<PAGE>
 
               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C. 20549

                                  FORM 10-QSB

(Mark One)
[X]    QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE 
       ACT OF 1934

                 For the quarterly period ended March 31, 1997

                                      OR

[_]    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
       EXCHANGE ACT OF 1934

                        Commission File Number: 0-27234


                             PHOTON DYNAMICS, INC.
       (Exact name of small business issuer as specified in its charter)


         CALIFORNIA                                   94-3007502
(State or other jurisdiction of           (I.R.S. Employer Identification No.)
 incorporation or organization)


                               6325 SAN IGNACIO
                              SAN JOSE, CA 95119
                   (Address of principal executive offices)


                                (408) 226 9900
                          (Issuer's telephone number)


Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the last 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
                                                              ---     ---

As of May 14, 1997 7,082,696 shares of the Issuer's Common Stock, no par value,
were outstanding.
<PAGE>
 
                               TABLE OF CONTENTS
<TABLE> 
<CAPTION> 
                                     PART I: FINANCIAL INFORMATION                               PAGE
                                                                                                 ----
<S>                                                                                              <C> 
ITEM 1.    Financial Statements (unaudited)
           Condensed Consolidated  Balance Sheets - March 31, 1997 and September 30, 1996....      2
           Condensed Consolidated Statements of Operations - three and six months ended
                March 31, 1997 and 1996......................................................      3
           Condensed Consolidated Statements of Cash Flows - six months ended March 31, 1997
                and 1996.....................................................................      4
           Notes to Condensed Consolidated Financial Statements..............................      5

ITEM 2.    Management's Discussion and Analysis of Financial Condition and Results of
                Operations...................................................................      6

OTHER      Risk Factors......................................................................      8

                                       PART II: OTHER INFORMATION

ITEM 1.    Legal Proceedings.................................................................     13
ITEM 2.    Changes in Securities.............................................................     13
ITEM 3.    Defaults Upon Senior Securities...................................................     13
ITEM 4.    Submission of Matters to a Vote of Security Holders...............................     13
ITEM 5.    Other Information.................................................................     14
ITEM 6.    Exhibits and Reports on Form 8-K..................................................     14

           Signatures........................................................................     15

</TABLE> 

                                       1
<PAGE>
 
                              Photon Dynamics, Inc.

                      Condensed Consolidated Balance Sheets
                                 (In thousands)
                                   (Unaudited)
<TABLE> 
<CAPTION> 
                                                                             March 31,          September 30,
                                                                               1997                  1996
                                                                          --------------        --------------
<S>                                                                       <C>                    <C> 

                                ASSETS
Current assets:
   Cash and cash equivalents                                              $        2,014        $        5,108
   Short term investments                                                          4,203                 4,066
   Accounts receivable, net of allowance for doubtful accounts
     of $629 ($629 at September 30, 1996)                                          8,574                 8,652
   Inventories                                                                     4,914                 4,125
   Prepaid expenses and other current assets                                         347                   518
                                                                          --------------        --------------
Total current assets                                                              20,052                22,469

Property, equipment, and leasehold improvements, net                               2,814                 1,849

Other assets                                                                         827                   640
                                                                          --------------        --------------
Total assets                                                              $       23,693        $       24,958
                                                                          ==============        ==============

                 LIABILITIES AND SHAREHOLDERS' EQUITY 
Current liabilities:
   Accounts payable                                                       $        2,178        $        2,743
   Accrued expenses and other liabilities                                          2,304                 2,067
   Customer deposits and deferred revenue                                             87                   353
   Current portion of long-term debt                                                   6                    16
                                                                          --------------        --------------
Total current liabilities                                                          4,575                 5,179

Noncurrent portion of long-term debt                                                   8                     9
Commitments and contingencies

Shareholders' equity:
   Common stock                                                                   38,372                38,064
   Accumulated deficit                                                           (19,122)              (18,201)
   Foreign currency translation adjustment and other                                 (14)                   (7)
   Notes receivable from shareholders                                               (126)                  (86)
                                                                          --------------        --------------
Total shareholders' equity                                                        19,110                19,770
                                                                          --------------        --------------
Total liabilities and shareholders' equity                                $       23,693        $       24,958
                                                                          ==============        ==============
</TABLE> 

See accompanying notes to condensed consolidated financial statements

Note: The balance sheet at September 30, 1996 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.

                                       2
<PAGE>
 
                             Photon Dynamics, Inc.

