from lower gross margin durable medical equipment to respiratory therapy equipment and services accounted for the decrease in product and supply costs. During the second quarter ended June 30, 2003, management completed
an assessment of the depreciation estimates made on April 1, 2002 related to long-lived assets acquired from our predecessor, Rotech Medical Corporation. Based on information then available, we revised our depreciation policy for these assets from
an aggregate of four years from the date acquired from our predecessor, to depreciating the assets over a period ending five years from the date the assets were originally acquired by our predecessor. The revised estimates on depreciable lives for
approximately $138.0 million of rental property was necessary to more closely match the replacement rates of rental property acquired with its specific useful remaining life. As a result of that change in depreciation estimate, we recognized
approximately $42.5 million in additional depreciation expense for the year ended December 31, 2003 which has been included as a component of cost of sales. This change in depreciation expense reduced net income by approximately 23.8 million. Cost
of net revenues as a percentage of net revenue was 30.4% for 2003 as compared to 22.9% for 2002.



The provision for doubtful accounts for the year ended December 31, 2003 increased by $4.9 million or 32.3% from the comparable period in 2002. The
provision for doubtful accounts expense as a percentage of net revenue increased to 3.5% for the year ended December 31, 2003 as compared to 2.5% for 2002. The increase in this expense is primarily attributed to our consolidation of billing centers,
change in our collection policies and procedures and the exit from certain contracts.



Selling, general and administrative expenses for the year ended December 31, 2003 decreased by $48.2 million or 13.4% to $311.1 million, from the comparable period in 2002. The primary factor in the decrease of
selling, general and administrative is attributable to the reduction of employees from 5,200 to 4,400 during 2003. Selling, general and administrative expenses as a percentage of net revenues decreased to 53.5% for the year ended December 31, 2003
from 58.2% for the year ended December 31, 2002.



Depreciation
and amortization for the year ended December 31, 2003 increased $5.4 million or 47.5% to $16.8 million, from the comparable period in 2002. The primary reason for the increase was due to shorter lease terms which increased amortization of leasehold
improvements.



Interest expense for the year ended December 31,
2003 increased $8.3 million from the comparable period in 2002. The increase is attributable to interest costs incurred in connection with our $200 million senior secured term loan which we entered into on March 26, 2002 and our $300 million
91⁄2% senior subordinated notes due 2012 which were issued on March 26, 2002. Included in interest expense is amortization of deferred debt issue costs which increased $2.9 million due primarily to accelerated prepayments made on our senior
secured term loan.



We incurred $186.2 million of
reorganization expenses for the year ended December 31, 2002 consisting primarily of: (a) fresh-start reporting adjustments of $153.2 million; (b) priority tax claims allowed of $9.0 million; (c) administrative expense claims allowed of
$7.8 million; (d) contribution of convertible redeemable preferred stock to our employee profit sharing plan of $5.0 million; (e) loss on sale/leaseback of vehicles of $4.9 million; (f) loss on closure of discontinued branch operations and
discontinued product lines, long term incentive compensation and other charges resulting from reorganization and restructuring of $3.4 million; (g) legal, accounting and consulting fees of $2.1 million; and (h) severance and termination payments in
the amount of approximately $0.8 million. There were no such expenses for the year ended December 31, 2003.



Federal and state income taxes for the year ended December 31, 2003 decreased $3.9 million to $6.8 million, from the comparable period in 2002. The
decrease in federal and state income taxes was due to lower earnings before income taxes in the year ended December 31, 2003.



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For the year ended December 31, 2003, we generated net earnings of $8.4 million as compared to a net loss
of $119.4 million for 2002. The large loss in the year ended December 31, 2002 resulted primarily from the $186.2 million of reorganization expenses incurred in 2002, the majority of which related to the fresh-start reporting adjustments
recorded by our predecessor.



Liquidity and Capital Resources



Net cash provided by operating activities and
reorganization items was $133.9 million for the year ended December 31, 2004 and was $148.3 million for the year ended December 31, 2003. Cash flows in both years were sufficient to fund capital expenditures and required repayments of debt.



Accounts receivable before allowance for doubtful accounts
decreased $10.4 million from $98.8 million at December 31, 2003 to $88.4 million at December 31, 2004. Accounts receivable decreased as a result of an increase in cash collections for the period. Days sales outstanding (calculated as of each period
end by dividing accounts receivable, less allowance for doubtful accounts, by the 90-day rolling average of net revenue) were 51 days at December 31, 2004 compared to 52 days at December 31, 2003.



Included in accounts receivable are earned but unbilled receivables of $12.2
million at December 31, 2004 and $14.8 million at December 31, 2003. Delays, ranging from a day to several weeks, between the date of service and billing can occur due to delays in obtaining certain required payor-specific documentation from
internal and external sources. Earned but unbilled receivables are aged from date of service and are considered in our analysis of historical performance and collectibility.



Due to the nature of the industry and the reimbursement environment in which we operate, certain estimates are required to
record net revenues and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available. Specifically, the complexity of many
third-party billing arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of
cash application, claim denial or account review.



Management
performs analyses to evaluate the net realizable value of accounts receivable. Specifically, management considers historical realization data, accounts receivable aging trends, other operating trends and relevant business conditions. Because of
continuing changes in the health care industry and third-party reimbursement, it is possible that managements estimates could change, which could have an impact on operations and cash flows.



We derive a significant portion of our revenues from the Medicare and
Medicaid programs and from managed care health plans. Payments for services rendered to patients covered by these programs may be less than billed charges. For Medicare and Medicaid revenues, provisions for contractual adjustments are made to reduce
the charges to these patients to estimated receipts based upon the programs principles of payment or reimbursement (retrospectively determined). Final payment under these programs is subject to administrative review and audit, and management
currently makes provisions for any adjustments which may result. Our provisions for contractual allowances under managed care health plans are based primarily on payment terms. Management closely monitors its historical collection rates as well as
changes in applicable laws, rules and regulations and contract terms to help assure that provisions are made using the most accurate information management believes to be available. However, due to the complexities involved in these estimations,
actual payments we receive could be different from the amounts we estimate and record.



Collection of receivables from third party payors and patients is our primary source of cash and is critical to our operating performance. Our primary collection risks relate to patient accounts for which the primary
insurance payor has paid, but patient responsibility amounts (generally deductibles and co-payments) remain outstanding. We estimate provisions for doubtful accounts based primarily upon the age of patients account, the economic ability of
patients to pay and the effectiveness of our collection efforts. We routinely review accounts receivable balances in conjunction with our historical collection rates and other economic conditions which



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might ultimately affect the collectibility of patient accounts when we consider the adequacy of the amounts we record as reserves for doubtful accounts.
Significant changes in payor mix, business office operations, economic conditions or trends in federal and state governmental health care coverage could affect our collection of accounts receivable, cash flows and results of operations.



Because of continuing changes in the health care industry and third-party
reimbursement, it is possible that managements estimates could change, which could have an impact on operations and cash flows. Our future liquidity may be materially adversely impacted by the Medicare Prescription Drug, Improvement and
Modernization Act of 2003. See BusinessRisk Factors above.



Capital expenditures totaled approximately $54.0 million for the year ended December 31, 2004 and $42.0 million for the year ended December 31, 2003. The increase in 2004 is attributed primarily to growth in new
rental units during 2004.



Cash flows from financing activities
primarily relate to debt facilities entered into on the effective date of our predecessors plan of reorganization on March 26, 2002. We currently have the following debt facilities and outstanding debt:



| |  |  | a five-year $75 million senior secured revolving credit facility that for general corporate purposes including working capital, capital expenditures and acquisitions. The interest
rates per annum applicable to the senior secured revolving credit facility is LIBOR or, at our option, the alternate base rate, which is the higher of (a) the rate of interest publicly announced by UBS AG as its prime rate in effect at its Stamford
Branch, and (b) the federal funds effective rate from time to time plus 0.50%, in each case, plus the applicable margin. The applicable margin with respect to the revolving credit facility, is determined in accordance with a performance grid based
on our consolidated leverage ratio and ranges from 3.25% to 2.25% in the case of Eurodollar rate advances and from 2.25% to 1.25% in the case of alternate base rate advances.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | a six-year $200 million senior secured term loan, the proceeds of which were used to repay certain pre-petition claims owed to Rotech Medical Corporations creditors as part of
its plan of reorganization. The term loan is repayable in an aggregate annual amount equal to 1% of the principal amount each year for the first five years with the balance due in year six. Interest is payable based on the election of either the
Eurodollar rate plus 3.00% or the prime rate plus 2.00%. The term loan was advanced as a Eurodollar rate advance.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | an aggregate principal amount of $300 million of 91⁄2% senior subordinated notes, the proceeds of which were used to repay certain pre-petition claims owed to the creditors of
our predecessor as part of its plan of reorganization. The notes mature on April 1, 2012. Interest of 91⁄2% is payable semi-annually in arrears on April 1 and October 1 of each year.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Borrowings under the revolving credit facility and term loan are secured by
substantially all of our assets and the agreements impose numerous restrictions, including, but not limited to, covenants requiring the maintenance of certain financial ratios, limitations on additional borrowing, capital expenditures, acquisitions
and investments. For example, our capital expenditures are limited to $95.0 million, $100.0 million and $105.0 million for 2005, 2006 and 2007, respectively and our acquisition expenditures are limited to $40.0 million annually for each of 2005,
2006 and 2007. Our actual capital expenditures in 2003 and 2004 were approximately $42.0 million and $54.0 million, respectively. Our actual acquisition expenditures in 2003 and 2004 were approximately $10.0 million and none, respectively.



We did not draw down on the revolving credit facility during
2004, although standby letters of credit totaling $11.2 million have been issued under this credit facility. Please see the section captioned BusinessSenior Secured Credit Facilities for discussion of our senior secured credit
facilities.



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During 2004, we made regularly scheduled amortization payments of $.6 million and voluntary prepayments
of principal of $24.7 million on the $200 million term loan. As of December 31, 2004, $42.7 million remained outstanding on the term loan.



Our working capital requirements relate primarily to the working capital needed for general corporate purposes. We currently have no commitments for
capital expenditures over the next twelve months other than to acquire equipment as needed to supply our patients. Our business requires us to make significant capital expenditures relating to the purchase and maintenance of the medical equipment
used in our business. For the year ended December 31, 2003, our capital expenditures were $42.0 million, representing 7.2% of our net revenues. For the year ended December 31, 2004, our capital expenditures were approximately $54.0 million,
representing 10.1% of our net revenues. We do not expect to exceed our debt limitations for capital expenditures during the year ended December 31, 2005. We believe that the cash generated from our operations, together with amounts available under
the $75 million revolving credit facility, will be sufficient to meet our working capital, capital expenditure and other cash needs for the foreseeable future.



Effective December 5, 2003, our board of directors adopted a policy of declaring dividends to the holders of the Series A convertible redeemable
preferred stock under the Rotech Healthcare Inc. Employees Plan on an annual basis, with each such declaration to be made at the annual meeting of the board of directors with respect to dividends payable for the preceding year. Such policy commenced
at the 2004 annual meeting of the board of directors and, in order to account for the period from the inception of the Rotech Healthcare Inc. Employees Plan to such date, the first declaration of dividends covered the preceding two years. In June
2004, dividends in amount of $0.9 million were declared on our Series A convertible redeemable preferred stock, which were paid in the first quarter of 2005.



In order to maintain compliance with certain requirements of the Rotech Healthcare Inc. Employees Plan, we have determined to make a cash contribution to
the plan in the amount of $0.5 million payable at any time prior to December 31, 2005.



Effective August 3, 2004, we repurchased $13.0 million of our 91⁄2% senior subordinated notes due 2012 resulting in a loss on extinguishment of debt of $0.9 million for the premium paid in association with the
retirement of such notes. The resulting loss on extinguishment of debt charge is included in selling, distribution and administrative expenses. In addition, effective October 12, 2004, we repurchased 804 shares of our Series A convertible redeemable
preferred stock for approximately $0.02 million in order to fund the cash payment of benefits under the Rotech Healthcare Inc. Employees Plan to certain plan participants that are no longer employed by us.





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Selected Quarterly Financial Data (unaudited)



The following tables present our unaudited quarterly results of operations for 2003 and 2004. You should read the following
tables in conjunction with the consolidated financial statements and related notes appearing elsewhere in this report. This unaudited information has been prepared on a basis consistent with the audited consolidated financial statements contained in
this report and includes all adjustments, consisting only of normal recurring adjustments, that are considered necessary for a fair presentation of our financial position and operating results for the quarters presented. You should not draw any
conclusions about our future results from the results of operations for any quarter.



The following is a summary of quarterly financial results for the year ended December 31, 2003:



|                                            |  |                                       |         |              |   |         |                   |  |                  |         |  |   |        
|------------------------------------------- |  | ------------------------------------- | ------- | ------------ | - | ------- | ----------------- |  | ---------------- | ------- |  | - | -------
|                                            |  | Three months ended                   
|                                            |  | March 31,2003                         |         | June 30,2003 |   |         | September 30,2003 |  | December 31,2003
|                                            |  | (in thousands, except per share data)
|Summary Statement of Operations Information |  |                                       |         |              |   |         |                   |  |                  |         |  |   |        
|Net revenues                                |  | $                                     | 152,577 |              | $ | 145,707 |                   |  | $                | 142,353 |  | $ | 140,584
|Interest expense                            |  |                                       | 10,806  |              |   | 9,824   |                   |  |                  | 10,676  |  |   | 10,096 
|Federal and state income taxes              |  |                                       | 3,967   |              |   | (5,168  | )                 |  |                  | 1,935   |  |   | 6,017  
|Net earnings (loss)                         |  |                                       | 4,997   |              |   | (6,679  | )                 |  |                  | 2,299   |  |   | 7,796  
|Net earnings per common sharebasic         |  |                                       | 0.20    |              |   | (0.27   | )                 |  |                  | 0.09    |  |   | 0.31   
|Net earnings per common sharediluted       |  |                                       | 0.20    |              |   | (0.27   | )                 |  |                  | 0.08    |  |   | 0.31   
|Market prices:                              |  |                                       |         |              |   |         |                   |  |                  |         |  |   |        
|High                                        |  |                                       | 17.80   |              |   | 23.05   |                   |  |                  | 25.75   |  |   | 31.25  
|Low                                         |  |                                       | 13.80   |              |   | 12.00   |                   |  |                  | 21.50   |  |   | 20.50  
|Summary Balance Sheet Information           |  |                                       |         |              |   |         |                   |  |                  |         |  |   |        
|Deferred tax asset (a)                      |  |                                       | 5,006   |              |   | 5,150   |                   |  |                  | 5,511   |  |   |        
|Other assets                                |  |                                       | 18,427  |              |   | 15,882  |                   |  |                  | 14,223  |  |   | 13,941 
|Other current assets (b)                    |  |                                       |         |              |   |         |                   |  |                  |         |  |   | 19,580 
|Retained earnings                           |  |                                       | 18,412  |              |   | 11,620  |                   |  |                  | 13,920  |  |   | 21,714 

---

|(a) |  | Included as a component of other current assets for the three months ended December 31, 2003.
|--- |  | ---------------------------------------------------------------------------------------------

|(b) |  | Includes deferred tax asset for the three months ended December 31, 2003 which was disclosed as a separate asset for prior quarters.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------



The following is a summary of quarterly financial results for the year ended
December 31, 2004:



|                                            |  |                                       |         |              |   |                   |  |                  |         |  |   |        
|------------------------------------------- |  | ------------------------------------- | ------- | ------------ | - | ----------------- |  | ---------------- | ------- |  | - | -------
|                                            |  | Three Months Ended                   
|                                            |  | March 31,2004                         |         | June 30,2004 |   | September 30,2004 |  | December 31,2004
|                                            |  | (in thousands, except per share data)
|Summary Statement of Operations Information |  |                                       |         |              |   |                   |  |                  |         |  |   |        
|Net Revenues                                |  | $                                     | 134,011 |              | $ | 133,400           |  | $                | 131,340 |  | $ | 135,751
|Interest expense                            |  |                                       | 9,232   |              |   | 8,392             |  |                  | 8,595   |  |   | 7,477  
|Federal and state income taxes              |  |                                       | 6,306   |              |   | 7,220             |  |                  | 5,859   |  |   | 9,547  
|Net earnings                                |  |                                       | 9,044   |              |   | 10,389            |  |                  | 8,431   |  |   | 10,353 
|Net earnings per common share-basic         |  |                                       | 0.36    |              |   | 0.41              |  |                  | 0.34    |  |   | 0.39   
|Net earnings per common share-diluted       |  |                                       | 0.35    |              |   | 0.40              |  |                  | 0.33    |  |   | 0.40   
|Market prices:                              |  |                                       |         |              |   |                   |  |                  |         |  |   |        
|High                                        |  |                                       | 24.00   |              |   | 26.50             |  |                  | 24.60   |  |   | 28.20  
|Low                                         |  |                                       | 20.25   |              |   | 20.75             |  |                  | 18.75   |  |   | 20.00  
|Summary Balance Sheet Information           |  |                                       |         |              |   |                   |  |                  |         |  |   |        
|Other assets                                |  |                                       | 13,276  |              |   | 12,725            |  |                  | 12,397  |  |   | 12,551 
|Other current assets                        |  |                                       | 16,700  |              |   | 16,928            |  |                  | 16,954  |  |   | 18,877 
|Retained earnings                           |  |                                       | 30,758  |              |   | 41,145            |  |                  | 49,576  |  |   | 59,481 



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Contractual Obligations



As of December 31, 2004, our future contractual cash obligations are as follows:



|                                                                                 |  |                                       |         |      |   |              |  |               |        |                    |   |        |  |   |        
|-------------------------------------------------------------------------------- |  | ------------------------------------- | ------- | ---- | - | ------------ |  | ------------- | ------ | ------------------ | - | ------ |  | - | -------
|Contractual Obligations (1)                                                      |  | Payments due by period (in thousands)
|                                                                                 |  | Total                                 |         | 2005 |   | 2006   2007 |  | 2008    2009 |        | 2010 andthereafter
|Obligations related to our senior secured notes and senior secured term loan (2) |  | $                                     | 329,671 |      | $ | 439          |  | $             | 31,811 |                    | $ | 10,421 |  | $ | 287,000
|Operating lease obligations (3)                                                  |  |                                       | 49,130  |      |   | 20,863       |  |               | 23,312 |                    |   | 4,789  |  |   | 166    
|Other long-term liabilities reflected on our balance sheet under GAAP (4)        |  |                                       | 6,237   |      |   | 1,411        |  |               | 2,793  |                    |   | 1,558  |  |   | 475    
|Total                                                                            |  | $                                     | 385,038 |      | $ | 22,712       |  | $             | 57,917 |                    | $ | 16,768 |  | $ | 287,641

---

|(1) |  | We do not have any purchase obligations other than standard purchase orders in the ordinary course of business.
|--- |  | ---------------------------------------------------------------------------------------------------------------



|(2) |  | Our debt is comprised of our $287 million of 91/2% senior secured notes due 2012 and our senior secured term loan. See Note 9 to the audited financial statements for the three months ended March 31, 2002, the nine months ended December 31, 2002, and the years ended December 31,
2003 and 2004 for a discussion of our long-term debt.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(3) |  | Our operating lease obligations are primarily comprised of building and vehicle lease commitments. See Note 10 to the audited financial statements for the three months ended March
31, 2002, the nine months ended December 31, 2002, and the years ended December 31, 2003 and 2004 for further discussion of our lease commitments.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(4) |  | Our other long-term liabilities reflected on our balance sheet primarily relate to the priority tax claim and our Series A Convertible Redeemable Preferred Stock.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



Off-balance Sheet Arrangements



We do not have off-balance sheet arrangements (as that term is defined in
Item 303(a)(4)(ii) of Regulation S-K) that have or are reasonably likely to have a current or future effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.



Recent Accounting Pronouncements



In June 2002, the FASB issued Statement 146,Accounting for Costs
Associated With Exit or Disposal Activities(Statement 146). Statement 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies (EITF) 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)(EITF 94-3). Statement 146 requires costs associated with exit or disposal activities to be recognized when the costs
are incurred, rather than at a date of commitment to an exit or disposal plan. Statement 146 was effective for exit or disposal activities that are initiated after December 31, 2002. The impact of adopting this standard did not have a material
impact on our consolidated financial statements.



In December
2002, Statement 148, Accounting for Stock-Based CompensationTransition and Disclosure(Statement 148) was issued by the FASB. This standard amends Statement 123, Accounting for Stock-Based Compensation(Statement 123), to provide
alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, this standard amends the disclosure requirements of Statement 123 to require prominent disclosure in
both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. Statement 148 is effective for financial statements for fiscal years ending
after December 15, 2002. We implemented Statement 148 effective January 1, 2003 regarding disclosure requirements for condensed financial statements. We did not change to the fair value based method of accounting for stock-based employee
compensation during 2003 or 2004.