                Condensed Consolidated Statements of Operations
                   (In thousands, except per share amounts)
                                   (Unaudited)
<TABLE> 
<CAPTION> 

                                                    THREE MONTHS ENDED            SIX MONTHS ENDED
                                                        MARCH 31,                     MARCH 31,
                                                     --------------------      ---------------------
                                                      1997          1996         1997         1996
                                                     ------       -------      --------     -------- 
<S>                                                  <C>          <C>           <C>          <C> 
Revenue:
   Product revenue                                   $5,085       $ 5,828      $ 10,181     $ 11,272
   Non product revenue                                    -           480         1,150        1,241
                                                     ------       -------      --------     -------- 
                                                      5,085         6,308        11,331       12,513

Cost of revenue:
   Product revenue                                    2,814         3,007         5,987        5,818
   Non product revenue                                    -           326             -          916
                                                     ------       -------      --------     -------- 
                                                      2,814         3,333         5,987        6,734
                                                     ------       -------      --------     -------- 
Gross margin                                          2,271         2,975         5,344        5,779

Operating expenses:
   Research and development                           1,852           975         3,488        1,878
   Selling, general, and administrative               1,466         1,378         2,852        2,644
                                                     ------       -------      --------     -------- 
Total operating expenses                              3,318         2,353         6,340        4,522
                                                     ------       -------      --------     -------- 
Operating income (loss)                              (1,047)          622          (996)       1,257

Interest income                                          98           234           209          305
Interest expense and other                              (24)          (60)         (131)        (171)
                                                     ------       -------      --------     -------- 
Income (loss) before provision for income taxes        (973)          796          (918)       1,391

Provision for income taxes                                -            45             3           77
                                                     ------       -------      --------     -------- 
Net income (loss)                                    $ (973)      $   751      $   (921)    $  1,314
                                                     ======       =======      ========     ======== 

Net income (loss) per share:                         $(0.14)      $  0.10      $  (0.13)     $  0.18
                                                     ======       =======      ========     ======== 
Shares used in computing net income (loss) per        
share                                                 7,034         7,674         6,995        7,114
                                                     ======       =======      ========     ======== 
</TABLE> 

See accompanying notes to condensed consolidated financial statements

                                       3
<PAGE>
 
                             Photon Dynamics, Inc.

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

                                                                              SIX MONTHS ENDED MARCH 31,
                                                                             1997                   1996
                                                                          --------------        -------------- 
<S>                                                                       <C>                   <C> 
OPERATING ACTIVITIES
Net Income (loss)                                                         $         (921)       $        1,314
Adjustments to reconcile net income (loss) to net cash used in
      operating activities:
    Depreciation and amortization                                                    525                   332
    Changes in operating assets and liabilities:
      Accounts receivable                                                             78                (1,720)
      Inventories                                                                   (789)                  649
      Prepaid expenses and other current assets                                      171                   (20)
      Other assets                                                                  (194)                   53
      Accounts payable                                                              (565)                  (48)
      Accrued expenses and other liabilities                                         237                   406
      Customer deposits and deferred revenue                                        (266)               (1,094)
                                                                          --------------        -------------- 
Net cash used in operating activities                                             (1,724)                 (128)

INVESTING ACTIVITIES
Acquisition of property and equipment                                             (1,490)               (1,007)
Maturities of short term investments                                               2,608                     -
Acquisition of short term investments                                             (2,745)               (5,547)
                                                                          --------------        -------------- 
Net cash used in investing activities                                             (1,627)               (6,554)

FINANCING ACTIVITIES
Repayment of lines of credit                                                           -                (2,325)
Principal payments under capital leases                                              (11)                  (16)
Proceeds from issuance of common stock, net of issuance costs                        308                16,934
Issuance of note receivable from shareholders                                        (56)                    -
Payment of note receivable from shareholders                                          16                     -
Payment of notes payable                                                               -                  (227)
                                                                          --------------        -------------- 
Net cash provided by financing activities                                            257                14,366
                                                                          --------------        -------------- 
                                                                                            
Net increase (decrease) in cash and cash equivalents                              (3,094)                7,684
Cash and cash equivalents at beginning of period                                   5,108                   298
                                                                          --------------        -------------- 
Cash and cash equivalents at end of period                                $        2,014        $        7,982
                                                                          ==============        ============== 
</TABLE> 

See accompanying notes to condensed consolidated financial statements

                                       4
<PAGE>
 
                             PHOTON DYNAMICS, INC.
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
                                  (Unaudited)

1.       SIGNIFICANT ACCOUNTING POLICIES

         Interim Financial Statements
         ----------------------------

         The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
for interim financial information and with the instructions to Form 10-QSB and
Regulation S-B. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three and six months ended March 31,
1997 are not necessarily indicative of the results that may be expected for the
fiscal year ending September 30, 1997. For further information, refer to the
audited consolidated financial statements and footnotes thereto for the fiscal
year ended September 30, 1996, included in the Company's Annual Report on Form
10-KSB


2.       INVENTORIES

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

           (In thousands)              March 31, 1997         September 30, 1996
                                       --------------         ------------------
           Raw Materials                 $      1,422          $          1,970
           Work-in-process                      2,514                     1,247
           Finished goods                         978                       908
                                         ------------           ---------------
                                         $      4,914           $         4,125
                                         ============           ===============

3.       IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

         In February 1997, The Financial Accounting Standards Board issued
Statement No. 128, Earnings Per Share, which is required to be adopted on
December 31, 1997. At that time, the Company will be required to change the
method currently used to compute earnings per share and to restate all prior
periods. Under the new requirements for calculating earnings per share, as
presented by the Company ("primary"), the dilutive effect of stock options will
be excluded. The impact is expected to result in an increase in primary earnings
per share for the three and six months ended March 31, 1996 of $0.01 and $0.03,
respectively. There is no impact for the three and six months ended March 31,
1997 as the Company had a loss. The impact of Statement 128 on the calculation
of fully diluted earnings per share, which has not been materially different
than primary earnings per share, for these periods is not expected to be
material.

                                       5
<PAGE>
 
                             PHOTON DYNAMICS, INC.

          MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                           AND RESULTS OF OPERATIONS

    The following discussion should be read in conjunction with the attached
unaudited condensed consolidated financial statements and notes thereto, and
with the Company's audited financial statements and notes thereto for the year
ended September 30, 1996. Except for the historical information contained
herein, the following discussion contains forward looking statements that
involve risk and uncertainties. The Company's actual results could differ
materially from those discussed here. Factors that could cause or contribute to
such differences include, but are not limited to, those discussed below under
the heading "Risk Factors" those discussed in this section, and those discussed
in the Company's Annual Report on Form 10-KSB for the year ended September 30,
1996.

    Results of Operations
    ---------------------

    Revenue. Total revenues for the second quarter of fiscal 1997 decreased 19%
to $5.1 million from $6.3 million in the second quarter of fiscal 1996. Total
revenues for the first six months of fiscal 1997 were $11.3 million, a decrease
of 9% from $12.5 million in the comparable period of 1996. Product sales
decreased 13% to $5.1 million in the second quarter of fiscal 1997 from $5.8
million in the second quarter of fiscal 1996. The Company derives substantially
all of its revenue from the sale of a relatively small number of systems, which
typically range in price from $400,000 to $1.5 million. As a result, the timing
of the sale of a single system could have a significant impact on the Company's
quarterly revenue. The Company also has relatively few customers and so the
timing of the construction of new facilities by customers will also impact
quarterly results.

    Non product revenue decreased to zero in the second quarter of fiscal 1997
from $480,000 in the first quarter of fiscal 1996. The decrease was due to the
ending of development contracts which the Company had with various third
parties. Non product revenue for the first six months of fiscal 1997 includes a
$1 million initial fee paid by a Korean company for the rights to be the
exclusive value added reseller of the Company's FIS Flex-P product in Korea.

    Gross Margin.  Gross margins on product revenue as a percent of revenue were
    ------------ 
45% and 41%, for the three and six month periods ended March 31, 1997,
respectively, compared to 48% for both of the same periods of the prior fiscal
year. The decrease in margins was the result of investments in infrastructure in
the first six months of fiscal 1997 as well as operating at less than full
capacity.

    Research and Development. The Company increased its research and development
    ------------------------
to $1.9 million in the second quarter of fiscal 1997, or 36% of revenue, from
$1.0 million in the second quarter of fiscal 1996, or 16% of revenue. Research
and development expenses for the first six months of fiscal 1997 were $3.5
million, an increase from $1.9 million in the comparable period of 1996, 31% and
15% of revenue respectively. The increase of combined research and development
spending reflects the increased costs of hiring and retaining experienced
engineers to increase the level of new product development. The Company does not
expect that product development expenses will decline in absolute dollar amounts
in the remainder of fiscal 1997.

    Selling, General and Administrative.  Selling, general and administrative
    -----------------------------------
expenses in the second quarter of fiscal 1997 increased to $1.5 million, from
$1.4 million in the second quarter of fiscal 1996, 29% and 22% of revenue,
respectively. Total selling, general and administrative expenses for the first
six months of fiscal 1997 were $2.9 million, an increase from $2.6 million in
the comparable period of fiscal 1996, representing 25% and 21% of revenue
respectively. The increase reflects the costs of establishing a Korean
subsidiary as well as an overall increase in sales efforts to take advantage of
potential opportunities in the coming year. Selling, general and administrative
expenses may increase in absolute dollar amounts in fiscal 1997 and in future
periods depending on factors including the level of the Company's revenue and
other operations. Selling expenses may also fluctuate

                                       6
<PAGE>
 
based on the Company's product and territory sales mix, due to different sales
channels and associated cost structures.

    Interest income/expense and other.  Interest income in the second quarter of
    ---------------------------------
fiscal 1997 decreased to $98,000 from $234,000 in the second quarter of fiscal
1996. The decrease was the result of lower cash and investment balances in the
second quarter of fiscal 1997 compared to the second quarter of fiscal 1996.