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In May 2003, the FASB issued Statement No. 150, Accounting for Certain Financial Instruments with
Characteristics of both Liabilities and Equity (Statement 150). This statement established standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires the
issuer to classify a financial instrument that is within the scope of the standard as a liability if such financial instrument embodies an unconditional obligation of the issuer. It was effective for financial instruments entered into or modified
after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. We adopted Statement 150 during the third quarter of 2003 and classified and accounted for our Series A Convertible
Redeemable Preferred Stock (the Series A Preferred) as a liability on our consolidated financial statements from July 1, 2003 through September 30, 2004. We have re-considered the implementation of Statement 150 effective October 1, 2004. The Series
A Preferred does not contain an unconditional obligation to redeem as defined in Statement 150. The Series A Preferred has conditional redemption features. Immediately prior to the closing of a firm commitment underwritten initial public offering of
our common stock pursuant to an effective registration statement under the Securities Act of 1933, which offering yields gross proceeds to us of no less than $100,000,000, each holder of Series A Preferred may convert their shares into our common
stock at the conversion rate of 0.8 shares of common stock for each share of Series A Preferred. In addition, after the fifth anniversary of the date of the first issuance of the Series A Preferred, any holder of any shares of the Series A Preferred
has the right, at his/her option, to convert all or any portion of his/her Series A Preferred into our common stock at the conversion rate of 0.8 shares of common stock for each share of Series A Preferred. Therefore, we have reclassified the Series
A Preferred from a liability presentation in 2003 to a mezzanine presentation in 2004. The related Series A Preferred return has been classified as preferred dividends. The Series A Preferred accounts in 2003 have been reclassified in the
accompanying consolidated financial statements to conform to the 2004 presentation. The financial statement impact of the change in presentation of the Series A Preferred was not material for either 2003 or 2004.



In January 2003, the FASB issued FIN No. 46,Consolidation of Variable
Interest Entities (FIN 46), and a revised interpretation of FIN 46 (FIN 46(R)) in December 2003, in an effort to expand upon existing accounting guidance that addresses when a company should consolidate the financial results of another
entity. FIN No. 46 requires variable interest entities, as defined, to be consolidated by a company if that company is subject to a majority of expected losses of the entity or is entitled to receive a majority of expected residual
returns of the entity, or both. A company that is required to consolidate a variable interest entity is referred to as the entitys primary beneficiary. The interpretation also requires certain disclosures about variable interest entities that
a company is not required to consolidate, but in which it has a significant variable interest. The consolidation and disclosure requirements apply immediately to variable interest entities created after January 31, 2003. We are not the primary
beneficiary of any variable interest entity created after January 31, 2003 nor do we have a significant variable interest in a variable interest entity created after January 31, 2003. For variable interest entities that existed before February 1,
2003, the consolidation requirements of FIN 46(R) are effective as of March 31, 2004. The adoption of FIN 46(R) will not have a material impact on our consolidated financial statements.



In December 2004, the FASB issued Statement No. 123R (Statement 123R), Share Based Payment. This statement revises
Statement 123 and supersedes APB 25 and amends FASB Statement No. 95, Statement of Cash Flows. This statement requires companies to expense the fair value of employee services received in exchange for an award of equity instruments, including
stock options. Statement 123R also provides guidance on valuing and expensing these awards, as well as disclosure requirements with respect to these equity arrangements. Statement 123R is effective for the first interim reporting period that begins
after June 15, 2005.



As currently permitted by Statement 123,
we currently account for share-based payments to employees using APB 25s intrinsic value method and, as such, we generally recognize no compensation costs for employee stock options. The adoption of Statement 123R will have a negative impact
on our results of operations, however, it will have no cash impact on our overall financial position. We will adopt the provisions of Statement 123R effective July 1, 2005. We have not yet determined the specific dollar impact that the adoption of
Statement 123R will have on our future results of operations.





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Inflation



We have not experienced large increases in either the cost of supplies or operating expenses due to inflation. With reductions in reimbursement by
government and private medical insurance programs and pressure to contain the costs of such programs, we bear the risk that reimbursement rates set by such programs will not keep pace with inflation.



ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Concurrently with our predecessors emergence from bankruptcy and the transfer to us of its business and operations, we entered into (i) a five-year
$75 million senior secured revolving credit facility and (ii) a six-year $200 million senior secured term loan. Our earnings may be affected by changes in interest rates relating to these debt facilities. Variable interest rates may rise, which
could increase the amount of interest expense. In March 2002, in consideration for the transfer of the assets of our predecessor to us, we borrowed the entire amount of the $200 million term loan and transferred the proceeds of that loan to Rotech
Medical Corporation to fund a portion of the cash distributions made by Rotech Medical Corporation in connection with its plan of reorganization. During 2004 and as of March 14, 2005, the $75 million senior secured revolving credit facility had not
been drawn upon, although standby letters of credit totaling $11.2 million have been issued under this credit facility. For the year ended December 31, 2004, we incurred $33.7 million of interest expense on our long-term debt. Assuming a
hypothetical increase of one percentage point for the variable interest rate applicable to the $200 million term loan (of which $42.7 million is outstanding as of December 31, 2004), we would incur approximately $0.4 million in additional interest
expense for the period January 1, 2005 through December 31, 2005.



ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



The financial statements and other financial information that are required by Item 8 are listed in Item 15 of Part IV. The financial statements and
supplementary financial information referenced in Item 15 are incorporated in this Item 8 by reference.



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



None.



ITEM 9A.    CONTROLS AND PROCEDURES



Disclosure Controls and Procedures



Our
management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended, (the Exchange Act)) as of the end of the period covered by this Annual Report on Form 10-K. Based on such evaluation, our principal executive officer and principal financial officer have concluded, as of
the end of such period, that our disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by us in our reports that we file or submit under the
Exchange Act.



Internal Control Over Financial Reporting



We evaluate our internal control over financial reporting on a regular
basis. If we identify a problem in our internal control over financial reporting during the course of our evaluations, we consider what revision, improvement and/or correction to make in order to ensure that our internal controls are effective. We
are currently in the process of enhancing internal controls to address issues identified through these evaluations,



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including ongoing improvements in our billing centers, increased system controls and improved controls over rental equipment to provide more accurate and
complete tracking. Pending full implementation of these enhancements, we have instituted additional procedures and policies to preserve our ability to accurately record, process and summarize financial data and prepare financial statements for
external purposes that fairly present our financial condition, results of operations and cash flows. Our principal executive and financial officers recognize that any set of controls and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired control objectives. Accordingly, we intend to continue to refine our internal control over financial reporting on an ongoing basis as we deem appropriate with a view towards making
improvements.



We have made no changes during the fourth
quarter of fiscal year 2004 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.



ITEM 9B.    OTHER INFORMATION



None.



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PART III



ITEM 10.    DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT



The information required by Part III, Item 10, to the extent not provided herein, is incorporated herein by reference to our definitive proxy statement
relating to the 2005 annual meeting of shareholders to be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K. Information regarding our executive officers is set forth under
the caption Executive Officers in Item 1 hereof.



Code of Ethics



We have adopted a code of ethics that applies to the
members of our board of directors, principal executive officer, principal financial officer and other persons performing similar functions. We have also issued a Policy Statement on Business Ethics and Conflicts of Interests which is applicable to
all employees. Our code of ethics and Policy Statement on Business Ethics and Conflicts of Interests are posted on our internet website, www.rotech.com, and are available, without charge, upon written request directed to the Chief Legal
Officer, Rotech Healthcare Inc., 2600 Technology Drive, Suite 300, Orlando, Florida, 32804.



ITEM 11.    EXECUTIVE COMPENSATION



The information required by Part III, Item 11, to the extent not provided herein, is incorporated herein by reference to our definitive proxy statement relating to the 2005 annual meeting of shareholders to be filed
with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K.



Executive Officer Agreements



Philip L. Carter



On November 1, 2002, we entered into an employment agreement with Philip L. Carter, pursuant to which Mr. Carter serves as our President and Chief
Executive Officer. Mr. Carters employment with us commenced on December 9, 2002 and will continue, subject to certain termination rights, for an initial term of four years. Absent timely notice from either party of its or his intention to
terminate the employment relationship at the conclusion of the initial four year employment term, the employment term will automatically renew for additional one year terms thereafter. Mr. Carters base salary was $850,000 for 2004. Under the
terms of the agreement, Mr. Carters base salary is reviewed at least annually by the board of directors or compensation committee. Mr. Carter is also eligible for an annual target bonus of up to 100% of his base salary which is based upon
certain goals and criteria established by our board of directors and/or compensation committee, and which, under certain circumstances, may exceed 100% of his base salary. In addition, Mr. Carter was issued stock options to purchase 750,000 shares
of common stock. The stock options vest over a four-year period. On the first anniversary of the effective date of Mr. Carters employment agreement, the board in its reasonable discretion had the ability to cancel 150,000 of these options
based upon performance. The board did not cancel such options.



In addition, in connection with his relocation to Orlando, Florida, Mr. Carter was reimbursed for all reasonable and customary expenses associated with the sale of his home in California as well as one months base salary to cover
additional miscellaneous costs and expenses related to his relocation (including any and all tax liabilities resulting from such reimbursement by us). Mr. Carter is also entitled to participate in our life, medical and disability benefits, 401(k)
plan and other benefit plans and policies. He is also provided with a company car.



Mr. Carters employment may be terminated by us for cause (as defined in the employment agreement) upon written notice. Either Mr. Carter or us may terminate the employment agreement for no fault at any time, for
any reason, by providing no less than 30 days written notice to the other party. If Mr. Carters employment is terminated for any reason, we will pay him: (a) any accrued and unused vacation time; (b) any earned and unpaid base salary; (c) any
accrued and unpaid bonus earned or awarded; (d) except in the case of termination of his employment by us for cause or voluntary termination by Mr. Carter without good reason (each as defined in the



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employment agreement), an amount equal to a pro rata portion of his current years bonus; and (e) unreimbursed business expenses in accordance with our
reimbursement policy.



If Mr. Carters employment is
terminated by us without cause or by Mr. Carter with good reason, in addition to the payments set forth in the above paragraph, we will: (a) pay him three times the sum of his then base salary plus the full amount of his bonus for the year in which
the termination occurs; (b) continue to provide benefits for a period of 24 months; and (c) pay the cost of up to 12 months of executive-level outplacement services. In the event of the automatic termination of Mr. Carters employment due to a
change of control of our company, as defined in the employment agreement, Mr. Carter will be entitled to the separation benefit as set forth in (a), (b) and (c) in the prior sentence and all of the options issued to Mr. Carter will immediately
become fully vested and exercisable. Pursuant to the terms of his employment agreement, Mr. Carters receipt of such separation benefit is in lieu of any severance, salary or income continuation plan or similar program that we now or hereafter
offer and is conditioned upon Mr. Carter executing and delivering to us a general release of claims.



Throughout Mr. Carters employment with us and thereafter, Mr. Carter has agreed to keep confidential all of our non-public information, matters and
materials and adhere to all of our policies with regard to our confidential information. Mr. Carter has also agreed not to, directly or indirectly, during the period of his employment and for 18 months following the termination of his employment,
solicit any of our employees to join another company that competes with us in any way. In addition, Mr. Carter has agreed not to, directly or indirectly, during the period of his employment and for two years following the termination of his
employment, compete with us or solicit any of our customers.



On March 19, 2004, Mr. Carters employment agreement was amended to provide for certain payments to be made to Mr. Carter in the event that he should incur liability for certain taxes as a result of the payment of benefits to Mr.
Carter following a change of control of the company. Effective as of January 1, 2005, Mr. Carters employment agreement was amended and restated to add that in the event Mr. Carters employment agreement is not renewed at the expiration of
the initial employment period or any renewal period, Mr. Carter will be entitled to the same payments had his employment been terminated by us without cause or by Mr. Carter with good reason, as described above.



The foregoing summary is qualified in its entirety by reference to the full
text of Mr. Carters amended and restated employment agreement, a copy of which is filed as Exhibit 10.19 to this annual report on Form 10-K.



Michael R. Dobbs



On April 4, 2003, we entered into an employment agreement with Michael R. Dobbs, pursuant to which Mr. Dobbs serves as our Chief Operating Officer. Mr.
Dobbs employment with us commenced on January 13, 2003 and will continue, subject to certain termination rights, for an initial term of four years. Absent timely notice from either party of its or his intention to terminate the employment
relationship at the conclusion of the initial four year employment term, the employment term will automatically renew for additional one year terms thereafter. Mr. Dobbs base salary was $450,000 for 2004. Under the terms of the agreement, Mr.
Dobbs base salary is reviewed at least annually by the board of directors or compensation committee. Mr. Dobbs is also eligible for an annual target bonus of up to 100% of his base salary which is based upon certain goals and criteria
established by our board of directors and/or compensation committee, and which, under certain circumstances, may exceed 100% of his base salary. In addition, Mr. Dobbs was issued stock options to purchase 400,000 shares of common stock. The stock
options vest over a four-year period. On April 4, 2004, our board of directors in its reasonable discretion had the ability to cancel 75,000 of these options based upon performance. The board did not cancel such options.



In addition, in connection with his relocation to Orlando, Florida, Mr. Dobbs
was reimbursed for all reasonable and customary expenses associated with the sale of his home in California as well as one months base salary to cover additional miscellaneous costs and expenses related to his relocation (including any and all
tax liabilities resulting from such reimbursement by us). Mr. Dobbs is also titled to participate in our life, medical and disability benefits, 401(k) plan and other benefit plans and policies. He is also provided with a company car.



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Mr. Dobbs employment may be terminated by us for cause (as defined in the employment agreement)
upon written notice. Either Mr. Dobbs or us may terminate the employment agreement for no fault at any time, for any reason, by providing no less than 30 days written notice to the other party. If Mr. Dobbs employment is terminated for any
reason, we will pay him: (a) any accrued and unused vacation time; (b) any earned and unpaid base salary; (c) any accrued and unpaid bonus earned or awarded; (d) except in the case of termination of his employment by us for cause or voluntary
termination by Mr. Dobbs without good reason (each as defined in the employment agreement), an amount equal to a pro rata portion of his current years bonus; and (e) unreimbursed business expenses in accordance with our reimbursement policy.



If Mr. Dobbs employment is terminated by us without
cause or by Mr. Dobbs with good reason, in addition to the payments set forth in the above paragraph, we will: (a) pay him two times the sum of his then base salary plus the full amount of his bonus for the year in which the termination occurs; (b)
continue to provide benefits for a period of 24 months; and (c) pay the cost of up to 12 months of executive-level outplacement services. In the event of the automatic termination of Mr. Dobbs employment due to a change of control of our
company, as defined in the employment agreement, Mr. Dobbs will be entitled to the separation benefit as set forth in (a), (b) and (c) in the prior sentence and all of the options issued to Mr. Dobbs will immediately become fully vested and
exercisable. Pursuant to the terms of his employment agreement, Mr. Dobbs receipt of such separation benefit is in lieu of any severance, salary or income continuation plan or similar program that we now or hereafter offer and is conditioned
upon Mr. Dobbs executing and delivering to us a general release of claims.



Throughout Mr. Dobbs employment with us and thereafter, Mr. Dobbs has agreed to keep confidential all of our non-public information, matters and materials and adhere to all of our policies with regard to our
confidential information. Mr. Dobbs has also agreed not to, directly or indirectly, during the period of his employment and for 18 months following the termination of his employment, solicit any of our employees to join another company that competes
with us in any way. In addition, Mr. Dobbs has agreed not to, directly or indirectly, during the period of his employment and for two years following the termination of his employment, compete with us or solicit any of our customers.



On March 19, 2004, Mr. Dobbs employment agreement was amended to
provide for certain payments to be made to Mr. Dobbs in the event that he should incur liability for certain taxes as a result of the payment of benefits to Mr. Dobbs following a change of control of the company. Effective as of January 1, 2005, Mr.
Dobbs employment agreement was amended and restated to add that in the event Mr. Dobbs employment agreement is not renewed at the expiration of the initial employment period or any renewal period, Mr. Dobbs will be entitled to the same
payments had his employment been terminated by us without cause or by Mr. Dobbs with good reason, as described above.



The foregoing summary is qualified in its entirety by reference to the full text of Mr. Dobbs amended and restated employment agreement, a copy of
which is filed as Exhibit 10.20 to this annual report on Form 10-K.



Barry E. Stewart



Effective as of August 10,
2004, we entered into a letter agreement with our Chief Financial Officer, Barry E. Stewart, pursuant to which, under certain circumstances, Mr. Stewart will have the right to receive certain benefits upon termination of his employment with us or in
the event of a change of control of our company. Upon termination of employment by Mr. Stewart for good reason or by us without cause (each as defined in the letter agreement), we will: (a) pay Mr. Stewart, any base salary or bonus earned but not
yet paid as of the date of the termination and reimburse him for all reimbursable expenses; (b) pay him in a lump sum no later than twenty (20) days after the termination of his employment, an amount equal to the sum of (i) 150% of his annual base
salary (measured as of the time of the termination of his employment and without mitigation due to any remuneration or other compensation earned by him following such termination of employment), and (ii) an amount equal to his annual target
performance bonus for the year in which his employment is terminated; and (c) provided that he timely elects to continue his medical coverage, pay on his behalf the cost of continuing his existing group medical benefits for a period of eighteen (18)
months from the date of the termination of his employment.



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In the event of the closing of a Change of Control (as such term is defined in the letter agreement), we
will pay to Mr. Stewart in a lump sum concurrent with such closing, an amount equal to the sum of (a) 150% of his annual base salary (measured as of the time of the closing of the Change of Control transaction), and (b) an amount equal to his annual
target performance bonus for the year in which the closing of the Change of Control transaction occurs. In the event of a Change of Control, the payments described in this paragraph will be Mr. Stewarts sole and exclusive benefits.
Accordingly, in the event Mr. Stewarts employment is terminated by us or by Mr. Stewart at any time following a Change of Control, for any reason, he will not be entitled to any of the payments or benefits provided for in the above paragraph,
unless otherwise provided by any company policy or applicable law. Mr. Stewarts entitlement to the termination and other benefits described above are conditioned upon him providing a general release of claims in favor of us and material
compliance with the covenants included in the letter agreement.



Throughout Mr. Stewarts employment with us and thereafter, Mr. Stewart has agreed to keep confidential all of our non-public information, matters and materials and adhere to all of our policies with regard to our confidential
information. Mr. Stewart has also agreed not to, directly or indirectly, during the period of his employment and for one year following the termination of his employment, compete with us, solicit any of our employees or knowingly do anything that
would be adverse in any material way to our interests.



The
foregoing summary is qualified in its entirety by reference to the full text of Mr. Stewarts letter agreement, a copy of which is filed as Exhibit 10.23 to this annual report on Form 10-K.



Executive Officer Incentive Awards



Each year our compensation committee establishes an annual incentive
(i.e., cash bonus) award plan for members of senior management, including each of our executive officers. Payments of bonus awards to executive officers under such programs are based on the compensation committees assessment of our
companys and each executive officers performance measured against previously set financial objectives and the achievement of certain strategic goals. In 2005, our compensation committee adopted a cash bonus plan to provide our executive
officers with bonus compensation upon the achievement of certain financial objectives related to our 2005 revenue, earnings before interest, taxes, depreciation and amortization (EBITDA) and earnings per share and the achievement of certain
strategic goals. If target levels of performance established in the 2005 cash bonus plan are achieved, Mr. Carter and Mr. Dobbs could be awarded a 2005 bonus of up to 100% of their respective base salaries and Mr. Stewart could be awarded a 2005
bonus of up to 75% of his base salary. In addition, Mr. Carter and Mr. Dobbs are eligible for an additional 2005 bonus payment in the discretion of the compensation committee as contemplated in their respective employment agreements.



Effective January 1, 2005 (the Effective Date), we established
the Rotech Healthcare Inc. Senior Management Incentive Plan (2005-2007). The plan is intended to benefit our shareholders by providing a multi-year incentive and reward compensation program for a limited group of key members of senior management
whose contributions, services and decisions are expected to have a long-term impact on our success. The plan is administered by the compensation committee of our board of directors. The participants in the plan are key members of senior management
and certain divisional directors, including our Chief Executive Officer, Chief Operating Officer and Chief Financial Officer. The terms of the plan provide for a three-year incentive period, commencing on January 1, 2005 and ending on December 31,
2007, for which our revenues and our earnings before interest, taxes and depreciation for that period will be compared to certain thresholds for each under the plan (the Performance Objective). If the Performance Objective is met, each
participant in our employ on February 15, 2008 will receive shares of our common stock having an aggregate value equal to his or her annualized rate of base salary from us as in effect on that date (Award). In most cases, failure to
satisfy the Performance Objective will result in no Award being payable at all; however, in certain limited circumstances, a partial Award would be payable. If a change of control (as defined in the plan) of our company should occur



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prior to February 15, 2008, no Awards will be paid under the plan; however, a cash payment would be made to each participant in our employ on the
change of control date (as defined in the plan) or within the 90-day period ending on the change of control date, equal to the amount of his or her base salary from us for the period beginning on the Effective Date and ending on the
change of control date, based on the participants annualized rate of base salary from us as in effect immediately prior to the change of control date. Should the employment of certain plan participants (including, our Chief Executive Officer,
Chief Operating Officer and Chief Financial Officer) terminate following the Effective Date but prior to the earlier of a change of control date or February 15, 2008, he or she may receive a prorated cash payment, calculated in a similar fashion to
change of control payments under the plan, depending upon the circumstances of such participants termination. The foregoing summary is qualified in its entirety by reference to the full text of the Rotech Healthcare Inc. Senior Management
Incentive Plan (2005-2007), a copy of which is filed as Exhibit 10.8 to this annual report on Form 10-K.



ITEM 12.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS



The information required by Part III, Item 12, is incorporated herein by reference to our definitive proxy statement relating to the 2005 annual meeting
of shareholders to be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K. Information regarding securities authorized for issuance under our equity compensation plans is set
forth under the caption Equity Compensation Plan Information in Item 5 hereof.