    Provision for Income Tax. The Company's effective tax rate for the three and
    ------------------------
six months ended March 31, 1997 is lower than the statutory rate of 34% due to
the utilization of loss carryforwards.

LIQUIDITY AND CAPITAL RESOURCES

    The Company has financed its growth primarily from a combination of amounts
raised in equity financings, loans, lines of credit from a bank and cash flows
from operations. As of March 31, 1997, the Company had working capital of $15.5
million of which $6.2 million was cash or cash equivalents and short term
investments.

    Cash used in operating activities was $1.7 million for the six months ended
March 31, 1997. Cash was primarily used to finance the net loss as well as
increase inventories as the Company prepares to ramp up production.

    Capital expenditures during the first six months of fiscal 1997 were $1.5
million compared to $1.0 million in the first six months of fiscal 1996. In the
first quarter of fiscal 1997, the Company relocated to a new facility and as a
result spent $682,000 on capital additions which related primarily to leasehold
improvements for the new facility. The Company also retired $1.2 million in
fully depreciated assets related to the previous facility.

    The Company believes that success in its industry requires substantial
capital in order to maintain the flexibility to take advantage of opportunities
as they may arise. The Company may, from time to time, invest in or acquire
complementary businesses, products or technologies. The Company may effect
additional equity or debt financing to fund such activities, although no such
financings are currently planned. The sale of additional equity or convertible
debt could result in additional dilution to the Company's shareholders.


OTHER FACTORS AFFECTING COMPANY RESULTS

    The Company has experienced and expects to continue to experience
significant fluctuations in its quarterly results of operations. The Company
derives substantially all of its revenue from the sale of a relatively small
number of systems, which typically range in price from $400,000 to $1,500,000.
As a result, the timing of the sale of a single system could have a significant
impact on the Company's quarterly revenue and results of operations. The failure
to receive anticipated orders or delays in shipments in a particular quarter,
due, for example, to unanticipated shipment reschedulings or cancellations by
customers or unexpected manufacturing difficulties, may cause revenue for that
quarter to fall significantly below the Company's expectations, which would have
a material adverse effect on the Company's results of operations for such
quarter. The Company's backlog at the beginning of each quarter is not
necessarily indicative of actual sales for any succeeding period. All orders are
subject to delay or cancellation with limited or no penalty. The Company's sales
will often reflect orders shipped in the same quarter that they are received.
Other factors which may have an influence on the Company's results of operations
in a particular quarter include the volume, mix and timing of the receipt of
orders from major customers, competitive pricing pressures, costs of components
and subsystems, the Company's ability to design, manufacture and introduce new
products on a cost effective and timely basis, the delay between incurrence of
expenses to further develop marketing and service capabilities and realization
of benefits from such improved capabilities, fluctuations in foreign exchange
rates, the timing of recognition of revenue under development contracts, the
introduction and announcement of new products by the Company's competitors and
changing conditions in the FPD ( "Flat Panel Display") market worldwide. In
particular, due to substantial differences in gross margin for the Company's
products, changes in the mix of products sold could result in substantial
fluctuations in the Company's gross margin. Accordingly, the Company's results
of operations are subject to significant variability from quarter to quarter.

                                       7
<PAGE>
 
                                 RISK FACTORS

FACTORS AFFECTING EARNINGS AND STOCK PRICE

    The statements contained in this report on Form 10-QSB that are not purely
historical are forward looking statements within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934, including statements regarding the Company's expectations, hopes,
intentions or strategies regarding the future. All forward looking statements
included in this document are based on information available to the Company on
the date hereof, and the Company assumes no obligation to update any such
forward looking statements. It is important to note that the Company's actual
results could differ materially from those in such forward looking statements.
You should consult the risk factors listed from time to time in the Company's
reports on Form 10-KSB, and annual reports to shareholders. Among the factors
that could cause actual results to differ materially are the following risk
factors:

VARIABILITY OF QUARTERLY RESULTS OF OPERATIONS; LIMITED HISTORY OF PROFITABILITY

    The Company has experienced and expects to continue to experience
significant fluctuations in its quarterly results of operations. The Company
derives substantially all of its revenue from the sale of a relatively small
number of systems, which typically range in price from $400,000 to $1,500,000.
As a result, the timing of the sale of a single system could have a significant
impact on the Company's quarterly revenue and results of operations. The failure
to receive anticipated orders or delays in shipments in a particular quarter,
due, for example, to unanticipated shipment reschedulings, cancellations by
customers or unexpected manufacturing difficulties, may cause revenue for that
quarter to fall significantly below the Company's expectations, which would have
a material adverse effect on the Company's results of operations for such
quarter. The Company's backlog at the beginning of each quarter is not
necessarily indicative of actual sales for any succeeding period. All orders are
subject to delay or cancellation with limited or no penalty. The Company's sales
will often reflect orders shipped in the same quarter that they are received.
Other factors which may have an influence on the Company's results of operations
in a particular quarter include the volume, mix and timing of the receipt of
orders from major customers, competitive pricing pressures, costs of components
and subsystems, the Company's ability to design, manufacture and introduce new
products on a cost effective and timely basis, the delay between incurrence of
expenses to further develop marketing and service capabilities and realization
of benefits from such improved capabilities, fluctuations in foreign exchange
rates, the timing of recognition of revenue under development contracts, the
introduction and announcement of new products by the Company's competitors and
changing conditions in the FPD ( "Flat Panel Display")market worldwide. In
particular, due to substantial differences in gross margin for the Company's
products, changes in the mix of products sold could result in substantial
fluctuations in the Company's gross margin. Accordingly, the Company's results
of operations are subject to significant variability from quarter to quarter.

DEPENDENCE ON RECENTLY INTRODUCED AND NEW PRODUCTS

    The markets for the Company's products are characterized by rapidly changing
technologies, extensive research and new product introductions. The Company
believes that its future success will depend in part upon its ability to
continue to enhance its existing products and to develop and manufacture new
products. As a result, the Company expects to continue to make a significant
investment in engineering, research and development. There can be no assurance
that the Company will be successful in the introduction, marketing and cost
effective manufacture of any of its new or recently introduced products or that
the Company will be able to develop and introduce new products or enhancements
to its existing products and processes in a timely manner which satisfy customer
needs, achieve market acceptance or address technological changes in the FPD
industry. In order to develop new products successfully, the Company is
dependent upon close relationships with its customers and the willingness of
those customers to share information with the Company. The failure to develop
products and introduce them successfully and in a timely manner could adversely
affect the Company's competitive position and results of operations. The Company
has experienced delays in obtaining final acceptance and final payment on some
products. If products have performance, reliability or quality problems or
shortcomings, then the Company may experience reduced orders, higher
manufacturing costs, continued delays in collecting accounts receivable and
additional warranty and service expenses which may have an adverse effect on the
Company's results of operations. In addition, future growth in sales of the
Company's products will depend upon the acceptance of the Company's IPT or FIS
technologies by a broader group of customers, including additional international
customers and FPD manufacturers who

                                       8
<PAGE>
 
currently do not perform the type of FPD test or inspection offered by the
Company's products or utilize alternative technologies for, or methods of,
inspection, such as "open/short" testing and human visual inspection. Because of
the large capital commitment involved in the construction and operation of an
FPD manufacturing facility, the decision by an FPD manufacturer to purchase the
Company's IPT or FIS systems involves a significant technological and financial
commitment as compared to current alternatives such as human inspection and
open/short testers. While the Company is actively promoting the acceptance of
these technologies, there can be no assurance that the Company will be
successful in obtaining broader acceptance of its IPT or FIS technologies.
Failure to achieve broader acceptance would have an adverse effect on the
Company's results of operations.

DEPENDENCE ON PRINCIPAL CUSTOMERS

    The FPD industry is extremely concentrated, with virtually all major FPD
manufacturers and many of the Company's principal customers located in Asia.
Although the composition of the Company's largest customers has changed from
year to year, direct sales to the Company's top six in fiscal 1996 and top four
in fiscal 1995 end user customers accounted for approximately 78% and 71%,
respectively, of the Company's total revenue. The Company currently has no
long-term purchase commitments with any of its customers and sales are generally
made pursuant to purchase orders. All orders are subject to delay or
cancellation with limited or no penalty. A reduction, delay, or cancellation of
orders from one or more of its significant customers, or the loss of one or more
of such customers, could have a material adverse effect on the Company's results
of operations.

DEPENDENCE ON SINGLE OR LIMITED SUPPLIERS

    Certain of the components and subassemblies included in the Company's
systems are obtained from a single source or a limited group of suppliers. For
example, the Company has obtained all of the high speed image processing
systems, materials handling platforms and ultra-high resolution cameras used in
its products from single source suppliers, including Kodak Corporation and
Anorad Corporation. The Company has not entered into any formal agreements with
such suppliers, other than long term purchase orders and, in some cases, volume
pricing agreements. The partial or complete loss of such suppliers could
increase the Company's manufacturing costs or delay product shipments while the
Company qualifies a new supplier, could require redesigning the Company's
products and could therefore have an adverse effect on the Company's results of
operations and damage customer relationships. Further, a significant increase in
the price of one or more of the components supplied by such suppliers could
adversely affect the Company's results of operations.