ITEM 13.    CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS



The information required by Part III, Item 13, is incorporated herein by reference to our definitive proxy statement relating to the 2005 annual meeting
of shareholders to be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K.



ITEM 14.    PRINCIPAL ACCOUNTING FEES AND SERVICES



The information required by Part III, Item 14, is incorporated herein by reference to our definitive proxy statement relating to the 2005 annual meeting
of shareholders to be filed with the Securities and Exchange Commission within 120 days after the end of the fiscal year covered by this Form 10-K.



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PART IV



ITEM 15.    EXHIBITS AND FINANCIAL STATEMENT SCHEDULES



(a) The following documents are filed as part of this report:



|   |  |                                                                                                                                                                                                                    |  |        
|-- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------
|   |  |                                                                                                                                                                                                                    |  | PageNo.
|1. |  | Index to Financial Statements                                                                                                                                                                                      |  | F-1    
|   |  | Report of Independent Registered Public Accounting Firm                                                                                                                                                            |  | F-2    
|   |  | Consolidated Balance Sheets as of December 31, 2003 and 2004                                                                                                                                                       |  | F-3    
|   |  | Consolidated Statements of Operations for the three months ended March 31, 2002 and nine months     ended December 31, 2002 and the years ended December 31, 2003 and
December 31, 2004                            |  | F-4    
|   |  | Consolidated Statements of Changes in Stockholders Equity for the three months ended    March 31, 2002 and nine months ended December 31, 2002 and the years
ended December 31, 2003 and December 31, 2004        |  | F-5    
|   |  | Consolidated Statements of Cash Flows for the three months ended March 31, 2002 and nine months     ended December 31, 2002 and the years ended December 31, 2003 and
December 31, 2004                            |  | F-6    
|   |  | Notes to Consolidated Financial Statements                                                                                                                                                                         |  | F-7    
|   |  |                                                                                                                                                                                                                   
|2. |  | Index to Financial Statement Schedule                                                                                                                                                                              |  |        
|   |  |                                                                                                                                                                                                                   
|   |  | Schedule IIValuation and Qualifying Accounts for the years ended December 31, 2002,     December 31, 2003 and December 31, 2004                                                                                   |  | 62     
|   | 
|   |  | Schedules other than that listed above are omitted because they are not applicable or the required     information is shown in the financial statements or
notes thereto.                                         
|   |  |                                                                                                                                                                                                                   
|3. |  | Exhibits                                                                                                                                                                                                           |  |        
|   | 
|   |  | The exhibits required by Item 601 of Regulation S-K filed as part of, or incorporated by reference in, this     report are listed in the accompanying Exhibit
Index found after the signature page to this report.



(b) See Item 15(a)(3).



(c) See Item 15(a)(2).



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SCHEDULE II



VALUATION AND QUALIFYING ACCOUNTS



For the years ended December 31, 2002, 2003 and 2004

(Dollars in thousands)



|                                       |  |                              |                             |           |                         |        |               |   |                        |   |         |   |  |   |       
|-------------------------------------- |  | ---------------------------- | --------------------------- | --------- | ----------------------- | ------ | ------------- | - | ---------------------- | - | ------- | - |  | - | ------
|                                       |  | Balance atBeginningof Period |                             | Additions |                         |        |               |   | Balanceat End ofPeriod
|                                       |  |                              | Charged toCosts andExpenses |           | Charged toOtherAccounts |        | Deductions(1) |   |                       
|Deducted from asset accounts:          |  |                              |                             |           |                         |        |               |   |                        |   |         |   |  |   |       
|Allowance for Contractual Adjustments: |  |                              |                             |           |                         |        |               |   |                        |   |         |   |  |   |       
|Year ended December 31, 2002           |  | $                            | 14,000                      |           | $                       | 75,654 |               |  |                        | $ | (75,654 | ) |  | $ | 14,000
|Year ended December 31, 2003           |  |                              | 14,000                      |           |                         | 65,844 |               |  |                        |   | (74,265 | ) |  |   | 5,579 
|Year ended December 31, 2004           |  |                              | 5,579                       |           |                         | 41,622 |               |  |                        |   | (41,524 | ) |  |   | 5,677 
|Allowance for Doubtful Accounts:       |  |                              |                             |           |                         |        |               |   |                        |   |         |   |  |   |       
|Year ended December 31, 2002           |  |                              | 24,625                      |           |                         | 15,142 |               |  |                        |   | (20,741 | ) |  |   | 19,026
|Year ended December 31, 2003           |  |                              | 19,026                      |           |                         | 20,033 |               |  |                        |   | (22,112 | ) |  |   | 16,947
|Year ended December 31, 2004           |  |                              | 16,947                      |           |                         | 15,209 |               |  |                        |   | (20,583 | ) |  |   | 11,573

---

|(1) |  | To record write-offs.
|--- |  | ---------------------



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SIGNATURES



In accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.



|                      |  |  |  |                        |  |                         |  |                                                                                      
|--------------------- |  |  |  | ---------------------- |  | ----------------------- |  | -------------------------------------------------------------------------------------
|                      |  |  |  | ROTECH HEALTHCARE INC.
|                      |  |  | 
|Dated: March 30, 2005 |  |  |  | By:                    |  | /S/    PHILIP L. CARTER
|                      |  |  |  |                        |  |                         |  | Philip L. Carter, President and Chief Executive Officer (Principal Executive Officer)



POWER OF ATTORNEY



KNOW ALL MEN BY THESE PRESENTS, that each person whose
signature appears below hereby constitutes and appoints Philip L. Carter and Rebecca L. Myers, and each of them, as his true and lawful attorneys-in-fact, as agent with full power of substitution and resubstitution, for him and in his name, place
and stead, in any and all capacities, to sign any or all amendments (including post-effective amendments) to this Form 10-K, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and
Exchange Commission, granting to each such attorney-in-fact and agent full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully and to all intents and purposes as he
might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.



In accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the dates indicated.



|                                                    |  |                                                                               |  |               
|--------------------------------------------------- |  | ----------------------------------------------------------------------------- |  | --------------
|/S/    PHILIP L.
CARTERPhilip
L. Carter             |  | President, Chief Executive Officer and Director (Principal Executive Officer) |  | March 30, 2005
|                                                    |  |                                                                              
|/S/    BARRY E.
STEWARTBarry
E. Stewart             |  | Chief Financial Officer (Principal Financial and Accounting Officer)          |  | March 30, 2005
|                                                    |  |                                                                              
|/S/    ARTHUR J.
REIMERSArthur
J. Reimers           |  | Chairman of the Board                                                         |  | March 30, 2005
|                                                    |  |                                                                              
|/S/    EDWARD L. KUNTZEdward L. Kuntz               |  | Director                                                                      |  | March 30, 2005
|                                                    |  |                                                                              
|/S/    WILLIAM J.
MERCERWilliam
J. Mercer           |  | Director                                                                      |  | March 30, 2005
|                                                    |  |                                                                              
|/S/    WILLIAM WALLACE
ABBOTTWilliam
Wallace Abbott |  | Director                                                                      |  | March 30, 2005
|                                                    |  |                                                                              
|/S/    GUY P. SANSONEGuy P. Sansone                 |  | Director                                                                      |  | March 30, 2005
|                                                    |  |                                                                              
|/S/    ARTHUR SIEGELArthur Siegel                   |  | Director                                                                      |  | March 30, 2005





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EXHIBIT INDEX



|               |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-------------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Title                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|               | 
|2.1(a)         |  | Second Amended Joint Plan of Reorganization of Rotech Medical Corporation and its subsidiaries under Chapter 11 of the Bankruptcy Code dated February 7, 2002.                                                                                                                                                                                                                                                                                                                                                                                                            
|               | 
|3.1(b)         |  | Certificate of Incorporation of Rotech Healthcare Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|               | 
|3.2            |  | Amended and Restated Bylaws of Rotech Healthcare Inc.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|               | 
|4.1(b)         |  | Form of specimen common stock certificate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|               | 
|4.2(a)         |  | Indenture dated as of March 26, 2002 by and among Rotech Healthcare Inc., each of the Guarantors named therein and The Bank of New York.                                                                                                                                                                                                                                                                                                                                                                                                                                  
|               | 
|4.3(a)         |  | Form of 91⁄2% Senior Subordinated Notes due 2012 (included with Exhibit 4.2).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|               | 
|10.1(c)        |  | Rotech Healthcare Inc. Common Stock Option Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|               | 
|10.2(c)        |  | Amendment No. 1 to the Rotech Healthcare Inc. Common Stock Option Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|               | 
|10.3(d)        |  | Amendment No. 2 to the Rotech Healthcare Inc. Common Stock Option Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|               | 
|10.4(e)        |  | Amendment No. 3 to the Rotech Healthcare Inc. Common Stock Option Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|               | 
|10.5(f)        |  | Form of Common Stock Option Agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|               | 
|10.6(c)        |  | Rotech Healthcare Inc. Nonemployee Director Restricted Stock Plan.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|               | 
|10.7(c)        |  | Form of Restricted Stock Award Agreement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|               | 
|10.8           |  | Rotech Healthcare Inc. Senior Management Incentive Plan (2005-2007).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|               | 
|10.9(a)        |  | $275,000,000 Credit Agreement among Rotech Healthcare Inc., as Borrower, The Several Lenders From Time to Time Parties hereto, UBS Warburg LLC and Goldman Sachs Credit Partners L.P., as Joint
Lead Arrangers and Joint Bookrunners, Goldman Sachs Credit Partners L.P., as Syndication Agent, The Bank of Nova Scotia, Deutsche Banc Alex. Brown Inc. and General Electric Capital Corporation, as Co-Documentation Agents, General Electric Capital
Corporation, as Collateral Agent, and UBS AG, Stamford Branch, as Administrative Agent, dated as of March 26, 2002.
|               | 
|10.10(g)       |  | Amendment, dated as of December 31, 2002, to the Companys $275,000,000 Credit Agreement dated as of March 26, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|               | 
|10.11(h)       |  | Second Amendment and Waiver, dated as of June 7, 2004, to the Companys $275,000,000 Credit Agreement dated as of March 26, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                         
|               | 
|10.12(a)       |  | Registration Rights Agreement dated as of March 26, 2002, by and among Rotech Healthcare Inc., each of the entities listed on Schedule A thereto, and UBS Warburg LLC, Goldman, Sachs &
Co., Deutsche Banc Alex. Brown Inc. and Scotia Capital (USA) Inc.                                                                                                                                                                                                                                                                                                                 
|               | 
|10.13(b)       |  | Amended and Restated Registration Rights Agreement dated June 21, 2002, between Rotech Healthcare Inc., and Oaktree Capital Management, LLC and General Electric Capital
Corporation.                                                                                                                                                                                                                                                                                                                                                                                     
|               | 
|10.14(a)       |  | Transfer Agreement between Rotech Healthcare Inc. and Rotech Medical Corporation dated March 26, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|               | 
|10.15(a)       |  | Tax Sharing Agreement among Integrated Health Services, Inc., Rotech Healthcare Inc. and Rotech Medical Corporation dated as of March 26, 2002.                                                                                                                                                                                                                                                                                                                                                                                                                           
|               | 
|10.16(f)       |  | Trust Agreement by and among Wachovia Bank, National Association and Rotech Healthcare Inc. dated July 27, 2004 with respect to the Rotech Healthcare Inc. Employees Plan.                                                                                                                                                                                                                                                                                                                                                                                                
|               | 
|10.17(i)       |  | Amendment and Restatement of the Rotech Healthcare Inc. Employees Plan effective January 1, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                         



64



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##### Table of Contents

|               |  |                                                                                                                                                                               
|-------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Title                                                                                                                                                                         
|               | 
|10.18(a)       |  | Corporate Integrity Agreement with the Office of Inspector General of the United States Department of Health and Human Services dated February 11, 2002.                      
|               | 
|10.19          |  | First Amended and Restated Employment Agreement with Philip L. Carter dated January 31, 2005.                                                                                 
|               | 
|10.20          |  | First Amended and Restated Employment Agreement with Michael R. Dobbs dated January 31, 2005.                                                                                 
|               | 
|10.21(e)       |  | Addendum to the Employment Agreement between Rotech Healthcare Inc. and Philip L. Carter dated March 19, 2004.                                                                
|               | 
|10.22(e)       |  | Addendum to the Employment Agreement between Rotech Healthcare Inc. and Michael R. Dobbs dated March 19, 2004.                                                                
|               | 
|10.23          |  | Letter agreement with Barry E. Stewart with Respect to Rights upon Termination of Employment dated August 10, 2004.                                                           
|               | 
|12.1           |  | Ratio of Earnings to Fixed Charges                                                                                                                                            
|               | 
|21.1           |  | List of Subsidiaries.                                                                                                                                                         
|               | 
|23.1           |  | Consent of Deloitte & Touche LLP, independent auditors.                                                                                                                       
|               | 
|24.1           |  | Power of Attorney (included on signature page of this report).                                                                                                                
|               | 
|31.1           |  | Certification of principal executive officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                       
|               | 
|31.2           |  | Certification of principal financial officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                       
|               | 
|32.1           |  | Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

---

|(a) |  | Incorporated by Reference to our Registration Statement on Form S-4 (file No. 333-100750) filed with the Securities and Exchange Commission on October 25, 2002, as amended January
27, 2003, February 10, 2003 and February 13, 2003.
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(b) |  | Incorporated by Reference to our Registration Statement on Form 8-A (file No. 000-50940) filed with the Securities and Exchange Commission on September 15, 2004.
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



|(c) |  | Incorporated by Reference to our Registration Statement on Form S-8 (file No. 333-119008) filed with the Securities and Exchange Commission on September 15, 2004.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(d) |  | Incorporated by Reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2003 filed with the Securities and Exchange Commission on November 14, 2003.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(e) |  | Incorporated by Reference to our Annual Report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission on April 14, 2004.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(f) |  | Incorporated by Reference to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2004 filed with the Securities and Exchange Commission on November 15, 2004.
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(g) |  | Incorporated by Reference to our Quarterly Report on Form 10-Q for the quarter ended March 31, 2003 filed with the Securities and Exchange Commission on May 15, 2003.
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(h) |  | Incorporated by Reference to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004 filed with the Securities and Exchange Commission on August 16, 2004.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|(i) |  | Incorporated by Reference to our Annual Report on Form 10-K for the year ended December 31, 2002 filed with the Securities and Exchange Commission on March 31, 2003.
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------



65



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##### Table of Contents



ROTECH HEALTHCARE INC.
AND SUBSIDIARIES



Table of Contents



|                                                                                                                                                                                                   |  |     
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|                                                                                                                                                                                                   |  | Page
|Report of Independent Registered Public Accounting Firm                                                                                                                                            |  | F-2 
|                                                                                                                                                                                                   | 
|Consolidated Balance Sheets as of December 31, 2003 and 2004                                                                                                                                       |  | F-3 
|                                                                                                                                                                                                   | 
|Consolidated Statements of Operations for the three months ended March 31, 2002 and nine months ended December 31, 2002 and the years ended December 31, 2003 and December 31, 2004                |  | F-4 
|                                                                                                                                                                                                   | 
|Consolidated Statements of Changes in Stockholders Equity for the three months ended March 31, 2002 and nine months ended December 31, 2002 and the years December 31, 2003 and December 31, 2004 |  | F-5 
|                                                                                                                                                                                                   | 
|Consolidated Statements of Cash Flows for the three months ended March 31, 2002 and nine months ended December 31, 2002 and the years ended December 31, 2003 and December 31, 2004                |  | F-6 
|                                                                                                                                                                                                   | 
|Notes to Consolidated Financial Statements                                                                                                                                                         |  | F-7 



F-1



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##### Table of Contents

Report of Independent Registered Public Accounting Firm



To the Board of Directors and Stockholders of

Rotech Healthcare Inc.



We have audited the accompanying consolidated balance sheets of Rotech Healthcare Inc. and subsidiaries as of December 31,
2003 and 2004, and the related consolidated statements of operations, changes in stockholders equity, and cash flows for the nine months ended December 31 2002, and the years ended December 31, 2003 and 2004 (Successor Company operations), and
for the three months ended March 31, 2002 (Predecessor Company operations). Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and financial statement schedule are the responsibility
of the Companys management. Our responsibility is to express an opinion on the financial statements and financial statement schedule based on our audits.



We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial
reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances but not for the purpose of expressing an opinion on the effectiveness of the
Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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.



As discussed in Note 3 to the financial statements, on February 13, 2002, the
Bankruptcy Court entered an order confirming the plan of reorganization which became effective after the close of business on March 26, 2002. Accordingly, the accompanying financial statements have been prepared in conformity with AICPA Statement of
Position 90-7, Financial Reporting for Entities in Reorganization Under the Bankruptcy Code, for the successor company as a new entity with assets, liabilities, and a capital structure having carrying values not comparable with prior periods
as described in Note 1.



In our opinion, the consolidated
financial statements present fairly, in all material respects, the consolidated financial position of the Rotech Healthcare Inc. and subsidiaries as of December 31, 2003 and 2004, and the results of their operations for the nine months ended
December 31, 2002 and the years ended December 31, 2003 and 2004, (Successor Company operations), in conformity with accounting principles generally accepted in the United States of America. Further, in our opinion, the Predecessor Company financial
statements referred to above present fairly, in all material respects, the consolidated results of their operations for the three months ended March 31, 2002, in conformity with accounting principles generally accepted in the United States of
America. 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.



Deloitte & Touche LLP



Orlando, Florida

March 29, 2005



F-2



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

December 31, 2003 and 2004

(In thousands, except share and per share data)



|                                                                                                                                                                                                                                    |  |                  |         |                  |   |          
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | ------- | ---------------- | - | ---------
|                                                                                                                                                                                                                                    |  | December 31,2003 |         | December 31,2004
|Assets                                                                                                                                                                                                                              |  |                  |         |                  |   |          
|Current assets:                                                                                                                                                                                                                     |  |                  |         |                  |   |          
|Cash and cash equivalents                                                                                                                                                                                                           |  | $                | 20,980  |                  | $ | 64,823   
|Accounts receivable, net                                                                                                                                                                                                            |  |                  | 81,862  |                  |   | 76,806   
|Other accounts receivable                                                                                                                                                                                                           |  |                  | 892     |                  |   | 1,172    
|Inventories                                                                                                                                                                                                                         |  |                  | 7,989   |                  |   | 8,726    
|Prepaid expenses                                                                                                                                                                                                                    |  |                  | 4,328   |                  |   | 4,794    
|Income tax receivable                                                                                                                                                                                                               |  |                  | 2,531   |                  |   |         
|Deferred tax asset                                                                                                                                                                                                                  |  |                  | 12,721  |                  |   | 12,911   
|                                                                                                                                                                                                                                    |  |                  |         |                  |   |          
|Total current assets                                                                                                                                                                                                                |  |                  | 131,303 |                  |   | 169,997  
|Property and equipment, net                                                                                                                                                                                                         |  |                  | 150,752 |                  |   | 129,403  
|Intangible assets (less accumulated amortization of $2,320 in 2003 and $3,394 in 2004)                                                                                                                                              |  |                  | 17,684  |                  |   | 16,610   
|Other goodwill                                                                                                                                                                                                                      |  |                  | 11,256  |                  |   | 11,256   
|Reorganization value in excess of fair value of identifiable assetsgoodwill                                                                                                                                                        |  |                  | 668,347 |                  |   | 668,347  
|Other assets                                                                                                                                                                                                                        |  |                  | 13,941  |                  |   | 12,551   
|                                                                                                                                                                                                                                    |  |                  |         |                  |   |          
|                                                                                                                                                                                                                                    |  | $                | 993,283 |                  | $ | 1,007,399
|                                                                                                                                                                                                                                    |  |                  |         |                  |   |          
|Liabilities and Stockholders Equity                                                                                                                                                                                                |  |                  |         |                  |   |          
|Current liabilities:                                                                                                                                                                                                                |  |                  |         |                  |   |          
|Accounts payable                                                                                                                                                                                                                    |  | $                | 16,652  |                  | $ | 18,465   
|Accrued expenses                                                                                                                                                                                                                    |  |                  | 27,034  |                  |   | 14,808   
|Accrued interest                                                                                                                                                                                                                    |  |                  | 9,873   |                  |   | 7,295    
|Dividends payable                                                                                                                                                                                                                   |  |                  |        |                  |   | 900      
|Deferred revenue                                                                                                                                                                                                                    |  |                  | 13,768  |                  |   | 10,335   
|Income taxes payable                                                                                                                                                                                                                |  |                  |        |                  |   | 2,805    
|Current portion of capital leases                                                                                                                                                                                                   |  |                  |        |                  |   | 207      
|Current portion of long-term debt                                                                                                                                                                                                   |  |                  | 692     |                  |   | 439      
|                                                                                                                                                                                                                                    |  |                  |         |                  |   |          
|Total current liabilities                                                                                                                                                                                                           |  |                  | 68,019  |                  |   | 55,254   
|Deferred tax liabilities                                                                                                                                                                                                            |  |                  | 25,905  |                  |   | 50,049   
|Priority tax claim                                                                                                                                                                                                                  |  |                  | 8,352   |                  |   | 5,707    
|Capital leases, less current portion                                                                                                                                                                                                |  |                  |        |                  |   | 293      
|Long-term debt, less current portion                                                                                                                                                                                                |  |                  | 367,308 |                  |   | 329,232  
|                                                                                                                                                                                                                                    |  |                 
|Series A convertible redeemable preferred stock, stated value $20 per share, 1,000,000 shares authorized, 250,000 shares issued and
outstanding at December 31, 2003 and 249,196 shares issued and outstanding at December 31, 2004 |  |                  | 6,101   |                  |   | 5,343    
|                                                                                                                                                                                                                                    |  |                 
|Stockholders equity:                                                                                                                                                                                                               |  |                  |         |                  |   |          
|Common stock, par value $.0001 per share 50,000,000 shares authorized, 25,042,029 shares issued and outstanding at December 31, 2003 and
25,323,745 shares issued and outstanding at December 31, 2004                              |  |                  | 3       |                  |   | 3        
|Additional paid-in capital                                                                                                                                                                                                          |  |                  | 495,881 |                  |   | 502,037  
|Retained earnings                                                                                                                                                                                                                   |  |                  | 21,714  |                  |   | 59,481   
|                                                                                                                                                                                                                                    |  |                  |         |                  |   |          
|Total stockholders equity                                                                                                                                                                                                          |  |                  | 517,598 |                  |   | 561,521  
|                                                                                                                                                                                                                                    |  |                  |         |                  |   |          
|                                                                                                                                                                                                                                    |  | $                | 993,283 |                  | $ | 1,007,399
|                                                                                                                                                                                                                                    |  |                  |         |                  |   |          



See accompanying notes
to consolidated financial statements.