RELATIONSHIP WITH IHI

    The Company has granted certain exclusive manufacturing and sales rights to
Ishikawajima-Harima Heavy Industries Co., Ltd. ("IHI") with respect to its IPT
systems, including the IPT-MPS, for Japan, Korea, a number of other Asian
countries, Saudi Arabia, Australia, New Zealand, India and Sri Lanka. Under the
terms of this relationship the Company reserves the rights to manufacture
certain critical components and to sell the components to IHI for inclusion in
IPT systems to be sold by IHI in its territory. The agreements between IHI and
the Company further provide for the Company to assist IHI in its sales efforts
in these countries in exchange for a commission. This relationship continues on
an exclusive basis for the IHI territory until June 1997, and, if such
exclusivity is not renewed, IHI will have non-exclusive manufacturing and sales
rights in its territory in periods thereafter. In exchange for these rights, IHI
has provided and continues to provide significant funding for development of the
IPT systems, which funding substantially enhanced the Company's ability to
complete development of these systems in a timely fashion. To date, IHI has
allowed Photon to manufacture all IPT systems sold by IHI in the IHI territory,
and the Company expects that many, if not all, of the IPT systems that will be
sold in IHI's territory will be manufactured by the Company. At present, IHI and
Photon share sales responsibility for Photon manufactured IPT systems in Japan,
and IHI has agreed to allow Photon to sell directly all IPT systems outside
Japan through June 1,, 1997. IHI performs all support and service for system
units in Japan, while Photon provides support and service in the balance of the
IHI territory. To the extent IHI determines in the future to exercise fully its
contractual rights to manufacture and sell these systems in the IHI territory,
such action would reduce revenue of the Company attributable to these IHI
manufactured IPT systems and may have a material adverse effect on the Company's
results of operations. Given the concentration of FPD manufacturers in the IHI
territory, the Company is highly dependent on IHI and the success of the
Company's relationship with IHI to market and sell the IPT systems, including
the IPT-MPS, in these critical markets. In the event IHI should determine to
reduce its internal budgets, staffing levels, research and 

                                       9
<PAGE>
 
development funding or other allocations of its resources for the development,
manufacture, sale and support of IPT systems in its territory, such action by
IHI could have a material adverse effect on the Company's ability to compete in
these markets and on the Company's results of operations. While the Company
believes that both it and IHI have obtained significant mutual benefit from
their continuing relationship, no assurance can be given that the IHI
relationship will continue to provide such benefits to the Company or that the
Company's results of operations will not be adversely impacted in the future
based on its dependency on IHI for the manufacture, sales and support of IPT
systems in Japan and other important Asian markets in the IHI territory.

INTERNATIONAL OPERATIONS

    Approximately 88% of the Company's total revenue for fiscal 1996 was
attributable to sales outside the U.S. The Company expects that international
sales will continue to represent a significant portion of its total sales. Sales
to customers outside the U.S. are subject to risks, including the imposition of
governmental controls, the need to comply with a wide variety of foreign and
U.S. export laws, political and economic instability, trade restrictions,
changes in tariffs and taxes, longer payment cycles typically associated with
international sales, and the greater difficulty of administering business
overseas as well as general economic conditions. Although substantially all of
the Company's direct international sales are denominated in U.S. dollars, both
direct sales by the Company and sales through IHI may be affected by changes in
demand resulting from fluctuations in interest and currency exchange rates. To
the extent the Company's sales are denominated in foreign currency, the
Company's revenue and results of operations may also be directly affected by
fluctuations in foreign currency exchange rates. Furthermore, although the
Company endeavors to meet technical standards established by foreign regulatory
bodies, there can be no assurance that the Company will be able to comply with
changes in foreign standards in the future. The inability of the Company to
design products to comply with foreign standards could have a material adverse
effect on the Company. In addition, the laws of certain foreign countries may
not protect the Company's intellectual property to the same extent as do the
laws of the U.S.

DEPENDENCE ON JAPANESE MARKET

    The future performance of the Company will be dependent, in part, upon its
ability to continue to compete successfully in the Japanese market, one of the
largest markets for FPD test, inspection and repair equipment. The Company's
ability to compete in this market in the future is dependent upon continuing
free trade between Japan and the U.S., the continuing ability of the Company to
develop products in a timely manner that meet the technical requirements of its
Japanese customers and the continuing ability of the Company to maintain
satisfactory relationships with leading companies in the Japanese FPD industry.
The Company believes that the Japanese companies with which it competes may have
a competitive advantage in Japan because of the preference of some Japanese
customers for Japanese equipment suppliers because such customers may have
longer standing or closer business relationships with such competitors. The
Company's sales to Japan and results of operations will also be affected by the
overall health of the Japanese economy, including the effects of currency
exchange rate fluctuations on the global competitiveness of Japanese FPD
manufacturers.