F-3



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except share and per share data)



|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|--------------------------------------------------------------------------------- |  | --------------------------------- | -------- | - | ----------------------------------- | - | ---------------------------- |  | ---------------------------- | ---------- |  | - | ---------- | -
|                                                                                  |  | Predecessor                       |          |   | Successor                           |  
|                                                                                  |  | Three months ended March 31, 2002 |          |   | Nine months ended December 31, 2002 |   | Year ended December 31, 2003 |  | Year ended December 31, 2004 |           
|Net revenues                                                                      |  | $                                 | 154,750  |   |                                     | $ | 463,025                      |  | $                            | 581,221    |  | $ | 534,503    |  
|Costs and expenses:                                                               |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Cost of net revenues:                                                             |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Product and supply costs                                                          |  |                                   | 22,513   |   |                                     |   | 67,542                       |  |                              | 73,900     |  |   | 70,583     |  
|Patient service equipment depreciation                                            |  |                                   | 12,147   |   |                                     |   | 39,363                       |  |                              | 102,819    |  |   | 61,362     |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Total cost of net revenues                                                        |  |                                   | 34,660   |   |                                     |   | 106,905                      |  |                              | 176,719    |  |   | 131,945    |  
|Provision for doubtful accounts                                                   |  |                                   | 3,661    |   |                                     |   | 11,481                       |  |                              | 20,033     |  |   | 15,214     |  
|Selling, general and administrative                                               |  |                                   | 84,996   |   |                                     |   | 274,300                      |  |                              | 311,075    |  |   | 273,825    |  
|Depreciation and amortization                                                     |  |                                   | 2,839    |   |                                     |   | 8,572                        |  |                              | 16,828     |  |   | 15,191     |  
|Interest (income) expense, net                                                    |  |                                   | (17      | ) |                                     |   | 33,093                       |  |                              | 41,402     |  |   | 33,696     |  
|Other income                                                                      |  |                                   |         |   |                                     |   |                             |  |                              |           |  |   | (2,516     | )
|Provision for inventory losses                                                    |  |                                   | 264      |   |                                     |   |                             |  |                              |           |  |   |           |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Total costs and expenses                                                          |  |                                   | 126,403  |   |                                     |   | 434,351                      |  |                              | 566,057    |  |   | 467,355    |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Earnings (loss) before reorganization items, income taxes and extraordinary items |  |                                   | 28,347   |   |                                     |   | 28,674                       |  |                              | 15,164     |  |   | 67,148     |  
|Reorganization items                                                              |  |                                   | 182,291  |   |                                     |   | 3,899                        |  |                              |           |  |   |           |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Earnings (loss) before income taxes and extraordinary items                       |  |                                   | (153,944 | ) |                                     |   | 24,775                       |  |                              | 15,164     |  |   | 67,148     |  
|Federal and state income (benefit) taxes                                          |  |                                   | (203     | ) |                                     |   | 10,903                       |  |                              | 6,751      |  |   | 28,931     |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Earnings (loss) before extraordinary items                                        |  |                                   | (153,741 | ) |                                     |   | 13,872                       |  |                              | 8,413      |  |   | 38,217     |  
|Extraordinary gain on debt discharge, net of taxes                                |  |                                   | 20,441   |   |                                     |   |                             |  |                              |           |  |   |           |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Net earnings (loss)                                                               |  |                                   | (133,300 | ) |                                     |   | 13,872                       |  |                              | 8,413      |  |   | 38,217     |  
|Accrued dividends on redeemable preferred stock                                   |  |                                   |         |   |                                     |   | 346                          |  |                              | 225        |  |   | 450        |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Net earnings (loss) available for common stockholders                             |  | $                                 | (133,300 | ) |                                     | $ | 13,526                       |  | $                            | 8,188      |  | $ | 37,767     |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Net earnings per common sharebasic                                               |  |                                   |          |   |                                     | $ | 0.54                         |  | $                            | 0.33       |  | $ | 1.50       |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Net earnings per common sharediluted                                             |  |                                   |          |   |                                     | $ | 0.54                         |  | $                            | 0.32       |  | $ | 1.48       |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Weighted average shares outstandingbasic                                         |  |                                   |          |   |                                     |   | 24,999,998                   |  |                              | 25,010,881 |  |   | 25,146,315 |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  
|Weighted average shares outstandingdiluted                                       |  |                                   |          |   |                                     |   | 25,199,998                   |  |                              | 25,363,107 |  |   | 25,744,016 |  
|                                                                                  |  |                                   |          |   |                                     |   |                              |  |                              |            |  |   |            |  



See accompanying notes
to consolidated financial statements.



F-4



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

(In thousands, except share data)



|                                                           |  |                        |   |                        |            |                            |   |   |                   |   |         |                            |  |   |          |   |  |   |          |  
|---------------------------------------------------------- |  | ---------------------- | - | ---------------------- | ---------- | -------------------------- | - | - | ----------------- | - | ------- | -------------------------- |  | - | -------- | - |  | - | -------- | -
|                                                           |  | Shares of Common Stock |   | Par Value Common Stock |            | Additional paid-in capital |   |   | Retained earnings |   |         | Total Stockholders Equity | 
|                                                           |  | Predecessor            |   |                        | Successor  |                            |   |   |                  
|Predecessor:                                               |  |                        |   |                        |            |                            |   |   |                   |   |         |                            |  |   |          |   |  |   |          |  
|Balance at December 31, 2001                               |  | 1,000                  |   |                        |           |                            | $ | 1 |                   | $ | 565,893 |                            |  | $ | 122,202  |   |  | $ | 688,096  |  
|Net loss for the three months ended March 31, 2002         |  |                       |   |                        |            |                            |   |  |                   |   |        |                            |  |   | (133,300 | ) |  |   | (133,300 | )
|Fresh-start reporting adjustments                          |  | (1,000                 | ) |                        | 24,999,998 |                            |   | 1 |                   |   | (70,895 | )                          |  |   | 11,098   |   |  |   | (59,796  | )
|                                                           |  |                        |   |                        |            |                            |   |   |                   |   |         |                            |  |   |          |   |  |   |          |  
|                                                           |  |                        |   |                        |            |                           
|Successor:                                                 |  |                        |   |                        |            |                            |   |   |                   |   |         |                            |  |   |          |   |  |   |          |  
|Balance at March 31, 2002                                  |  |                       |   |                        | 24,999,998 |                            |   | 2 |                   |   | 494,998 |                            |  |   |         |   |  |   | 495,000  |  
|Net earnings for the nine months ended December 31, 2002   |  |                        |   |                        |            |                            |   |  |                   |   |        |                            |  |   | 13,872   |   |  |   | 13,872   |  
|Accrued dividends on redeemable preferred stock            |  |                       |   |                        |           |                            |   |  |                   |   |        |                            |  |   | (346     | ) |  |   | (346     | )
|                                                           |  |                        |   |                        |            |                            |   |   |                   |   |         |                            |  |   |          |   |  |   |          |  
|Balance at December 31, 2002                               |  |                       |   |                        | 24,999,998 |                            |   | 2 |                   |   | 494,998 |                            |  |   | 13,526   |   |  |   | 508,526  |  
|Net earnings for the twelve months ended December 31, 2003 |  |                        |   |                        |           |                            |   |  |                   |   |        |                            |  |   | 8,413    |   |  |   | 8,413    |  
|Tax benefit from exercise of stock options                 |  |                        |   |                        |           |                            |   |  |                   |   | 56      |                            |  |   |         |   |  |   | 56       |  
|Proceeds from exercise of stock options                    |  |                        |   |                        | 42,031     |                            |   | 1 |                   |   | 827     |                            |  |   |         |   |  |   | 828      |  
|Accrued dividends on redeemable preferred stock            |  |                        |   |                        |           |                            |   |  |                   |   |        |                            |  |   | (225     | ) |  |   | (225     | )
|                                                           |  |                        |   |                        |            |                            |   |   |                   |   |         |                            |  |   |          |   |  |   |          |  
|Balance at December 31, 2003                               |  |                       |   |                        | 25,042,029 |                            | $ | 3 |                   | $ | 495,881 |                            |  | $ | 21,714   |   |  | $ | 517,598  |  
|Net earnings for the twelve months ended December 31, 2004 |  |                       |   |                        |           |                            |   |  |                   |   |        |                            |  |   | 38,217   |   |  |   | 38,217   |  
|Tax benefit from exercise of stock options                 |  |                       |   |                        |           |                            |   |  |                   |   | 419     |                            |  |   |         |   |  |   | 419      |  
|Proceeds from exercise of stock options                    |  |                       |   |                        | 281,716    |                            |   |  |                   |   | 5,737   |                            |  |   |         |   |  |   | 5,737    |  
|Accrued dividends on redeemable preferred stock            |  |                       |   |                        |           |                            |   |  |                   |   |        |                            |  |   | (450     | ) |  |   | (450     | )
|                                                           |  |                        |   |                        |            |                            |   |   |                   |   |         |                            |  |   |          |   |  |   |          |  
|Balance at December 31, 2004                               |  |                       |   |                        | 25,323,745 |                            | $ | 3 |                   | $ | 502,037 |                            |  | $ | 59,481   |   |  | $ | 561,521  |  
|                                                           |  |                        |   |                        |            |                            |   |   |                   |   |         |                            |  |   |          |   |  |   |          |  





See accompanying notes to consolidated financial statements.



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##### Table of Contents

ROTECH HEALTHCARE INC. AND SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|------------------------------------------------------------------------------------------ |  | ---------------------------- | -------- | - | ------------------------------ | - | ------- | ----------------------- |  | - | -------- | - |  | - | ------- | -
|                                                                                           |  | Predecessor                  |          |   | Successor                      |  
|                                                                                           |  | Three months ended March 31, |          |   | Nine months ended December 31, |   |         | Year ended December 31, | 
|                                                                                           |  | 2002                         |          |   | 2002                           |   |         | 2003                    |  |   | 2004     |  
|Net earnings (loss)                                                                        |  | $                            | (133,300 | ) |                                | $ | 13,526  |                         |  | $ | 8,188    |   |  | $ | 37,767  |  
|Adjustments to reconcile net earnings (loss) to net cash provided by operating activities: |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Reorganization items                                                                       |  |                              | 182,291  |   |                                |   | 3,899   |                         |  |   |         |   |  |   |        |  
|Provision for doubtful accounts                                                            |  |                              | 3,661    |   |                                |   | 11,481  |                         |  |   | 20,033   |   |  |   | 15,214  |  
|Depreciation and amortization                                                              |  |                              | 14,986   |   |                                |   | 47,935  |                         |  |   | 119,647  |   |  |   | 79,124  |  
|Loss on disposal of fixed assets                                                           |  |                              |         |   |                                |   |        |                         |  |   | 367      |   |  |   | 371     |  
|Dividends accrued                                                                          |  |                              |         |   |                                |   | 346     |                         |  |   | 225      |   |  |   | 450     |  
|Loss on extinguishment of debt                                                             |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   | 910     |  
|Deferred income taxes                                                                      |  |                              |         |   |                                |   | (448    | )                       |  |   | 2,971    |   |  |   | 23,954  |  
|Extraordinary gain on debt discharge                                                       |  |                              | (20,441  | ) |                                |   |        |                         |  |   |         |   |  |   |        |  
|Changes in operating assets and liabilities:                                               |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|(Increase) decrease in accounts receivable                                                 |  |                              | (7,998   | ) |                                |   | 9,843   |                         |  |   | (4,177   | ) |  |   | (10,158 | )
|Decrease (increase) in other receivables                                                   |  |                              | 1,146    |   |                                |   | (3,814  | )                       |  |   | 1,174    |   |  |   | (280    | )
|(Increase) decrease in inventories                                                         |  |                              | (2,045   | ) |                                |   | 2,469   |                         |  |   | 3,994    |   |  |   | (737    | )
|Decrease (increase) in prepaid expenses                                                    |  |                              | 124      |   |                                |   | (798    | )                       |  |   | (699     | ) |  |   | (466    | )
|Decrease in income tax receivable                                                          |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   | 2,531   |  
|(Increase) decrease in other assets                                                        |  |                              | (6,929   | ) |                                |   | (363    | )                       |  |   | 5,541    |   |  |   | (1,179  | )
|(Decrease) increase in accounts payable and accrued expenses                               |  |                              | (5,086   | ) |                                |   | 5,341   |                         |  |   | (9,107   | ) |  |   | (10,413 | )
|(Decrease) in accrued interest                                                             |  |                              |         |   |                                |   | 10,281  |                         |  |   | 122      |   |  |   | (2,886  | )
|Increase in income taxes payable                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   | 3,225   |  
|Decrease in deferred revenue                                                               |  |                              |         |   |                                |   |        |                         |  |   |         |   |  |   | (3,433  | )
|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Net cash provided by operating activities                                                  |  |                              | 26,409   |   |                                |   | 99,698  |                         |  |   | 148,279  |   |  |   | 133,994 |  
|Net cash used by reorganization items                                                      |  |                              | (8,848   | ) |                                |   | (1,710  | )                       |  |   |         |   |  |   |        |  
|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Net cash provided by operating activities and reorganization items                         |  |                              | 17,561   |   |                                |   | 97,988  |                         |  |   | 148,279  |   |  |   | 133,994 |  
|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Cash flows from investing activities:                                                      |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Purchases of property and equipment                                                        |  |                              | (15,299  | ) |                                |   | (47,273 | )                       |  |   | (41,993  | ) |  |   | (54,003 | )
|Business acquisitions                                                                      |  |                              |         |   |                                |   | (2,903  | )                       |  |   | (3,029   | ) |  |   |        |  
|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Net cash used in investing activities                                                      |  |                              | (15,299  | ) |                                |   | (50,176 | )                       |  |   | (45,022  | ) |  |   | (54,003 | )
|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Cash flows from financing activities:                                                      |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Proceeds from long term borrowings                                                         |  |                              | 500,000  |   |                                |   |        |                         |  |   |         |   |  |   |        |  
|Debt issuance costs                                                                        |  |                              | (16,960  | ) |                                |   |        |                         |  |   |         |   |  |   |        |  
|Payments of long term borrowings                                                           |  |                              |         |   |                                |   | (21,487 | )                       |  |   | (110,513 | ) |  |   | (39,240 | )
|Payments of liabilities subject to compromise/priority tax claim                           |  |                              | (27,932  | ) |                                |   |        |                         |  |   | (605     | ) |  |   | (2,645  | )
|Net proceeds from stock option exercises                                                   |  |                              |         |   |                                |   |        |                         |  |   | 829      |   |  |   | 5,737   |  
|Net proceeds from sale/lease back of vehicles                                              |  |                              | 10,191   |   |                                |   |        |                         |  |   |         |   |  |   |        |  
|Distributions to parent company, net                                                       |  |                              | (470,844 | ) |                                |   |        |                         |  |   |         |   |  |   |        |  
|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Net cash used in financing activities                                                      |  |                              | (5,545   | ) |                                |   | (21,487 | )                       |  |   | (110,289 | ) |  |   | (36,148 | )
|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|(Decrease) increase in cash and cash equivalents                                           |  |                              | (3,283   | ) |                                |   | 26,325  |                         |  |   | (7,032   | ) |  |   | 43,843  |  
|Cash and cash equivalents, beginning of period                                             |  |                              | 4,970    |   |                                |   | 1,687   |                         |  |   | 28,012   |   |  |   | 20,980  |  
|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Cash and cash equivalents, end of period                                                   |  | $                            | 1,687    |   |                                | $ | 28,012  |                         |  | $ | 20,980   |   |  | $ | 64,823  |  
|                                                                                           |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Supplemental disclosures of noncash investing and financing activities                     |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Property and equipment acquired through capital leases                                     |  | $                            |         |   |                                | $ |        |                         |  | $ |         |   |  | $ | 500     |  
|Supplemental disclosures of cash flow information:                                         |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Cash payments for:                                                                         |  |                              |          |   |                                |   |         |                         |  |   |          |   |  |   |         |  
|Interest                                                                                   |  | $                            | 14       |   |                                | $ | 23,275  |                         |  | $ | 37,104   |   |  | $ | 33,002  |  
|Income taxes                                                                               |  |                              |         |   |                                | $ | 767     |                         |  | $ | 4,451    |   |  | $ | 1,202   |  



Income tax payments for the three
months ended March 31, 2002 were made on behalf of the Company by Integrated Health Services, Inc. (IHS). Reorganization cash payments are included within the individual line items above.



See accompanying notes to consolidated financial statements.



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ROTECH HEALTHCARE INC. AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Three month period ended March 31, 2002, nine month period ended

December 31, 2002 and Years Ended December 31, 2003 and 2004

(In thousands, except share and per share data)



(1)    Basis of Presentation



The accompanying consolidated financial statements include the accounts of Rotech Healthcare Inc. and its subsidiaries, and its predecessor, Rotech Medical Corporation and its subsidiaries, and have been prepared in
accordance with generally accepted accounting principles for all the periods presented. Rotech Medical Corporation emerged from bankruptcy on March 26, 2002 and transferred to Rotech Healthcare Inc. substantially all of its assets in a restructuring
transaction. The financial statements included herein reflect these transactions effective as of March 31, 2002. As used in these notes, unless otherwise specified or the context otherwise requires, references to the Company refer to the
business and operations of Rotech Healthcare Inc. and its subsidiaries for all periods subsequent to March 31, 2002 and to the business and operations of Rotech Medical Corporation and its subsidiaries for all periods prior to April 1, 2002.
References to the Predecessor refer to Rotech Medical Corporation and its subsidiaries. References to the Successor refer to Rotech Healthcare Inc. and its subsidiaries.



Pursuant to the Plan of Reorganization (the Plan), on March 26, 2002, Rotech
Medical Corporation transferred to Rotech Healthcare Inc. substantially all of the assets it used in connection with its businesses and operations (including stock of substantially all of its subsidiaries). As partial consideration for the transfer
of the assets to Rotech Healthcare Inc., Rotech Healthcare Inc. transferred to Rotech Medical Corporation 24,999,998 shares of common stock, which represented all of its outstanding shares of common stock, for further distribution by Rotech Medical
Corporation to its senior creditors as contemplated by the Plan.



The Companys certificate of incorporation authorizes the Company to issue up to 250,000 shares of Series A Convertible Redeemable Preferred Stock with an aggregate face value of $5,000. Concurrent with the effectiveness of the Plan,
the Company issued all of the shares of Series A Convertible Redeemable Preferred Stock to an employee profit sharing plan.



In connection with its emergence from bankruptcy, the Company reflected the terms of the Plan in its consolidated financial statements by adopting the
fresh-start reporting provisions of the American Institute of Certified Public Accountants Statement of Position 90-7, Financial Reporting by Entities in Reorganization Under the Bankruptcy Code (SOP 90-7). SOP 90-7 is applicable because
pre-reorganization shareholders will receive less than 50% of the Companys new common stock and the reorganization value of the assets of the reorganized company is less than the total of all post-petition liabilities and allowed claims. Under
fresh-start reporting, the reorganization value of the Company was allocated to the Companys assets based on their respective fair values similar in nature to the purchase method of accounting for business combinations; any portion not
attributed to specific tangible or identified intangible assets are reported as an intangible asset referred to as reorganization value in excess of value of identifiable assetsgoodwill. For accounting purposes, the fresh-start
adjustments have been recorded in the consolidated financial statements as of March 31, 2002.



For accounting purposes, the Company assumed that the Plan was consummated on March 31, 2002. The consolidated financial statements as of and for the nine month period ended December 31, 2002 are presented for the
Company after the consummation of the Plan. While the adoption of fresh-start reporting as of March 31, 2002 materially changed the amounts previously recorded in the consolidated financial statements of the Predecessor, management believes the
operations of the Predecessor are generally comparable to that of the Successor. However capital costs (rent, interest, deprecation and amortization) of the Predecessor that were based on pre-petition contractual agreements and historical costs are
not comparable to those of the Successor. In



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



addition, the reported financial position and cash flows of the Predecessor for periods prior to April 1, 2002 generally are not comparable to those of the
Successor.