RAPID AND FUNDAMENTAL TECHNOLOGICAL CHANGE

The FPD industry is an evolving industry characterized by extensive research and
development which has and is expected to continue to lead to rapid technological
change. The development by others of new or improved products or technologies
may make the Company's current or proposed products obsolete or less
competitive. Although the Company devotes significant efforts and financial
resources to further develop and enhance its existing products, there can be no
assurance that advances in other or alternative technologies will not make the
Company's products obsolete or less competitive. Currently, the predominant
technology used in the FPD industry is liquid crystal display ("LCD")
technology. Although the Company has installed its products or has entered into
discussions with manufacturers utilizing virtually all of the alternative FPD
technologies which the Company believes are commercially viable FPD
technologies, its revenue is derived primarily from sales of products related to
a variant of LCD technology used in a substantial portion of all FPDs, AMLCD
technology. An industry shift away from AMLCD technology or the emergence of new
competing technologies could have a material adverse effect on the Company's
business and results of operations.

                                       10
<PAGE>
 
COMPETITION

    The FPD equipment industry is highly competitive. The Company faces the
prospect of substantial future competition from established companies, some of
which are expected to be larger companies, or parts thereof, some of which are
expected to have greater financial, engineering and manufacturing resources than
the Company and some of which are expected to have larger sales and service
organizations and long-standing customer relationships with major FPD
manufacturers. In the event that the Company's agreements with IHI are not
extended in 1997, IHI may compete with the Company in selling the Company's IPT
systems in Japan, Korea and the rest of the IHI territory. The Company also
expects it may face additional competition from new entrants into the FPD
equipment industry and from competitors utilizing new technologies. The
Company's competitors can be expected to continue to improve the design and
performance of their products and to introduce new products with competitive
price/performance characteristics. In addition, the Company's customers may
choose to develop proprietary technology and FPD equipment which may obviate or
lessen their need to purchase the Company's products. The Company's customers
may also use multiple technologies and solutions, including competitors'
products, to provide the functionality of the Company's systems. Competitive
pressures may necessitate price reductions which could adversely affect the
Company's results of operations. Although the Company believes that it has
certain technological and other advantages over its competitors, realizing and
maintaining such advantages will require a continued high level of investment by
the Company in engineering, research and development, marketing and customer
service and support. There can be no assurance that the Company will have
sufficient resources to continue to make such investments or that the Company
will be able to make the technological advances necessary to maintain such
competitive advantages.

FLAT PANEL DISPLAY INDUSTRY DOWNTURNS OR SLOWDOWNS

    The Company's business depends in large part upon the capital equipment
expenditures of FPD manufacturers, which in turn depend on the current and
anticipated market demand for FPDs and products utilizing FPDs. For example, the
Company believes that historical shortages of supplies of semiconductor
components may have in the past temporarily limited the quantities of laptop
computers that were manufactured, which in turn may have reduced demand from
laptop computer manufacturers for certain FPDs. Should these conditions have
continued for an extended period, the resulting reduced long-term demand for
FPDs suitable for laptop computers could adversely affect the level of capital
expenditure by FPD manufacturers. Although to date the FPD industry has had a
relatively steady growth rate, the FPD industry may, like the semiconductor
industry, become highly cyclical and experience periodic downturns or slowdowns
in growth, which may have a material adverse effect on capital equipment
expenditures by FPD manufacturers and in turn adversely affect the Company's
results of operations. No assurance can be given that the Company's results of
operations would not be adversely affected if such downturns or slowdowns in the
FPD industry were to occur in the future. In addition, the need for continued
investment in engineering, research and development and marketing required to
penetrate targeted foreign markets and maintenance of extensive worldwide
customer service and support capabilities will limit the Company's ability to
reduce expenses during downturns or slowdowns in growth in the FPD industry.

PATENTS AND PROPRIETARY RIGHTS

    The Company's future success and competitive position are dependent in part
upon its proprietary technology, and the Company relies on patent, trade secret,
trademark and copyright law to protect its intellectual property. There can be
no assurance that any patent owned or licensed by the Company will not be
invalidated, circumvented, challenged or licensed to others, that the rights
granted thereunder will provide competitive advantages to the Company or that
any of the Company's pending or future patent applications will be issued with
the scope of the claims sought by the Company, if at all. Furthermore, there can
be no assurance that others will not develop technologies that are similar or
superior to the Company's technology, duplicate the Company's technology or
design around the patents owned by the Company. In addition, effective copyright
and trade secret protection may be unavailable or limited in certain foreign
countries. There can be no assurance that the steps taken by the Company will
prevent misappropriation of its technology. In addition, litigation may be
necessary in the future to enforce the Company's patents and other intellectual
property rights, to protect the Company's trade secrets, to determine the
validity and scope of the proprietary rights of others or to defend against
claims of infringement or invalidity. Such litigation could result in
substantial costs and diversion of resources and could have a material adverse
effect on the Company's results of operations.