In connection with the implementation of
fresh-start reporting, the Company recorded an extraordinary gain of $20,441 from a gain on debt discharge in accordance with the provisions of the Plan. Additionally, other significant adjustments were also recorded to reflect the provisions of the
Plan and the fair values of the assets and liabilities of the Successor as of March 31, 2002. For accounting purposes, these transactions have been reflected in the operating results of the Predecessor for the three months ended March 31, 2002. See
Note 2.



(2)    Summary of Significant Accounting
Policies



Principles of Consolidation



The consolidated financial statements include the
accounts of the Company and its wholly-owned subsidiaries. All significant intercompany accounts and balances have been eliminated in the consolidated financial statements.



Revenue Recognition



Revenues are recognized when services and related products are provided to patients and are recorded at amounts estimated to be received under
reimbursement arrangements with third-party payors. Revenues derived from capitation arrangements are insignificant.



The Companys rental arrangements generally provide for fixed monthly payments established by fee schedules (subject to capped rentals in some
instances) for as long as the patient is using the equipment and medical necessity continues. Once initial delivery is made to the patient (initial setup), a monthly billing is established based on the initial setup service date. Subsequent to the
Predecessors emergence from bankruptcy, at the end of each reporting period, the Company defers revenue for the portion of the monthly bill which is unearned. No separate revenue is earned from the initial setup process. The Company has no
lease with the patient or third-party payor, no continuing service obligation (other than oxygen refills and servicing equipment based on manufacturers recommendations) after the initial setup, and no refund obligation for the return of
equipment after the monthly billing date.



Revenues for the
sale of durable medical equipment and related supplies, including oxygen equipment, ventilators, wheelchairs, hospital beds and infusion pumps, are recognized at the time of delivery. Revenues for the sale of nebulizer medications, which are
generally dispensed by Company pharmacies and shipped directly to the patients home, are recognized at the time of shipment.



Due to the nature of the industry and the reimbursement environment in which the Company operates, certain estimates are required to record net revenues
and accounts receivable at their net realizable values. Inherent in these estimates is the risk that they will have to be revised or updated as additional information becomes available. Specifically, the complexity of many third-party billing
arrangements and the uncertainty of reimbursement amounts for certain services from certain payors may result in adjustments to amounts originally recorded. Such adjustments are typically identified and recorded at the point of cash application,
claim denial or account review.



Management performs analyses
to evaluate the net realizable value of accounts receivable. Specifically, management considers historical realization data, accounts receivable aging trends, other operating trends and



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



relevant business conditions. Because of continuing changes in the healthcare industry and third-party reimbursement, it is possible that managements
estimates could change, which could impact operations and cash flows.



Net Patient Service Revenues



The
Company derives a significant portion of its revenues from the Medicare and Medicaid programs and from managed care health plans. Payments for services we render to patients covered by these programs may be less than billed charges. For Medicare and
Medicaid revenues, provisions for contractual adjustments are made to reduce the charges to these patients to estimated receipts based upon the programs principles of payment or reimbursement (retrospectively determined). Final payment under
these programs is subject to administrative review and audit, and the Company currently makes provisions for any adjustments which may result. The Companys provisions for contractual allowances under managed care health plans are based
primarily on payment terms. The Company closely monitors its historical collection rates as well as changes in applicable laws, rules and regulations and contract terms to help assure that provisions are made using the most accurate information the
Company believes to be available. However, due to the complexities involved in these estimations, actual payments the Company receives could be different from the amounts the Company estimates and records.



Provision for Doubtful Accounts



Collection of receivables from third party payors and patients is the
Companys primary source of cash and is critical to its operating performance. The Companys primary collection risks relate to patient accounts for which the primary insurance payor has paid, but patient responsibility amounts (generally
deductibles and co-payments) remain outstanding. The Company estimates provisions for doubtful accounts based primarily upon the age of patients account, the economic ability of patients to pay and the effectiveness of the Companys
collection efforts. The Company routinely reviews accounts receivable balances in conjunction with its historical collection rates and other economic conditions which might ultimately affect the collectibility of patient accounts when the Company
considers the adequacy of the amounts the Company records as reserves for doubtful accounts. Significant changes in payer mix, business office operations, economic conditions or trends in federal and state governmental health care coverage could
affect our collection of accounts receivable, cash flows and results of operations.



Cash and Cash Equivalents



Cash and cash equivalents consist of highly liquid debt instruments with original maturities of three months or less at the date of investment by the Company. The Companys cash and cash equivalents are invested
in money market accounts.



Inventories



Inventories consisting principally of medical
supplies, medical equipment and replacement parts, and pharmaceutical products are stated at the lower of cost or market, on a first-in, first-out method.



Property and Equipment



Prior to March 31, 2002, property and equipment was stated at cost. Subsequent to March 31, 2002, property and equipment are stated at cost, adjusted for
the impact of fresh start reporting. Patient service



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



equipment represents medical equipment rented or held for rental to in-home patients. Patient service equipment is accounted for using a composite method,
due to its characteristics of high unit volumes of relative low dollar unit cost items. Under the composite method, the purchase cost of monthly purchases of patient service equipment are capitalized and depreciated over five years using the
straight-line convention, without specific physical tracking of individual items. The Company believes the five year depreciation period provides a proper matching of the cost of patient service equipment with the patient service revenues generated
from use of the equipment, when considering the wear and tear, damage, loss and ultimately scrapping of patient service equipment over its life. Other property and equipment is accounted for by a specific identification system. Depreciation for
other property and equipment is provided on the straight-line method over the estimated useful lives of the assets, seven years for furniture and office equipment, five years for vehicles, three years for computer equipment, and the shorter of the
remaining lease term or the estimated useful life for leasehold improvements.



Capitalized Software



Included in property and equipment are costs related to internally-developed and purchased software that are capitalized and amortized over periods from three to fifteen years. Capitalized costs include direct costs of materials and
services incurred in developing or obtaining internal-use software and payroll and payroll-related costs for employees directly involved in the development of internal-use software. The carrying value of capitalized software is reviewed if the facts
and circumstances suggest that it may be impaired. Indicators of impairment may include a subsequent change in the extent or manner in which the software is used or expected to be used, a significant change to the software is made or expected to be
made or the cost to develop or modify internal-use software exceeds that expected amount. Management does not believe any impairment of its capitalized software existed at December 31, 2004.



Fresh-Start Reporting



The Company adopted fresh-start reporting, effective March 31, 2002. Under
fresh-start reporting, the reorganization value of the Company is allocated to the Companys assets based on their respective fair values in conformity with a method similar in nature to the purchase method of accounting for business
combinations; any portion not attributed to specific tangible or identified intangible assets are reported as an intangible asset referred to as reorganization value in excess of value of identifiable assetsgoodwill. In adopting
fresh-start reporting, the Company engaged an independent financial advisor to assist in the determination of the reorganization value or fair value of the entity. The estimate of reorganization value was based upon the Companys cash flows,
selected comparable market multiples of publicly traded companies, lease obligations, and other applicable valuation techniques. Upon adoption of fresh-start reporting, the Company recorded $651,814 in reorganization value in excess of identifiable
assetsgoodwill.



Additionally, the Predecessor realized a
charge of $182,291 (see Note 3) related to the reorganization under fresh-start accounting as well as realized an extraordinary gain of $20,441 relative to the forgiveness of liabilities. For accounting purposes, the charge and the gain have been
reflected in the operating results of the Predecessor for the three-month period ended March 31, 2002.



Reorganization Value in Excess of Fair Value of Identifiable AssetsGoodwill and Intangible Assets



Reorganization value in excess of fair value of identifiable
assetsgoodwill, represents the portion of reorganization value of the Company at March 26, 2002 that could not be attributed to specific tangible or identified intangible assets recorded in connection with the implementation of fresh-start
reporting.



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Goodwill and intangible assets prior to March 26, 2002, represent the excess of cost over the fair
value of assets acquired and liabilities assumed in business combinations. Prior to January 1, 2002, such assets were amortized on a straight-line basis over an estimated life of approximately 20 years.



Effective January 1, 2002, the Company adopted the provisions of Financial
Accounting Standards Board (FASB) Statement No. 142, Goodwill and Other Intangible Assets) (Statement 142). Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for
impairment at least annually in accordance with the provisions of Statement 142. As a result of adopting Statement 142, goodwill and a portion of the companys intangible assets are no longer amortized. Pursuant to Statement 142, goodwill and
indefinite lived intangible assets must be periodically tested for impairment.



For impairment testing purposes, Management has determined that branch locations have similar economic characteristics and should be aggregated into one reporting unit for assessing fair value. If the carrying amount
of the goodwill and intangible assets exceeds its fair value, an impairment loss is recognized. Fair values for goodwill and intangible assets are determined based upon discounted cash flows, market multiples or appraised values as appropriate.



Management performs the required annual impairment test during
the fourth quarter each year, unless indicators of impairment are present and suggest earlier testing is warranted. During the years ended December 31, 2003 and 2004 the Company completed its impairment reviews, which indicated that there were no
impairments.



The carrying value of goodwill increased by
approximately $8,940 due to the acquisition of Northern Kentucky Respiratory Care (NKR) on February 6, 2003 (see Note 5).



Estimated amortization expense of intangible assets subject to amortization for the next five fiscal years is as follows: 2005$984; 2006$984;
2007$964; 2008$945; 2009$943. Accumulated amortization expense was $2,320 and $3,394 at December 31, 2003 and 2004, respectively.



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##### Table of Contents

ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Provided below is an accounting of intangible assets, goodwill and reorganization value in excess of
fair value of identifiable assetsgoodwill from January 1, 2002 through December 31, 2004:



|                                                                                       |  |                                         |        |   |          |   |          |                                                                                |  |   |         |  
|-------------------------------------------------------------------------------------- |  | --------------------------------------- | ------ | - | -------- | - | -------- | ------------------------------------------------------------------------------ |  | - | ------- | -
|                                                                                       |  | Intangible AssetsSubject toAmortization |        |   | Goodwill |   |          | Reorganization value in excess of fair value of identifiable
assets  goodwill | 
|Balance at January 1, 2002                                                             |  | $                                       | 8,604  |   |          | $ | 774,825  |                                                                                |  | $ |        |  
|Fresh start reporting adjustments                                                      |  |                                         | (8,604 | ) |          |   | (774,825 | )                                                                              |  |   |        |  
|Allocation of reorganization value under fresh start reporting                         |  |                                         | 19,803 |   |          |   |         |                                                                                |  |   | 651,814 |  
|                                                                                       |  |                                         |        |   |          |   |          |                                                                                |  |   |         |  
|Balance at March 31, 2002                                                              |  |                                         | 19,803 |   |          |   |         |                                                                                |  |   | 651,814 |  
|Acquisitions during the nine months ended December 31, 2002                            |  |                                         | 150    |   |          |   | 2,316    |                                                                                |  |   |        |  
|Adjustments to reorganization value in excess of value of identifiable assetsgoodwill |  |                                         |       |   |          |   |         |                                                                                |  |   | 17,109  |  
|Amortization expense for nine months ended December 31, 2002                           |  |                                         | (987   | ) |          |   |         |                                                                                |  |   |        |  
|                                                                                       |  |                                         |        |   |          |   |          |                                                                                |  |   |         |  
|Balance at December 31, 2002                                                           |  |                                         | 18,966 |   |          |   | 2,316    |                                                                                |  |   | 668,923 |  
|Acquisitions during the year ended December 31, 2003                                   |  |                                         | 50     |   |          |   | 8,940    |                                                                                |  |   |        |  
|Adjustments to reorganization value                                                    |  |                                         |       |   |          |   |         |                                                                                |  |   | (576    | )
|Amortization expense for year ended December 31, 2003                                  |  |                                         | (1,332 | ) |          |   |         |                                                                                |  |   |        |  
|                                                                                       |  |                                         |        |   |          |   |          |                                                                                |  |   |         |  
|Balance at December 31, 2003                                                           |  |                                         | 17,684 |   |          |   | 11,256   |                                                                                |  |   | 668,347 |  
|Amortization expense for year ended December 31, 2004                                  |  |                                         | (1,074 | ) |          |   |         |                                                                                |  |   |        |  
|                                                                                       |  |                                         |        |   |          |   |          |                                                                                |  |   |         |  
|Balance at December 31, 2004                                                           |  | $                                       | 16,610 |   |          | $ | 11,256   |                                                                                |  | $ | 668,347 |  
|                                                                                       |  |                                         |        |   |          |   |          |                                                                                |  |   |         |  



Impairment of
Long-Lived Assets



Periodically, when indicators of
impairment are present, the Company evaluates the recoverability of the net carrying value of its property and equipment and its other amortizable intangible assets by comparing the carrying values to the estimated future undiscounted cash flows,
excluding interest. A deficiency in these cash flows relative to the carrying amounts is an indication of the need for a write-down due to impairment. Among other variables, the Company considers factors such as the effects of external changes to
the Companys business environment, competitive pressures, market erosion, technological and regulatory changes as factors which could provide indications of impairment. Based on this analysis, no impairment charge was required for the years
ended December 31, 2003 and 2004.



Deferred Financing
Costs



In conjunction with the closing of the
Companys senior secured term loan and the 91/2% Senior Subordinated Notes due 2012 in March 2002, the
Company capitalized approximately $18,625 in financing costs incurred to obtain the bank loans. These costs are being amortized over eight years, the average life of the bank loans, on a method that approximates the effective interest rate method.
Amortization of the deferred financing costs was approximately $1,866 for the nine month period ended December 31, 2002, $4,746 and $2,572 for the years ended December 31, 2003 and 2004, respectively. Accumulated amortization of the deferred
financing costs was $6,612 and $9,184 as of December 31, 2003 and 2004, respectively.



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Investment in Provider of Home Health Care Products and Services



The Company had an investment in a provider of home health care products and
services (the Provider) in the amount of $6,804 at December 31, 2002. The investment was accounted for using the cost method of accounting and was included in other assets. The Company also entered into a management agreement with the Provider. The
Companys share of the operating results pursuant to the agreement was recorded as management fee income, and classified as revenue in the Companys consolidated statement of operations. Such management fee income was $619 for the three
months ended March 31, 2002, and $1,107 for the nine months ended December 31, 2002.



On February 6, 2003, the Company entered into an Asset Purchase Agreement with the Provider (see Note 5).



Advertising Expense



Advertising costs are expensed as incurred. For the three and nine month periods ending March 31, 2002 and December 31, 2002, and the years ended December
31, 2003 and 2004, the advertising expenses were $435 $918, $725 and $395, respectively.



Rebates and Early Pay Discounts Earned



Rebates and early pay discounts for product sold during a reporting period are estimated and recorded based on a systematic and rational allocation of the cash consideration offered from each vendor to each of the
underlying transactions that results in progress by the Company toward earning the rebate or refund provided the amounts are probable and reasonably estimable. The Company records all rebates based upon volume discounts as a reduction of the prices
for those vendors products, and characterizes the rebate as a reduction of cost of sales in the income statement, in accordance with FASB Emerging Issues Task Force Issue No. (EITF) 02-16: Accounting by a Customer (Including a Reseller) for
Certain Consideration Received from a Vendor (EITF 02-16). If the rebate or refund is not probable and reasonably estimable, it is recognized as the milestones are achieved.



Income Taxes



The Company accounts for income taxes under the asset and liability method.



Deferred tax assets and liabilities are determined based upon differences between financial reporting and the tax bases of
assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Valuation allowances are established when necessary to reduce deferred income tax assets to amounts
expected to be realized.



For the three month period ended
March 31, 2002, the current and deferred tax expense was allocated among the members of the IHS controlled corporate group, including the Predecessor.



Earnings Per Common Share



Basic earnings per share (EPS) is computed by dividing earnings (losses) attributable to common shareholders by the weighted average number of common
shares outstanding for the periods. Diluted EPS reflects the potential dilution of securities that could share in the earnings and are based upon the weighted average number of common and common equivalent shares outstanding during the year. Common
equivalent



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



shares are excluded from the computation of diluted EPS in periods where they have an anti-dilutive effect. The Company uses the treasury stock method to
compute the dilutive effects of potentially dilutive securities.



A reconciliation of the number of common shares used in calculation of basic and diluted EPS for the nine months ended December 31, 2002 and the years ended December 31, 2003 and 2004, respectively are presented below:



|                                                     |  |                                  |  |                             |  |                            
|---------------------------------------------------- |  | -------------------------------- |  | --------------------------- |  | ---------------------------
|                                                     |  | Nine monthsendedDecember 31,2002 |  | Year ended December 31,2003 |  | Year ended December 31,2004
|Weighted average basic shares                        |  | 24,999,998                       |  | 25,010,881                  |  | 25,146,315                 
|Effect of dilutive securities:                       |  |                                  |  |                             |  |                            
|Stock options                                        |  |                                 |  | 352,226                     |  | 397,701                    
|Conversion of convertible redeemable preferred stock |  | 200,000                          |  |                            |  | 200,000                    
|                                                     |  |                                  |  |                             |  |                            
|Weighted average diluted shares                      |  | 25,199,998                       |  | 25,363,107                  |  | 25,744,016                 
|                                                     |  |                                  |  |                             |  |                            



Stock-Based
Compensation



As permitted under FASB Statements 148
and 123, the Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees(APB 25), which prescribes the intrinsic value method of accounting for its stock-based awards issued to
employees and directors. Accordingly, the Company does not currently recognize compensation expense for its stock-based awards to employees in the consolidated statements of operations if issued at fair value.



The Company applies APB 25 for valuing options, and typically the exercise
price of the options granted to employees is equal to or exceeds the fair value of the underlying stock on the date of grant. The Company applies the fair value provisions of Statement 123 for options granted to non-employees who perform services
for the Company. There was no stock-based compensation expense related to stock options for any of the periods presented in the accompanying consolidated statements of operations.



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Had compensation cost been determined on the basis of fair value pursuant to Statement 123, the
Companys net earnings (loss) and basic and diluted earnings (loss) per share would have been as follows for the nine months ended December 31, 2002 and the twelve months ended December 31, 2003 and 2004.



|                                                                                                                                                                                                              |  |      |        |      |   |       |  |   |       
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------ | ---- | - | ----- |  | - | ------
|                                                                                                                                                                                                              |  | 2002 |        | 2003 |   | 2004 
|Net earnings available for common stockholders:                                                                                                                                                               |  |      |        |      |   |       |  |   |       
|As reported                                                                                                                                                                                                   |  | $    | 13,526 |      | $ | 8,188 |  | $ | 37,767
|Add: preferred stock dividends                                                                                                                                                                                |  |      |       |      |   | 225   |  |   | 450   
|Less: employee stock compensation, net of tax, included in net income as reported that would have been included in the determination of net
income had the fair value based method been applied to all awards |  |      | 617    |      |   | 1,225 |  |   | 1,453 
|                                                                                                                                                                                                              |  |      |        |      |   |       |  |   |       
|Pro forma                                                                                                                                                                                                     |  | $    | 12,909 |      | $ | 7,188 |  | $ | 36,764
|                                                                                                                                                                                                              |  |      |        |      |   |       |  |   |       
|Basic net earnings available for common stockholders per share:                                                                                                                                               |  |      |        |      |   |       |  |   |       
|As reported                                                                                                                                                                                                   |  | $    | 0.54   |      | $ | 0.33  |  | $ | 1.50  
|Pro forma                                                                                                                                                                                                     |  | $    | 0.52   |      | $ | 0.28  |  | $ | 1.44  
|Diluted net earnings available for common stockholders per share:                                                                                                                                             |  |      |        |      |   |       |  |   |       
|As reported                                                                                                                                                                                                   |  | $    | 0.54   |      | $ | 0.32  |  | $ | 1.48  
|Pro forma                                                                                                                                                                                                     |  | $    | 0.51   |      | $ | 0.28  |  | $ | 1.43  



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.



Fair Value of Financial Instruments



The Company believes the carrying amounts of cash, patient accounts receivable-net, other accounts receivable, prepaid expenses, accounts payable and
accrued expenses approximate fair value because of the short-term nature of these instruments.



It is not practicable to estimate the fair value of investments in provider of home health care products and services since they are not traded, no quoted values are readily available for similar financial instruments
and the Company believes it is not cost-effective to have valuations performed. However, management believes that there has been no permanent impairment in the value of such investments.



The fair value of the Companys variable rate senior secured term loan approximates its carrying value, because the
current interest rates approximate rates at which similar types of borrowing arrangements could be currently obtained by the Company. The fair value of the Companys senior subordinated notes are estimated based upon a discounted value of the
future cash flows expected to be paid over the maturity period of these notes. The estimated fair value of the senior subordinated notes at December 31, 2003 and 2004 was $321,000 and $315,700, respectively.





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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Concentrations of Credit Risk



The Companys revenue is generated through approximately 475 locations
in 48 states. The Company generally does not require collateral or other security in extending credit to patients; however, the Company routinely obtains assignment of (or is otherwise entitled to receive) benefits receivable under the health
insurance programs, plans or policies of patients (e.g., Medicare, Medicaid, commercial insurance and managed care organizations). Revenues were derived from the following payor sources for the periods ended:



|                                                                                           |  |                                   |   |  |                                     |   |  |                                       |   |  |                                       |  
|------------------------------------------------------------------------------------------ |  | --------------------------------- | - |  | ----------------------------------- | - |  | ------------------------------------- | - |  | ------------------------------------- | -
|                                                                                           |  | Predecessor                       |   |  | Successor                           |  
|                                                                                           |  | Three months ended March 31, 2002 |   |  | Nine months ended December 31, 2002 |   |  | Twelve months ended December 31, 2003 |   |  | Twelve months ended December 31, 2004 |  
|Medicare, Medicaid and other federally funded programs (primarily Veterans Administration) |  | 67.9                              | % |  | 69.1                                | % |  | 71.1                                  | % |  | 71.0                                  | %
|Private payors                                                                             |  | 6.5                               | % |  | 5.8                                 | % |  | 4.6                                   | % |  | 3.5                                   | %
|Commercial payors                                                                          |  | 25.6                              | % |  | 25.1                                | % |  | 24.3                                  | % |  | 25.5                                  | %
|                                                                                           |  |                                   |   |  |                                     |   |  |                                       |   |  |                                       |  
|                                                                                           |  | 100.0                             | % |  | 100.0                               | % |  | 100.0                                 | % |  | 100.0                                 | %
|                                                                                           |  |                                   |   |  |                                     |   |  |                                       |   |  |                                       |  



Segment
Information



The Company follows a centralized
approach to management of its branch locations through standard operating procedures developed and monitored at the corporate level. Each autonomous branch location provides essentially the same products and services to customers at similar margins
through similar distribution and delivery methods. Management reporting and analysis is done on a monthly basis for each location, and then aggregated for analysis as one operating segment for the chief operating decision maker. Additionally, each
location operates in a highly regulated environment principally subjected to the same Medicaid and Medicare reimbursements and operating regulations. Additionally, management continually monitors the revenue, profits and losses, and allocated assets
to each location for the assessments of whether quantitative thresholds have been exceeded under the aggregation criteria in FASB Statement 131. Disclosures about Segments of an Enterprise and Related Information.The Company operates in one
reportable segment, as defined by Statement 131; the provision of home medical equipment and related products and services.



Recent Accounting Pronouncements



In June 2002, the FASB issued Statement 146,Accounting for Costs Associated With Exit or Disposal Activities(Statement 146). Statement 146
addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies (EITF) 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain
Costs Incurred in a Restructuring)(EITF 94-3). Statement 146 requires costs associated with exit or disposal activities to be recognized when the costs are incurred, rather than at a date of commitment to an exit or disposal plan. Statement 146
was effective for exit or disposal activities that are initiated after December 31, 2002. The impact of adopting this standard did not have a material impact on the Companys consolidated financial statements.



In December 2002, Statement 148, Accounting for Stock-Based
CompensationTransition and Disclosure(Statement 148) was issued by the FASB. This standard amends Statement 123, Accounting for Stock-Based Compensation(Statement 123), to provide alternative methods of transition for a voluntary
change to the fair value method of accounting for stock-based employee compensation. In addition, this standard amends the



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



disclosure requirements of Statement 123 to require prominent disclosure in both annual and interim financial statements about the method of accounting for
stock-based employee compensation and the effect of the method used on reported results. Statement 148 is effective for financial statements for fiscal years ending after December 15, 2002. The Company implemented Statement 148 effective January 1,
2003 regarding disclosure requirements for condensed financial statements. The Company did not change to the fair value based method of accounting for stock-based employee compensation during 2003 or 2004.



In May 2003, the FASB issued Statement No. 150, Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity (Statement 150). This statement established standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and
equity. It requires the issuer to classify a financial instrument that is within the scope of the standard as a liability if such financial instrument embodies an unconditional obligation of the issuer. It was effective for financial instruments
entered into or modified after May 31, 2003, and otherwise was effective at the beginning of the first interim period beginning after June 15, 2003. The Company adopted Statement 150 during the third quarter of 2003 and classified and accounted for
our Series A Convertible Redeemable Preferred Stock (the Series A Preferred) as a liability on our consolidated financial statements from July 1, 2003 through September 30, 2004. The Company has re-considered the implementation of Statement 150
effective October 1, 2004. The Series A Preferred does not contain an unconditional obligation to redeem as defined in Statement 150. The Series A Preferred has conditional redemption features. Immediately prior to the closing of a firm commitment
underwritten initial public offering of the Companys common stock pursuant to an effective registration statement under the Securities Act of 1933, which offering yields gross proceeds to the Company of no less than $100,000, each holder of
Series A Preferred may convert their shares into the Companys common stock at the conversion rate of 0.8 shares of common stock for each share of Series A Preferred. In addition, after the fifth anniversary of the date of the first issuance of
the Series A Preferred, any holder of any shares of the Series A Preferred has the right, at his/her option, to convert all or any portion of his/her Series A Preferred into the Companys common stock at the conversion rate of 0.8 shares of
common stock for each share of Series A Preferred. Therefore, we have reclassified the Series A Preferred from a liability presentation in 2003 to a mezzanine presentation in 2004. The related Series A Preferred return has been classified as
preferred dividends. The Series A Preferred accounts in 2003 have been reclassified in the accompanying consolidated financial statements to conform to the 2004 presentation. The financial statement impact of the change in presentation of the Series
A Preferred was not material for either 2003 or 2004.



In
January 2003, the FASB issued FIN No. 46,Consolidation of Variable Interest Entities (FIN 46), and a revised interpretation of FIN 46 (FIN 46(R)) in December 2003, in an effort to expand upon existing accounting guidance that
addresses when a company should consolidate the financial results of another entity. FIN No. 46 requires variable interest entities, as defined, to be consolidated by a company if that company is subject to a majority of expected losses
of the entity or is entitled to receive a majority of expected residual returns of the entity, or both. A company that is required to consolidate a variable interest entity is referred to as the entitys primary beneficiary. The interpretation
also requires certain disclosures about variable interest entities that a company is not required to consolidate, but in which it has a significant variable interest. The consolidation and disclosure requirements apply immediately to variable
interest entities created after January 31, 2003. The Company is not the primary beneficiary of any variable interest entity created after January 31, 2003 nor does the Company have a significant variable interest in a variable interest entity
created after January 31, 2003. For variable interest entities that existed before February 1, 2003, the consolidation requirements of FIN 46(R) are effective as of March 31, 2004. The adoption of FIN 46(R) will not have a material impact on the
Companys consolidated financial statements.



In December
2004, the FASB issued Statement No. 123R (Statement 123R), Share Based Payment. This statement revises Statement 123 and supersedes APB 25 and amends FASB Statement No. 95, Statement of Cash



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Flows. This statement requires companies to expense the fair value of employee services received in exchange for an award of equity instruments,
including stock options. Statement 123R also provides guidance on valuing and expensing these awards, as well as disclosure requirements with respect to these equity arrangements. Statement 123R is effective for the first interim reporting period
that begins after June 15, 2005.



As currently permitted by
Statement 123, the Company currently accounts for share-based payments to employees using APB 25s intrinsic value method and, as such, the Company generally recognizes no compensation costs for employee stock options. The adoption of Statement
123R will have a negative impact on the Companys results of operations, however, it will have no cash impact on the Companys overall financial position. The Company will adopt the provisions of Statement 123R effective July 1, 2005. The
Company has not yet determined the specific dollar impact that the adoption of Statement 123R will have on its future results of operations.



Reclassifications



Certain amounts presented in the prior periods have been reclassified to conform to the current period presentation.



(3)    Petitions for Reorganization under Chapter 11 and Other
Information



The Predecessor was incorporated on September
1, 1981. The Company, through its subsidiaries, provides respiratory and other home medical equipment and services to patients in the home throughout the United States through its approximately 475 branch locations. In 1997, the Predecessor entered
into a definitive merger agreement pursuant to which the Predecessor became a wholly-owned subsidiary of IHS effective as of October 21, 1997.



On February 2, 2000, IHS and substantially all of its subsidiaries, including the Predecessor and its subsidiaries, filed separate voluntary petitions for
relief under Chapter 11 (Chapter 11) of the United States Bankruptcy Code (the Bankruptcy Code) with the United States Bankruptcy Court in the District of Delaware (the Bankruptcy Court). On November 23, 2001, IHS filed a Plan of Reorganization for
the Predecessor and its subsidiaries, which was approved by the creditors and confirmed by the Bankruptcy Court on February 13, 2002. The Plan became effective on March 26, 2002 as the conditions to the effectiveness of the Plan were fulfilled. On
the effective date, the Predecessor transferred to the Company substantially all of the assets used by it in connection with its businesses and operations (including the stock of substantially all of its subsidiaries).



In February 2002, the Predecessor settled all outstanding government
litigation and pre-petition and certain post-petition claims arising from Medicare payments made to certain of the Companys operating centers as well as claims in unliquidated amounts for a cash settlement of $17 million. The settlement became
effective on March 26, 2002, upon the effectiveness of the Plan.



In addition, on February 13, 2002, IHS and its subsidiaries, including the Predecessor, entered into a stipulation with the Centers for Medicare and Medicaid Services (CMS), whereby CMS was permitted to set off certain underpayments to IHS
with certain overpayments to the Predecessor in exchange for a full release of all CMS claims against IHS and its subsidiaries, including the Predecessor, to the effective date of the stipulation. The Bankruptcy Court signed the stipulation on April
12, 2002.



Reorganization Items



Reorganization items consist of expenses and other costs directly related to
the reorganization of the Predecessor since the Chapter 11 filing.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



During the three months ended March 31, 2002, and the nine months ended December 31, 2002,
reorganization items included in the consolidated statements of operations are summarized as follows:



|                                                                                                                                                                                     |  |                                   |         |                                     |   |      
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | --------------------------------- | ------- | ----------------------------------- | - | -----
|                                                                                                                                                                                     |  | Predecessor                       |         | Successor                          
|                                                                                                                                                                                     |  | Three Months Ended March 31, 2002 |         | Nine Months Ended December 31, 2002
|Severance and terminations                                                                                                                                                           |  | $                                 | 837     |                                     | $ |     
|Legal, accounting and consulting fees                                                                                                                                                |  |                                   | 175     |                                     |   | 1,928
|Loss on sale/leaseback of vehicles                                                                                                                                                   |  |                                   | 4,686   |                                     |   | 169  
|Priority tax claim allowed                                                                                                                                                           |  |                                   | 9,000   |                                     |   |     
|Contribution of convertible redeemable preferred stock to an employee profit sharing plan                                                                                            |  |                                   | 5,000   |                                     |   |     
|Administrative expense claims allowed                                                                                                                                                |  |                                   | 7,800   |                                     |   |     
|Fresh-start reporting adjustments                                                                                                                                                    |  |                                   | 153,197 |                                     |   |     
|Loss on closure of discontinued branch operations and discontinued product lines, long term incentive compensation and other charges resulting
from reorganization and restructuring |  |                                   | 1,596   |                                     |   | 1,802
|                                                                                                                                                                                     |  |                                   |         |                                     |   |      
|                                                                                                                                                                                     |  | $                                 | 182,291 |                                     | $ | 3,899
|                                                                                                                                                                                     |  |                                   |         |                                     |   |      



During the fourth
quarter of 2000, in connection with the reorganization, management of the Predecessor finalized a plan of restructuring to eliminate and discontinue certain product lines and branch locations used in the operations of its business. The Plan
specifically identified products and branches that would not be continued. In 2001, a provision for the closure and consolidation of billing centers of $4,161, a provision for discontinued life insurance on a former employee of the Predecessor of
$1,055 and a provision for the sale of pharmacies of $3,732 was recognized as reorganization expense. For the three-month period ended March 31, 2002, and the nine-month period ended December 31, 2002, the loss of $270 and $13, respectively
represents the write-down of assets.



The restructuring plan to
eliminate and discontinue certain product lines and branch locations identified certain employees who would be terminated as a result of the restructuring. Accordingly, the Company terminated approximately 25 employees and recorded termination costs
of $837 for the three months ended March 31, 2002, respectively. Accrued liabilities for employee severance and termination costs, recognized in accordance with EITF 94-3 Liability Recognition for Certain Employee Termination Benefits and Other
Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring), are summarized as follows for the year ended December 31, 2003:



|                                       |  |   |     |  
|-------------------------------------- |  | - | --- | -
|Balance at December 31, 2002           |  | $ | 62  |  
|Payments charged against the liability |  |   | (62 | )
|                                       |  |   |     |  
|Balance at December 31, 2003           |  | $ | 0   |  
|                                       |  |   |     |  



Major Settlements and Other
Bankruptcy Matters



Subsequent to the filing of the
bankruptcy case on February 2, 2000 (which case was closed by the Delaware Bankruptcy Court on December 20, 2004), the Predecessor was required to seek approval of the



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Bankruptcy Court for certain material decisions regarding its continued operations. The following summarizes the major matters approved during the bankruptcy
case:



Settlement with the United States Federal
Government.    The federal government of the United States filed a $48,000 claim against the Predecessor claiming trebled damages with respect to an underlying $16,000 claim relating to, among other things, claims arising
from Medicare billings as well as claims in unliquidated amounts. Although the Predecessor disputed the validity of the claims and the allowability of a trebled damage claim, in an effort to compromise this and other issues, the Predecessor and the
Department of Justice, or DOJ, entered into a settlement agreement dated on or about February 11, 2002. Pursuant to the terms of the settlement agreement, which was approved by the Bankruptcy Court on February 13, 2002, the Predecessor paid the
federal government $17,000 in cash in full settlement and satisfaction of the aforementioned claims and certain claims which arose during the bankruptcy case.



The parties to the settlement agreement are the Predecessor and its affiliates, the DOJ and the Office of Inspector General for the Department of
Health and Human Services, or DHHS. On March 26, 2002, the effective date of the Plan, the DOJ provided a release of all administrative and civil monetary claims under the False Claims Act, Civil Monetary Penalties Law, Program Fraud Civil Remedies
Act, common law theories of payment by mistake, unjust enrichment, breach of contract, and fraud for the covered conduct in the agreement. The Office of Inspector General also provided the Predecessor with a release of its right to, with respect to
covered conduct in the agreement, permissively exclude us from participating in federal health care programs.



In connection with the settlement agreement, the Predecessor entered into a Corporate Integrity Agreement with the Office of Inspector General for the
DHHS. As the successor to Rotech Medical Corporation, the Company is subject to the terms of the Corporate Integrity Agreement as described below.



Settlement with IHS.    During the pendency of the Chapter 11 case, the Predecessor and IHS operated pursuant to an integrated
cash management system controlled by IHS. Pursuant to the settlement agreement with IHS, among other things, the Predecessor and IHS have fully and finally satisfied the claims they have against each other by a transfer of $40,000 in cash and a
$5,000 promissory note. The Predecessor and IHS exchanged, effective as of the effective date of the plan of reorganization, general releases, which cover all intercompany claims against each other. As the successor to Rotech Medical Corporation,
the Company is subject to the terms of the settlement agreement.



Settlement with CMS.    IHS and its subsidiaries, including the Predecessor, receive reimbursement under Part B of the Medicare Program. The Centers for Medicare and Medicaid Services, or CMS, had asserted that it
overpaid IHS Part B Providers, including the Predecessor, approximately $1,100 in the aggregate for certain services and underpaid approximately $2,500 in the aggregate for certain services. CMS was holding the underpayments in administrative freeze
pending a resolution of its right to set them off against the overpayments. As part of a stipulation filed with the Bankruptcy Court, the parties agreed that CMS is permitted to off-set the underpayments against the overpayments and hold in
administrative freeze the balance remaining after the off-set, subject to (A) mutual agreement by the parties or (B) an order from the Court concerning the disposition of said funds. Effective March 26, 2002, all of (A) CMSs claims against IHS
and its subsidiaries, including the Predecessor, and (B) all of IHSs and its subsidiaries, including the Predecessors, claims against CMS for underpayments arising under Medicare Part B before the February 13, 2002 settlement date
have been released, subject to limited exceptions, including insurance obligations retained by IHS. The Bankruptcy Court signed the stipulation on April 12, 2002.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Corporate Integrity Agreement



The Predecessor and the Office of Inspector General of the DHHS entered into a Corporate Integrity Agreement as part of the
process of settling the federal governments fraud claims against the Predecessor in the bankruptcy proceeding. As the successor to the business and operations of the Predecessor, the Company is subject to the provisions of the Corporate
Integrity Agreement.



Providers and suppliers enter into
corporate integrity agreements as part of settlements with the federal government in order that the federal government will waive its right to permissively exclude them from participating in federal health care programs.



The Corporate Integrity Agreement is for a term of five years. Among other
things, the Corporate Integrity Agreement requires the Company to conduct internal claims reviews related to our Medicare billing. In the first and fourth years of the agreement, the internal claims reviews will also be reviewed by an Independent
Review Organization (IRO). Under certain circumstances, the internal claims reviews may also be reviewed by the IRO in the fifth year of the agreement. KPMG LLP acted as our IRO during the first year of the agreement. The Company must file reports
of the reviews with the Office of Inspector General of the DHHS.



In addition, the Corporate Integrity Agreement imposes upon the Company (including in most instances our officers, directors, employees and others) various training requirements, as well as the need to have certain policies and procedures
in place. It also requires that the Company have a Compliance Officer, several Compliance Liaisons, and a Compliance Committee.



The Corporate Integrity Agreement also mandates that the Company have certain procedures in place with respect to our acquisition process. More
specifically, the Company is required to have an Acquisition Committee which approves all acquisitions before they are consummated. As part of the acquisition process, the Company will be required to conduct operational and file reviews of potential
entities in which the Company might acquire an interest. Assuming that the Company decides to acquire an entity, the Company will be required to provide a report to the Office of Inspector General of the DHHS indicating that the Company followed the
acquisition procedures set forth in the Corporate Integrity Agreement and specifying any corrective action that might be necessary post acquisition.



The Corporate Integrity Agreement restricts the Company from hiring any person or contractor who is ineligible to participate in federal health care
programs, federal procurement or federal non-procurement programs or has been convicted of a criminal offense related to the provision of health care items or services. The Company is obligated to conduct ongoing reviews of the qualifications of all
of our employees and contractors. If a current employee or contractor is or becomes an ineligible employee as contemplated by the Corporate Integrity Agreement, such individual must be relieved of any responsibility for, and removed from any
involvement with, our business operations relating to federal health care programs.



As part of the Corporate Integrity Agreement, the Company also has certain obligations with respect to repayment of identified overpayments and reporting of Material Deficiencies the Company may learn of
with respect to our relationship with federal health care programs. The Company also must submit annual reports to the Office of Inspector General of the DHHS regarding our compliance with the Corporate Integrity Agreement generally. To the extent
that the Company violates the terms of the Corporate Integrity Agreement, the Company may be subject to substantial penalties, including stipulated cash penalties ranging from $1 per day to $2.5 per day for each day the Company is in breach of the
agreement, and, possibly, exclusion from federal health care programs.



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##### Table of Contents

ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(4)    Accounts Receivable



Accounts receivable, net of allowances for doubtful accounts consist of the following at December 31:



|                                     |  |      |        |      |   |       
|------------------------------------ |  | ---- | ------ | ---- | - | ------
|                                     |  | 2003 |        | 2004
|Patient accounts receivable          |  | $    | 98,809 |      | $ | 88,379
|Less allowance for doubtful accounts |  |      | 16,947 |      |   | 11,573
|                                     |  |      |        |      |   |       
|                                     |  | $    | 81,862 |      | $ | 76,806
|                                     |  |      |        |      |   |       



Included in patient
accounts receivable at December 31, 2003 and 2004 are amounts due from Medicare, Medicaid and other federally funded programs (primarily Veterans Administration) which represents 58% and 57% of total outstanding receivables, respectively.



Included in accounts receivable are earned but unbilled
receivables of $14,822 at December 31, 2003 and $12,254 at December 31, 2004. Billing backlogs, ranging from a day to several weeks, can occur due to delays in obtaining certain required payor-specific documentation from internal and external
sources.



(5)    Business Acquisitions



On February 6, 2003, the Company entered into an asset purchase agreement
with Daniels Investment, Inc. doing business as Northern Kentucky Respiratory Care (NKR) to acquire its principal operating assets and certain liabilities (including a loan and outstanding management fees owed to the Company) for a cash purchase
price of up to $5,000.



Pursuant to the asset purchase
agreement, the Company paid $2,000 in cash on the closing date, with the remaining cash purchase price to be paid out based on an earn-out provision in the agreement. During 2003, $1,000 was paid in cash as part of the purchase price.



The business combination of NKR was accounted for by the purchase method of
accounting. The results of the operations of the acquired business are included in the condensed consolidated financial statements from the purchase date. The Company acquired the following assets and liabilities in the NKR acquisition:



|                                                |  |   |        |  
|----------------------------------------------- |  | - | ------ | -
|Cash                                            |  | $ | 127    |  
|Accounts receivable                             |  |   | 300    |  
|Property and equipment                          |  |   | 613    |  
|Intangible assets                               |  |   | 50     |  
|Goodwill                                        |  |   | 8,940  |  
|Assumption of liabilities                       |  |   | (66    | )
|                                                |  |   |        |  
|Fair value of purchased assets                  |  | $ | 9,964  |  
|Loan and management fees payable to the Company |  |   | (6,964 | )
|                                                |  |   |        |  
|Cash paid for acquisition                       |  | $ | 3,000  |  
|                                                |  |   |        |  



The purchase price is
subject to change until December 31, 2005, the date the earn-out period expires. The unaudited pro forma effects of the acquisition of NKR on the Companys revenues, net earnings and net earnings per share, for the period ended December 31,
2002 and 2003, had the acquisition occurred on January 1, 2002 and January 1, 2003, are not material and are not presented.