                                       11
<PAGE>
 
    Competitors in both the U.S. and foreign countries, many of which have
substantially greater resources and have made substantial investments in
competing technologies, may have applied for or obtained, or may in the future
apply for and obtain, patents that will prevent, limit or interfere with the
Company's ability to manufacture and sell its products. The Company has not
conducted an independent review of patents issued to third parties. Although the
Company believes that its products do not infringe the patents or other
proprietary rights of third parties, there can be no assurance that other third
parties will not assert infringement claims against the Company or that such
claims will not be successful. Even successful defense of patent suits are both
costly and time-consuming. An adverse outcome in the defense of a patent suit
could subject the Company to significant liabilities to third parties, require
disputed rights to be licensed from third parties or require the Company to
cease selling its products.

MANAGEMENT OF GROWTH

    The Company has recently experienced and may continue to experience growth
in the number of its employees and the scope of its operations, resulting in
increased responsibilities for management personnel. To manage recent and
potential future growth effectively, the Company will need to continue to
implement and improve its operational, financial and management information
systems and to hire, train, motivate and manage a growing number of employees.
The future success of the Company also will depend on its ability to attract and
retain qualified technical, marketing and management personnel, particularly
highly skilled software engineers, for whom competition is intense. In
particular, the current availability of qualified engineers is limited, and
competition among companies for skilled and experienced engineering personnel is
very strong. The Company is currently attempting to hire a number of engineering
personnel and has experienced delays in filling such positions. The Company
expects to experience continued difficulty in filling its needs for qualified
engineers and other personnel. There can be no assurance that the Company will
be able to achieve or manage effectively any such growth, and failure to do so
could delay product development cycles or otherwise have a material adverse
effect on the Company's results of operations.

DEPENDENCE ON KEY EMPLOYEES

    The future success of the Company is dependent, in part, on its ability to
retain certain key personnel. The Company also needs to attract additional
skilled personnel in all areas of its business to continue to grow. While many
of the Company's current employees have many years of service with the Company,
there can be no assurance that the Company will be able to retain its existing
personnel or attract additional qualified employees in the future.

POSSIBLE VOLATILITY OF COMMON STOCK PRICE

     Many factors such as, but not limited to, announcements of technological
innovations or new products by the Company, its competitors or third parties, as
well as quarterly variations in the Company's actual or anticipated results of
operations, may cause the market price of the Company's Common Stock to
fluctuate significantly. Furthermore, the stock market has experienced extreme
price and volume fluctuations, which have particularly affected the market
prices of many high technology companies and which have often been unrelated to
the operating performance of such companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock.

                                       12
<PAGE>
 
                          PART II: OTHER INFORMATION



ITEM 1.  LEGAL PROCEEDINGS

              None.

ITEM 2.  CHANGES IN SECURITIES

              None.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

              None.

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

The Company held its Annual Meeting of Shareholders on February 17, 1997.
Matters voted upon at the meeting included:

    1)  Election of directors (listed below)

    The following directors were elected to hold office until the next
    Annual Meeting of Shareholders of the Company:

      Director                                    For            Withheld
      --------                                    ---            --------
      Floyd Kvamme......................          6,036,703          91,596
      Vincent Sollitto..................          6,036,560          91,739
      Francois Henley...................          6,036,560          91,739
      Barry Cox.........................          5,983,062         145,237
      Michael Kim.......................          5,488,003         640,296
      Steven Krausz.....................          6,032,203          96,096
      Malcolm Thompson..................          6,103,428          24,871



     2)  Approval of an increase in shares reserved for issuance under the 1995
     Stock Option Plan by 510,943 from 300,000 shares to 810,943

          For...............................          3,914,361
          Against...........................            345,915
          Abstained.........................             18,828
          No Vote...........................          1,849,195

                                       13
<PAGE>
 
    3)  Approval of an amendment to the 1995 Stock Option Plan to
    increase the maximum number of shares with respect to which options may be
    granted to any individual per calendar year by 150,000 shares from 100,000
    to 250,000 shares.


          For..............................           5,543,698
          Against..........................             216,486
          Abstained.........................             56,478
          No Vote...........................            311,637

    4)  Approval of the appointment of Ernst & Young LLP as the
    independent auditors for the Company for the fiscal year ending
    September 30, 1997.

          For..............................           5,975,862
          Against..........................             142,092
          Abstained.........................             10,345
          No Vote...........................                  0



ITEM 5.  OTHER INFORMATION

              None.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

     (a)  EXHIBITS

          11.1   Statement Re: Computation of Per Share Earnings
          27     Financial Data Schedule

     (b)  REPORTS ON FORM 8-K

          None.

                                       14
<PAGE>
 
                                  SIGNATURES


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



                                       PHOTON DYNAMICS, INC.
                                                      (Registrant)



Date: May 14, 1997                     /s/ Vincent Sollitto
                                       ----------------------------------------
                                       Vincent Sollitto
                                       Chief Executive Officer and Director
                                       (Principal Executive Officer)





Date: May 14, 1997                     /s/ Howard Bailey
                                       -----------------------------------------
                                       Howard Bailey
                                       Chief Financial Officer and Secretary
                                       (Principal Financial and Accounting 
                                       Officer)

                                       15