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##### Table of Contents

ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



There were no acquisitions during 2004.



The Company allocates the cost of its business acquisitions to the respective assets acquired and liabilities assumed,
including pre-acquisition contingencies, on the basis of estimated fair values at the date of acquisition. Often the Company must wait for resolution or final measurement of contingencies and valuation estimates during the allocation period, which
does not exceed one year from the date of acquisition. Accordingly, the effect of the resolution or final measurement of such matters during the allocation period is treated as an acquisition adjustment primarily to the amount of goodwill recorded.
After the allocation period, such resolution or final measurement is recognized in the determination of net earnings. Pre-acquisition contingencies in connection with the Companys business acquisitions primarily relate to Medicare and Medicaid
regulatory compliance matters, income tax matters and legal proceedings. During the three year period ended December 31, 2004, the Company resolved or completed the final measurement of certain pre-acquisition contingencies related to business
acquisitions; however, the effect of such adjustments was not significant to the Companys consolidated financial statements.



(6)    Property and Equipment



Property and equipment consist of the following at December 31:



|                                               |  |      |         |      |   |        
|---------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                               |  | 2003 |         | 2004
|Patient service equipment                      |  | $    | 266,421 |      | $ | 250,973
|Furniture, office equipment and software       |  |      | 36,651  |      |   | 51,244 
|Vehicles                                       |  |      | 4,783   |      |   | 4,077  
|Leasehold improvements                         |  |      | 6,992   |      |   | 10,201 
|                                               |  |      |         |      |   |        
|                                               |  |      | 314,847 |      |   | 316,495
|Less accumulated depreciation and amortization |  |      | 164,095 |      |   | 187,092
|                                               |  |      |         |      |   |        
|                                               |  | $    | 150,752 |      | $ | 129,403
|                                               |  |      |         |      |   |        



Effective April 1,
2003, we changed our estimated useful life on certain long-lived assets acquired from our predecessor, Rotech Medical Corporation. The estimated useful life of certain acquired rental property was changed from an aggregate of four years from the
date acquired from our predecessor to a five-year useful life from the original acquisition date by our predecessor. The change increased depreciation expense in the twelve months ended December 31, 2003 by $42,500 and decreased net income by
approximately $23,800, or $0.95 per basic share and $0.94 per diluted share for the fiscal year ended December 31, 2003. The change in estimate was made to more closely match the replacement rates of rental property acquired with its specific
remaining useful life.



During 2004, the Company undertook a
project to physically count the patient service equipment within all the respective operating locations and to estimate the equipment utilized for rental within patient homes, in order



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



to refine the estimate of patient service equipment being accounted for under the composite method (see Note 2). As a result of this project, the Company
believes that certain of the equipment acquired from the Predecessor, is no longer in service or held by the Company or its patients. Such equipment is presumed to have been fully depreciated prior to December 31, 2004. Accordingly, the Company has
reduced the gross patient service equipment account and the related accumulated depreciation by offsetting $52 million. This adjustment had no impact on our results of operations in 2004.



(7)    Other Assets



Other assets consist of the following at December 31:



|                           |  |      |        |      |   |       
|-------------------------- |  | ---- | ------ | ---- | - | ------
|                           |  | 2003 |        | 2004
|Debt issue costs           |  | $    | 12,013 |      | $ | 9,445 
|Prepaid expenseslong term |  |      |       |      |   | 531   
|Deposits                   |  |      | 1,928  |      |   | 2,575 
|                           |  |      |        |      |   |       
|                           |  | $    | 13,941 |      | $ | 12,551
|                           |  |      |        |      |   |       



Debt issue costs
relate to the long-term debt obtained upon emergence from bankruptcy.



(8)    Accrued Expenses



Accrued expenses consist of the following at December 31:



|                                          |  |      |        |      |   |       
|----------------------------------------- |  | ---- | ------ | ---- | - | ------
|                                          |  | 2003 |        | 2004
|Accrued salaries and wages                |  | $    | 17,986 |      | $ | 9,094 
|Accrued health insurance and other claims |  |      | 6,202  |      |   | 3,746 
|Sales tax payable                         |  |      | 1,393  |      |   | 846   
|Other                                     |  |      | 1,453  |      |   | 1,122 
|                                          |  |      |        |      |   |       
|                                          |  | $    | 27,034 |      | $ | 14,808
|                                          |  |      |        |      |   |       



(9)    Long-Term Debt



The
Companys long-term debt consists of the following at December 31:



|                                                                                                                                                                                       |  |      |         |      |   |        
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                                                                                                                                                                       |  | 2003 |         | 2004
|Capital lease obligations with interest at a fixed rate of 4.5% at December 31, 2004, due in monthly installments through 2007, secured by
equipment                                   |  | $    |        |      | $ | 500    
|Priority tax claim                                                                                                                                                                     |  |      | 8,352   |      |   | 5,707  
|Senior Secured Term Loan; $109 payable quarterly through March 31, 2007 with remainder due quarterly through March 31, 2008, interest payable
at LIBOR rate plus 3%, payable quarterly |  | $    | 68,000  |      | $ | 42,671 
|91/2%
Senior Subordinated Notes, due April 1, 2012, interest payable semi-annually on April 1 and October 1                                                                            |  |      | 300,000 |      |   | 287,000
|                                                                                                                                                                                       |  |      |         |      |   |        
|Sub-total                                                                                                                                                                              |  |      | 376,352 |      |   | 335,878
|Less current portion                                                                                                                                                                   |  |      | 692     |      |   | 646    
|                                                                                                                                                                                       |  |      |         |      |   |        
|Total long-term debt and priority tax claim                                                                                                                                            |  | $    | 375,660 |      | $ | 336,232
|                                                                                                                                                                                       |  |      |         |      |   |        



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In addition to the above, as of December 31, 2004, the Company has a $75 million five-year revolving
credit facility available. No debt was outstanding under this facility at December 31, 2004, however the Company has issued letters of credit totaling $11,190 under this facility.



Long-term debt maturities excluding capital lease obligations are as follows: 2005$1,624; 2006$1,663;
2007$32,637; 2008$11,257; 2009$722; and thereafter$287,475.



Required future payments for capital lease obligations and the present value of net minimum capital lease payments are as follows:



|                                                |  |               |    
|----------------------------------------------- |  | ------------- | ---
|                                                |  | CapitalLeases
|2005                                            |  | $             | 226
|2006                                            |  |               | 215
|2007                                            |  |               | 89 
|                                                |  |               |    
|Total                                           |  | $             | 530
|Less amount representing interest               |  |               | 30 
|                                                |  |               |    
|Present value of minimum capital lease payments |  | $             | 500
|                                                |  |               |    



At December 31, 2004,
the equipment under capital leases is included in property and equipment with a carrying amount of $500 and accumulated depreciation of $23. The present value of the lease obligations are included in capital leases in the accompanying 2004
consolidated balance sheet.



Interest expense (income) were as
follows for the three months ended March 31, 2002, the nine months ended December 31, 2002, and the years ended December 31, 2003 and 2004:



|                              |  |                                   |     |   |                                     |   |        |                                       |  |   |                                       |   |  |   |        |  
|----------------------------- |  | --------------------------------- | --- | - | ----------------------------------- | - | ------ | ------------------------------------- |  | - | ------------------------------------- | - |  | - | ------ | -
|                              |  | Predecessor                       |     |   | Successor                           |  
|                              |  | Three months ended March 31, 2002 |     |   | Nine months ended December 31, 2002 |   |        | Twelve months ended December 31, 2003 |  |   | Twelve months ended December 31, 2004 |  
|Interest expense              |  | $                                 | 14  |   |                                     | $ | 33,556 |                                       |  | $ | 42,109                                |   |  | $ | 33,967 |  
|Interest income               |  |                                   | (31 | ) |                                     |   | (463   | )                                     |  |   | (707                                  | ) |  |   | (271   | )
|                              |  |                                   |     |   |                                     |   |        |                                       |  |   |                                       |   |  |   |        |  
|Interest (income) expense net |  | $                                 | (17 | ) |                                     | $ | 33,093 |                                       |  | $ | 41,402                                |   |  | $ | 33,696 |  
|                              |  |                                   |     |   |                                     |   |        |                                       |  |   |                                       |   |  |   |        |  



The senior secured
credit facilities contain customary affirmative and negative covenants, including, without limitation, limitations on indebtedness; limitations on liens; limitations on guarantee obligations; limitations on mergers, consolidations, liquidations and
dissolutions; limitations on sales of assets; limitations on leases; limitations on dividends and other payments in respect of capital stock; limitations on investments, loans and advances; limitations on capital expenditures; limitations on
optional payments and modifications of subordinated and other debt instruments; limitations on transactions with affiliates; limitations on granting negative pledges; and limitations on changes in lines of business. Our senior secured credit
facilities also contain customary financial covenants including, maintenance of the following ratios: (a) a consolidated total leverage ratio, (b) a consolidated senior leverage ratio, (c) a consolidated interest coverage ratio and (d) a
consolidated fixed charge coverage ratio. As of December 31, 2004, the Company is in compliance with its covenants.



All obligations under the credit facilities and the guarantees are secured by a perfected first priority security interest in substantially all of the
Companys tangible and intangible assets, including intellectual property, real property and all of the capital stock of each of the Companys direct and indirect subsidiaries, excluding immaterial subsidiaries in the process of
dissolution and other specified immaterial subsidiaries.



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(10)    Lease Commitments



The Company operates principally in leased offices and warehouse facilities. In addition, Company vehicles, delivery
vehicles and office equipment are leased under various operating leases. Lease terms range from one to ten years with renewal options for additional periods. Many leases provide that the Company pay taxes, maintenance, insurance and other expenses.
Rentals are generally increased annually by the Consumer Price Index, subject to certain maximum amounts defined within individual agreements.



Rental expense for building and vehicle leases approximated $5,715 for the three months ended March 31, 2002, $20,537 for the nine months ended December
31, 2002, $24,590 and $22,079 for the years ended December 31, 2003 and 2004, respectively, and is included as a component of selling, general and administrative expenses on the accompanying consolidated statement of operations.



Future minimum rental commitments under non-cancelable leases, for branch
locations and vehicle leases, are as follows:



|                                  |  |   |       
|--------------------------------- |  | - | ------
|For the years ending December 31: |  |   |       
|2005                              |  | $ | 20,863
|2006                              |  |   | 15,354
|2007                              |  |   | 7,958 
|2008                              |  |   | 2,803 
|2009                              |  |   | 1,986 
|Thereafter                        |  |   | 166   
|                                  |  |   |       
|                                  |  | $ | 49,130
|                                  |  |   |       



(11)    Income
Taxes



In connection with the Plan, the Company entered
into a Tax Sharing Agreement with the Predecessor and IHS that sets forth the Companys rights and obligations with respect to taxes arising from and in connection with the implementation of the Plan. The Tax Sharing Agreement sets forth that
the parties to the agreement will, for tax purposes, treat the transfer of the Predecessors assets to the Company as a taxable event rather than as a tax-free reorganization. An election was made under Section 338(h)(10) of the Internal
Revenue Code of 1986, as amended, and under analogous state and local law, with respect to the transfer of the Predecessors assets to the Company. As a result of such election, the Company accounted for the acquisition of the stock of all of
the subsidiaries as if it had acquired the assets of those subsidiaries for income tax purposes. This deemed asset purchase agreement resulted in some increase in the immediate tax cost of the restructuring, but the Companys tax basis used in
calculating depreciation and amortization deductions for these assets increased substantially, resulting in future tax savings. The Company believes that the present value of such future tax savings will be significantly greater than the tax costs
incurred in making the election.



The parties have agreed to
provide assistance to each other in the preparation and filing of tax returns, defending audits and related matters. The Company has agreed to indemnify the Predecessor and IHS for all taxes attributable to the Company and incurred in connection
with the implementation of the Plan and will indemnify the Predecessor and IHS for all taxes that they incur as a result of the Section 338(h)(10) and similar elections, other than up to $2 million of certain specified taxes. Also, IHS has agreed to
indemnify the Company and the Predecessor for all taxes attributable to IHS and subsidiaries that are not also subsidiaries of the Company or the Predecessor.



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Prior to March 31, 2002, the Predecessor was included in IHSs consolidated federal income tax
return. The allocated provision for current income taxes is applied to increase balances due to the parent company. The allocated provision for income taxes on earnings before income taxes is summarized below for the three months ended March 31,
2002, the nine months ended December 31, 2002, the years ended December 31, 2003 and 2004:



|                         |  |                                   |      |   |                                     |   |                                       |  |   |                                       |   |  |   |       
|------------------------ |  | --------------------------------- | ---- | - | ----------------------------------- | - | ------------------------------------- |  | - | ------------------------------------- | - |  | - | ------
|                         |  | Predecessor                       |      |   | Successor                          
|                         |  | Three months ended March 31, 2002 |      |   | Nine months ended December 31, 2002 |   | Twelve months ended December 31, 2003 |  |   | Twelve months ended December 31, 2004
|Current:                 |  |                                   |      |   |                                     |   |                                       |  |   |                                       |   |  |   |       
|Federal                  |  | $                                 | (184 | ) |                                     | $ |                                      |  | $ |                                      |   |  | $ | 2,434 
|State                    |  |                                   | (19  | ) |                                     |   | 691                                   |  |   | 3,723                                 |   |  |   | 2,454 
|                         |  |                                   |      |   |                                     |   |                                       |  |   |                                       |   |  |   |       
|Total current provision  |  |                                   | (203 | ) |                                     |   | 691                                   |  |   | 3,723                                 |   |  |   | 4,888 
|                         |  |                                   |      |   |                                     |   |                                       |  |   |                                       |   |  |   |       
|Deferred:                |  |                                   |      |   |                                     |   |                                       |  |   |                                       |   |  |   |       
|Federal                  |  |                                   |     |   |                                     |   | 9,405                                 |  |   | 4,437                                 |   |  |   | 21,633
|State                    |  |                                   |     |   |                                     |   | 807                                   |  |   | (1,409                                | ) |  |   | 2,410 
|                         |  |                                   |      |   |                                     |   |                                       |  |   |                                       |   |  |   |       
|Total deferred provision |  |                                   |     |   |                                     |   | 10,212                                |  |   | 3,028                                 |   |  |   | 24,043
|                         |  |                                   |      |   |                                     |   |                                       |  |   |                                       |   |  |   |       
|                         |  | $                                 | (203 | ) |                                     | $ | 10,903                                |  | $ | 6,751                                 |   |  |   | 28,931
|                         |  |                                   |      |   |                                     |   |                                       |  |   |                                       |   |  |   |       



Deferred income taxes
reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Companys deferred tax
liabilities and assets as of December 31 are as follows:



|                                                        |  |      |         |   |      |   |         |  
|------------------------------------------------------- |  | ---- | ------- | - | ---- | - | ------- | -
|                                                        |  | 2003 |         |   | 2004 |  
|Deferred tax liabilities:                               |  |      |         |   |      |   |         |  
|Excess of book over tax basis of property and equipment |  | $    | (4,737  | ) |      | $ | 1,672   |  
|Excess of book over tax basis of intangible assets      |  |      | 30,642  |   |      |   | 48,377  |  
|                                                        |  |      |         |   |      |   |         |  
|Total deferred tax liabilities                          |  |      | 25,905  |   |      |   | 50,049  |  
|                                                        |  |      |         |   |      |   |         |  
|                                                        |  |     
|Deferred tax assets:                                    |  |      |         |   |      |   |         |  
|Deferred revenue                                        |  |      | 5,766   |   |      |   | 8,084   |  
|Other accrued liabilities                               |  |      | (2,347  | ) |      |   | (661    | )
|Net operating loss                                      |  |      | (15,988 | ) |      |   | (21,702 | )
|Other                                                   |  |      | (152    | ) |      |   | 1,368   |  
|                                                        |  |      |         |   |      |   |         |  
|Total deferred tax assets                               |  |      | (12,721 | ) |      |   | (12,911 | )
|                                                        |  |      |         |   |      |   |         |  
|Net deferred tax liabilities                            |  |      | 13,184  |   |      | $ | 37,138  |  
|                                                        |  |      |         |   |      |   |         |  



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



A reconciliation of the tax provision (benefit) computed at the statutory federal tax rate on
earnings (loss) before income taxes to the actual income tax provision (benefit) is as follows for the three months ended March 31, 2002, and the nine months ended December 31, 2002 and the years ended December 31, 2003 and 2004:



|                                                                                 |  |                                   |         |   |                                   |   |                            |  |   |                            |   |  |   |       
|-------------------------------------------------------------------------------- |  | --------------------------------- | ------- | - | --------------------------------- | - | -------------------------- |  | - | -------------------------- | - |  | - | ------
|                                                                                 |  | Predecessor                       |         |   | Successor                        
|                                                                                 |  | Three months ended March 31, 2002 |         |   | Nine monthsended December 31,2002 |   | Year endedDecember 31,2003 |  |   | Year endedDecember 31,2004
|Tax provision computed at the statutory rate                                     |  | $                                 | (52,131 | ) |                                   | $ | 8,672                      |  | $ | 5,211                      |   |  | $ | 23,502
|Fresh start reporting adjustments                                                |  |                                   | 51,869  |   |                                   |   |                           |  |   |                           |   |  |   |      
|State income taxes, net of federal income tax benefit                            |  |                                   | 19      |   |                                   |   | 1,063                      |  |   | 735                        |   |  |   | 2,217 
|Intangibles amortization and other book expenses not deductible for tax purposes |  |                                   | 40      |   |                                   |   | 1,168                      |  |   | 828                        |   |  |   | 374   
|Other                                                                            |  |                                   |        |   |                                   |   |                           |  |   | (237                       | ) |  |   | 2,838 
|                                                                                 |  |                                   |         |   |                                   |   |                            |  |   |                            |   |  |   |       
|Total income tax expense                                                         |  | $                                 | (203    | ) |                                   | $ | 10,903                     |  | $ | 6,751                      |   |  | $ | 28,931
|                                                                                 |  |                                   |         |   |                                   |   |                            |  |   |                            |   |  |   |       



Generally accepted
accounting principles require a valuation allowance to be provided to reduce the carrying value of deferred tax assets reported if, based on the weight of the evidence, it is more likely than not that some portion or all of the deferred tax assets
will not be realized. After consideration of all the evidence, both positive and negative, management has determined that a valuation allowance is not necessary as of December 31, 2003 and 2004.



At December 31, 2004, the Company has available federal net operating loss
carryforwards of approximately $55,788, which expire in 2024.



The Company believes it has adequately provided for income tax issues not yet resolved with federal, state and local tax authorities. At December 31, 2004, $4,000 was accrued for such federal, state and local tax matters and is included in
income taxes payable. Although not probable, the most adverse resolution of these federal, state and local tax issues could result in additional charges to earnings in future periods in addition to the $4,000 currently provided. Based upon a
consideration of all relevant facts and circumstances, the Company does not believe the ultimate resolution of tax issues for all open tax periods will have a material adverse effect upon its results of operations or financial condition.



(12)    Insurance Coverage



The Company has a self-insured plan for health and medical coverage for its
employees. A stop-loss provision provides for coverage by a commercial insurance company of specific claims paid in the plan year in excess of $175. Prior to March 26, 2002, the Company had a plan for health and medical coverage through its parent,
IHS. Total recorded liabilities for group health insurance claims payable, including an estimate for incurred but not reported claims included in other current liabilities in the accompanying consolidated balance sheets, were approximately $6,063
and $2,744 as of December 31, 2003 and 2004, respectively.



The
Company is subject to workers compensation and employee health benefit claims, which are primarily self-insured; however, the Company does maintain certain stop-loss and other insurance coverage which management believes to be appropriate.
Provisions for estimated settlements relating to the workers compensation and health benefit plans are provided in the period of the related claim on a case-by-case basis plus an amount for incurred but not reported claims. Differences between
the amounts accrued and subsequent settlements are recorded in operations in the period of settlement.



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ROTECH HEALTHCARE AND SUBSIDIARIES



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(13)    Certain Significant Risks and Uncertainties



The Company and others in the healthcare business are subject to certain
inherent risks, including the following:



| |  |  | Substantial dependence on revenues derived from reimbursement by the Federal Medicare and State Medicaid programs which have been reduced in recent years and which entail exposure
to various health care fraud statutes;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Government regulations, government budgetary constraints and proposed legislative and regulatory changes; and
| | - |  | -------------------------------------------------------------------------------------------------------------



| |  |  | Lawsuits alleging malpractice and related claims.
| | - |  | -------------------------------------------------



Such inherent risks require the use of certain management estimates in the preparation of the Companys consolidated financial statements and it is
reasonably possible that a change in such estimates may occur.



The Company receives payment for a significant portion of services rendered to patients from the Federal government under Medicare and other federally funded programs (primarily Veterans Administration) and from the states in which its
facilities and/or services are located under Medicaid. Revenue derived from Medicare, Medicaid and other federally funded programs represented a significant concentration of business (see Concentration of Credit Risk).



Recent legislation continues to impact and reduce Medicare payment levels.
Under the Medicare Prescription Drug, Improvement and Modernization Act of 2003, or MMA, additional reductions have been imposed. Changes under MMA include a freeze in payments for home medical equipment from 2004 through 2008, competitive bidding
requirements, new clinical conditions for payment and quality standards. The changes affect our products generally, although specific products may be affected by some but not all of the MMA provisions. Medicare payments for home medical equipment,
including wheelchairs, nebulizers, and oxygen and oxygen equipment, are set at the 2003 level for 2004 through 2008, unless they are subject to further reductions based on Federal Employee Health Benefits Program median payment amounts as described
below, or are subject to competitive bidding. In addition, as of January 1, 2005, the fee schedule amounts for certain items of HME, including wheelchairs and nebulizers, were further reduced, based on the percentage difference between the amount of
payment otherwise determined for 2002 and the median amount of payment under the Federal Employee Health Benefits Program, or FEHBP as determined by the Office of Inspector General of DHHS, or OIG. The FEHBP adjusted payments are to remain
frozen through 2008 unless the particular item becomes subject to competitive bidding. The fee schedule amounts for oxygen and oxygen equipment are also to be calculated using this methodology, but because the OIG has not yet finalized
the median FEHBP payment amounts for these items, CMS set interim payment amounts for these items in 2005 at the 2004 fee schedule amounts. As of January 1, 2005, MMA also reduced payments for inhalation drugs delivered through nebulizer equipment
to an amount based on 106% of average sales price. Reductions in Medicare reimbursement for oxygen, nebulizers and inhalation medications could have a material adverse effect on our revenues, profitability and results of operations.



The Companys operations are subject to a variety of Federal, State and
Local legal and regulatory risks, including without limitation the Federal Anti-Kickback Statute and the Federal Ethics in Patient Referral Act (so-called Stark Law), many of which apply to virtually all companies engaged in the
healthcare services industry. The Anti-Kickback Statute prohibits, among other things, the offer, payment, solicitation or receipt of any form of remuneration in return for the referral of Medicare and Medicaid patients. The Stark Law prohibits,
with limited exceptions, financial relationships between ancillary service providers and referring physicians. Other



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



regulatory risks assumed by the Company and other companies engaged in the health care industry are as follows:



| |  |  | False ClaimsOperation Restore Trust is a major anti-fraud demonstration project of the Office of the Inspector General. The primary purpose for the project is to
scrutinize the activities of healthcare providers which are reimbursed under the Medicare and Medicaid programs. False claims are prohibited pursuant to criminal and civil statutes and are punishable by imprisonment and monetary penalties.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Regulatory Requirement DeficienciesIn the ordinary course of business, health care facilities receive notices of deficiencies for failure to comply with various regulatory
requirements. In some cases, the reviewing agency may take adverse actions against a facility, including the imposition of fines, temporary suspension or decertification from participation in the Medicare and Medicaid programs and, in extreme cases,
revocation of a facilitys license.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Changes in laws and regulationsChanges in laws and regulations could have a material adverse effect on licensure, eligibility for participation in government programs,
permissible activities, operating costs and the levels of reimbursement from governmental and other sources.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In response to the aforementioned regulatory risks, the Company formed a Corporate Compliance Department to help identify, prevent and deter instances of
Medicare, Medicaid and other noncompliance. Although the Company strives to manage these regulatory risks, there can be no assurance that federal and/or state regulatory agencies that currently have jurisdiction over matters including, without
limitation, Medicare, Medicaid and other government reimbursement programs, will take the position that the Companys business and operations are in compliance with applicable law or with the standards of such regulatory agencies.



The Company is also subject to malpractice and related claims, which arise
in the normal course of business and which could have a significant effect on the Company. As a result, the Company maintains occurrence basis professional and general liability insurance with coverage and deductibles which management believes to be
appropriate.



(14)    Legal
ProceedingsContingencies



Due to the nature of the
business, the Company is involved from time to time in lawsuits that arise in the ordinary course of business. Management does not believe that any lawsuit the Company (or the Predecessor) are a party to, if resolved adversely, would have a material
adverse effect on the financial condition or results of operations.



As noted previously, on February 2, 2000, IHS and substantially all of its subsidiaries, including the Predecessor filed voluntary petitions in the Bankruptcy Court under Chapter 11 of the United States Bankruptcy Code. By order of the
Bankruptcy Court, the last day on which claims could be filed, with certain exceptions, was August 29, 2000. Claims were asserted against the Predecessor with respect to various obligations. On February 13, 2002, the Bankruptcy Court confirmed the
Predecessors plan of reorganization which became effective on March 26, 2002. On December 20, 2004, the Bankruptcy Court entered a final decree closing the Predecessors bankruptcy case. In connection with its emergence from bankruptcy,
claims made against the Predecessor prior to the date it filed for bankruptcy protection were satisfied in accordance with the terms of the Plan or pursuant to settlement agreements approved by the Bankruptcy Court prior to emergence from
bankruptcy. However, although management believes that all pre-petition state claims have also been discharged or dealt with in the plan of reorganization, states in other bankruptcy cases have challenged whether, as a matter of law, their claims
could be discharged in a federal bankruptcy proceeding if they never made an appearance in the case. The issue has not been finally settled by the United States Supreme Court. Therefore, there is no



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



assurance that a court would find that emergence from bankruptcy would discharge all such state claims against the Predecessor or the Company involving
pre-petition claims.



(15)    Employee Benefit Plans



401(k) Savings Plan



The Company sponsors a 401(k) Savings Plan (the Savings Plan) covering all
full-time employees who have met certain eligibility requirements. The Savings Plan is funded by voluntary employee contributions and by discretionary Company contributions equal to a certain percentage of the employee contributions. Employees
interests in Company contributions vest over five years. The Companys contribution expense was approximately $238 for the three months ended March 31, 2002; $936 for the nine months ended December 31, 2002; and $608 and $565 for the years
ended December 31, 2003 and 2004, respectively.



Employee
Profit Sharing Plan



Pursuant to the Plan of
Reorganization, the Company contributed 250,000 shares of Series A Convertible Redeemable Preferred Stock (see Note 18) (Initial Company Contribution) to a trust to establish a tax-qualified defined contribution employee profit sharing retirement
plan (Employees Plan). Employees of the Company as of the effective date of the Employees Plan (Effective Date), were the initial participants in the Employees Plan, and employees joining the Company after the Effective Date are eligible to join the
Employees Plan on the January 1 or July 1 following their first day of employment with the Company. Company contributions to the Employees Plan are fully discretionary. There are no employee contributions under the Employees Plan. Participants are
fully and immediately vested in any and all Company contributions made to the Employees Plan. Any contributions made by the Company to the Employees Plan are allocated to individual participant accounts on the basis of the respective compensation of
each participant, as compared to the aggregate compensation of all participants. The Initial Company Contribution to the Employees Plan was valued at $5,000 and was charged to operations of the Predecessor for the three months ended March 31, 2002.
There were no Company contributions made to the Employees Plan for the years ended December 31, 2003 or 2004. A cash contribution in the amount of $500 was authorized by the Companys board of directors in February 2005. Such contribution is
payable at any time prior to December 31, 2005. Effective October 12, 2004, the Company repurchased 804 shares of Series A Preferred for approximately $20 in order to fund the cash payment of benefits under the Employees Plan to certain plan
participants that are no longer employed by the Company.



(16)    Stock Compensation Plans



Under the Companys Common Stock Option Plan, which became effective March 26, 2002, the Company can grant to employees, directors, or consultants incentive and nonqualified options to purchase up to 4,025,000 shares of common stock.
The stock options are exercisable over a period determined by the Board of Directors, but no longer than ten years. At December 31, 2004, options to acquire up to 486,878 shares of common stock may be granted pursuant to this plan, options
exercisable for 3,214,375 shares of common stock are outstanding and 323,747 shares of common stock have been issued upon the exercise of options granted under the Companys Common Stock Option Plan.



The fair value of each option granted is estimated on the date of the grant
using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants during the twelve months ended December 31, 2003 and 2004: expected volatility of 5% for 2003 and 27.98% for 2004; dividend yield of 0.0%;
expected option life of approximately 5 years for 2003 and 6.86 years for 2004; and an average risk-free interest rate of 2.98% for 2003 and 3.6% for 2004.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following table summarizes the Companys stock option transactions for the twelve months
ended December 31, 2003 and 2004:



|                                         |  |                  |   |  |                        |      
|---------------------------------------- |  | ---------------- | - |  | ---------------------- | -----
|                                         |  | Number of Shares |   |  | Weighted Average Price
|Options outstanding at December 31, 2002 |  | 2,106,875        |   |  | $                      | 18.91
|Granted                                  |  | 1,627,500        |   |  |                        | 18.15
|Exercised                                |  | (42,031          | ) |  |                        | 19.68
|Forfeited                                |  | (401,094         | ) |  |                        | 19.28
|                                         |  |                  |   |  |                        |      
|Options outstanding at December 31, 2003 |  | 3,291,250        |   |  |                        | 18.48
|Granted                                  |  | 440,000          |   |  |                        | 23.39
|Exercised                                |  | (281,716         | ) |  |                        | 19.54
|Forfeited                                |  | (235,159         | ) |  |                        | 18.70
|                                         |  |                  |   |  |                        |      
|Options outstanding at December 31, 2004 |  | 3,214,375        |   |  | $                      | 19.04
|                                         |  |                  |   |  |                        |      



The weighted average
fair value per share of options granted during the twelve months ended December 31, 2003 and 2004 respectively were $1.77 and $8.80. There were 857,029 options and 1,381,365 options with a weighted average exercise price of $18.68 and $18.47,
exercisable at December 31, 2003 and December 31, 2004, respectively.



Options to purchase approximately 3,291,250 shares of common stock at prices ranging from $14.55 to $24.95 per share were outstanding as of December 31, 2003. Options to purchase approximately 3,214,375 shares of common stock at prices
ranging from $14.55 to $26.00 per share were outstanding as of December 31, 2004.



The following table summarizes the Companys stock options outstanding and exercisable by ranges of option price, as of December 31, 2004:



|                      |  |                              |  |                                        |  |                              |       |                              |           |                              |   |      
|--------------------- |  | ---------------------------- |  | -------------------------------------- |  | ---------------------------- | ----- | ---------------------------- | --------- | ---------------------------- | - | -----
|                      |  | Options Outstanding          |  | Options Exercisable                   
|Range of Option Price |  | Number of OptionsOutstanding |  | Weighted AverageRemaining Life (Years) |  | Weighted AverageOption Price |       | Number of OptionsExercisable |           | Weighted AverageOption Price
|$14.55 - 16.99        |  | 40,000                       |  | 8.38                                   |  | $                            | 14.55 |                              | 40,000    |                              | $ | 14.55
|$17.00 - 19.94        |  | 1,753,750                    |  | 8.14                                   |  |                              | 17.00 |                              | 765,742   |                              |   | 17.00
|$19.95 - 20.00        |  | 703,125                      |  | 7.43                                   |  |                              | 20.00 |                              | 453,750   |                              |   | 20.00
|$20.01 - 26.00        |  | 717,500                      |  | 9.15                                   |  |                              | 23.35 |                              | 121,873   |                              |   | 23.26
|                      |  |                              |  |                                        |  |                              |       |                              |           |                              |   |      
|Total                 |  | 3,214,375                    |  | 8.21                                   |  | $                            | 19.04 |                              | 1,381,365 |                              | $ | 18.47
|                      |  |                              |  |                                        |  |                              |       |                              |           |                              |   |      



Effective as of August
1, 2004, the Company established the Rotech Healthcare Inc. Nonemployee Director Restricted Stock Plan. Under the terms of the plan, non-employee directors will receive a certain number of shares per year subject to transfer restrictions for a set
period of time. The maximum number of shares issued under the plan cannot exceed 200,000. As of December 31, 2004, restricted stock awards for an aggregate amount of 32,000 shares of common stock had been granted to the Companys non-employee
directors. Stock compensation expense recognized by the Company in the year ended December 31, 2004 under the restricted stock plan was approximately $232.



The Companys common stock currently trades in interdealer and over-the-counter transactions and price quotations are provided in the pink
sheets by Pink Sheets LLC under the symbol ROHI.PK.



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



(17)    Revenue Data



Net revenues are derived from the following principal service categories:



|                                     |  |                                   |         |                                    |   |                             |  |                             |         |  |   |        
|------------------------------------ |  | --------------------------------- | ------- | ---------------------------------- | - | --------------------------- |  | --------------------------- | ------- |  | - | -------
|                                     |  | Predecessor                       |         | Successor                         
|                                     |  | Three months ended March 31, 2002 |         | Nine monthsended December 31, 2002 |   | Year endedDecember 31, 2003 |  | Year endedDecember 31, 2004
|Oxygen and other respiratory therapy |  | $                                 | 120,618 |                                    | $ | 369,875                     |  | $                           | 487,567 |  | $ | 462,772
|Home medical equipment               |  |                                   | 30,745  |                                    |   | 83,916                      |  |                             | 86,014  |  |   | 65,986 
|Other                                |  |                                   | 3,387   |                                    |   | 9,234                       |  |                             | 7,640   |  |   | 5,745  
|                                     |  |                                   |         |                                    |   |                             |  |                             |         |  |   |        
|                                     |  | $                                 | 154,750 |                                    | $ | 463,025                     |  | $                           | 581,221 |  | $ | 534,503
|                                     |  |                                   |         |                                    |   |                             |  |                             |         |  |   |        



(18)    Series
A Convertible Redeemable Preferred Stock



The Company
issued 250,000 shares of Series A Convertible Redeemable Preferred Stock (Series A Preferred) upon emergence from bankruptcy pursuant to the Plan of Reorganization. The Series A Preferred is held by the Companys employee profit sharing plan
(see Note 15) and the total preferred stock authorized by the Company is 1,000,000 shares. Each share of Series A Preferred has a stated value of $20 and entitles the holder to an annual cumulative dividend equal to 9% of its stated value, payable
semi-annually at the discretion of the Companys board of directors in cash or in additional shares of Series A Preferred.



During the first five years, the Series A Preferred is only convertible immediately prior to the consummation of an underwritten initial public offering
of the Companys common stock pursuant to an effective registration statement under the Securities Act of 1933 at a price per share of at least $20 and with gross proceeds to the Company of at least $100,000. After the fifth anniversary of the
date of the first issuance of the Series A Preferred, the Series A Preferred is convertible into shares of the Companys common stock at any time at the option of the holder based on the conversion ratio of 0.8 shares of common stock for each
share of Series A Preferred. If the Series A Preferred is not converted, it must be redeemed by the Company on June 26, 2012 at a redemption amount of $20 per share, plus any accrued and unpaid dividends. The amount of mandatory redemption of the
outstanding 249,196 shares of Preferred Stock would be approximately $4,984 plus any accrued unpaid dividends. Effective October 12, 2004, the Company repurchased 804 shares of Series A Preferred for approximately $20 in order to fund the cash
payment of benefits under the Companys employee profit sharing plan to certain plan participants that are no longer employed by the Company.



No dividends will be declared or paid upon the Companys common stock, unless and until dividends have been declared on the Series A Preferred.
During June 2004, the Companys Board of Directors declared a dividend in the amount of $900 payable to the holder of the Series A Preferred, which was paid on March 23, 2005.



In the event of any liquidation, or sale or merger, each holder of preferred stock shall receive, out of the assets of the
Company legally available for distribution to its stockholders, prior to any payment to any junior securities, the redemption amount described above as a preferential distribution.



(19)    Restructuring Accruals



During 2003 and 2004, the Company implemented certain restructuring activities that included employee reductions and real
estate consolidations to improve operating effectiveness and efficiencies. The Company terminated approximately 15% of its employees during the year ended December 31, 2003. The terminated employees consisted of a variety of corporate and
administrative personnel and field staff in a variety of capacities. During the year ended December 31, 2003, $6,508 of restructuring related charges were



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



recognized, which consisted of severance and lease cancellation charges. Of the $6,508 in charges, $6,232 was paid in cash. As of December 31, 2003, the
Company had approximately $1,676 recorded in accrued expenses related to restructuring charges. During the year ended December 31, 2004, $538 in restructuring related charges were recognized, which consisted of severance and lease cancellation
charges. The Company made payments in the amount of $1,698 relating to severance and lease cancellation charges. As of December 31, 2004 the Company had approximately $516 recorded in accrued expense related to restructuring charges. The
restructuring related charges are included in selling, general and administrative expenses in the accompanying consolidated statements of earnings.



(20)    Quarterly Financial Data (Unaudited)



The following is a summary of unaudited quarterly financial results for the years ended December 31, 2003:



|                                                                             |  |                    |         |              |   |         |                   |  |                  |         |  |   |        
|---------------------------------------------------------------------------- |  | ------------------ | ------- | ------------ | - | ------- | ----------------- |  | ---------------- | ------- |  | - | -------
|                                                                             |  | Three months ended
|                                                                             |  | March 31,2003      |         | June 30,2003 |   |         | September 30,2003 |  | December 31,2003
|Summary Statement of Operations Information                                  |  |                    |         |              |   |         |                   |  |                  |         |  |   |        
|Net revenues                                                                 |  | $                  | 152,577 |              | $ | 145,707 |                   |  | $                | 142,353 |  | $ | 140,584
|Interest expense                                                             |  |                    | 10,806  |              |   | 9,824   |                   |  |                  | 10,676  |  |   | 10,096 
|Federal and state income taxes                                               |  |                    | 3,967   |              |   | (5,168  | )                 |  |                  | 1,935   |  |   | 6,017  
|Earnings (loss) before cumulative effect of a change in accounting principle |  |                    | 4,997   |              |   | (6,679  | )                 |  |                  | 2,299   |  |   | 7,796  
|Net earnings (loss)                                                          |  |                    | 4,997   |              |   | (6,679  | )                 |  |                  | 2,299   |  |   | 7,796  
|Net earnings per common sharebasic                                          |  |                    | 0.20    |              |   | (0.27   | )                 |  |                  | 0.09    |  |   | 0.31   
|Net earnings per common sharediluted                                        |  |                    | 0.20    |              |   | (0.27   | )                 |  |                  | 0.08    |  |   | 0.31   
|Market prices:                                                               |  |                    |         |              |   |         |                   |  |                  |         |  |   |        
|High                                                                         |  |                    | 17.80   |              |   | 23.05   |                   |  |                  | 25.75   |  |   | 31.25  
|Low                                                                          |  |                    | 13.80   |              |   | 12.00   |                   |  |                  | 21.50   |  |   | 20.50  
|Summary Balance Sheet Information                                            |  |                    |         |              |   |         |                   |  |                  |         |  |   |        
|Deferred tax asset (a)                                                       |  |                    | 5,006   |              |   | 5,150   |                   |  |                  | 5,511   |  |   |       
|Other assets                                                                 |  |                    | 18,427  |              |   | 15,882  |                   |  |                  | 14,223  |  |   | 13,941 
|Other current assets (b)                                                     |  |                    |        |              |   |        |                   |  |                  |        |  |   | 19,580 
|Retained earnings                                                            |  |                    | 18,412  |              |   | 11,620  |                   |  |                  | 13,920  |  |   | 21,714 

---

|(a) |  | Included as a component of other current assets for the three months ended December 31, 2003.
|--- |  | ---------------------------------------------------------------------------------------------

|(b) |  | Includes deferred tax asset for the three months ended December 31, 2003 which was disclosed as a separate asset for prior quarters.
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------



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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following is a summary of unaudited quarterly financial results for the years ended December 31,
2004:



|                                                                             |  |                    |         |              |   |                   |  |                  |         |  |   |        
|---------------------------------------------------------------------------- |  | ------------------ | ------- | ------------ | - | ----------------- |  | ---------------- | ------- |  | - | -------
|                                                                             |  | Three months ended
|                                                                             |  | March 31,2004      |         | June 30,2004 |   | September 30,2004 |  | December 31,2004
|Summary Statement of Operations Information                                  |  |                    |         |              |   |                   |  |                  |         |  |   |        
|Net Revenues                                                                 |  | $                  | 134,011 |              | $ | 133,400           |  | $                | 131,340 |  | $ | 135,751
|Interest expense                                                             |  |                    | 9,232   |              |   | 8,392             |  |                  | 8,595   |  |   | 7,477  
|Federal and state income taxes                                               |  |                    | 6,306   |              |   | 7,220             |  |                  | 5,859   |  |   | 9,547  
|Earnings (loss) before cumulative effect of a change in accounting principle |  |                    | 9,044   |              |   | 10,389            |  |                  | 8,431   |  |   | 10,353 
|Net earnings (loss)                                                          |  |                    | 9,044   |              |   | 10,389            |  |                  | 8,431   |  |   | 10,353 
|Net earnings per common share-basic                                          |  |                    | 0.36    |              |   | 0.41              |  |                  | 0.34    |  |   | 0.39   
|Net earnings per common share-diluted                                        |  |                    | 0.35    |              |   | 0.40              |  |                  | 0.33    |  |   | 0.40   
|Market prices:                                                               |  |                    |         |              |   |                   |  |                  |         |  |   |        
|High                                                                         |  |                    | 24.00   |              |   | 26.50             |  |                  | 24.60   |  |   | 28.20  
|Low                                                                          |  |                    | 20.25   |              |   | 20.75             |  |                  | 18.75   |  |   | 20.00  
|Summary Balance Sheet Information                                            |  |                    |         |              |   |                   |  |                  |         |  |   |        
|Other assets                                                                 |  |                    | 13,276  |              |   | 12,725            |  |                  | 12,397  |  |   | 12,551 
|Other current assets                                                         |  |                    | 16,700  |              |   | 16,928            |  |                  | 16,954  |  |   | 18,877 
|Retained earnings                                                            |  |                    | 30,758  |              |   | 41,145            |  |                  | 49,576  |  |   | 59,481 



F-35