<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 December 31, 1996

                                       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 February 12, 1997 7,026,376 shares of the Issuer's Common Stock, no par
value, were outstanding.
<PAGE>
 
                               TABLE OF CONTENTS
                                                                            PAGE
                                                                            ----

                         PART I: FINANCIAL INFORMATION

ITEM 1.  Financial Statements (unaudited)

         Condensed Consolidated Balance Sheets - December 31, 1996
           and September 30, 1996.........................................    2

         Condensed Consolidated Statements of Operations - three
           months ended December 31, 1996 and 1995........................    3

         Condensed Consolidated Statements of Cash Flows - three months
           ended December 31, 1996 and 1995...............................    4

         Notes to Condensed Consolidated Financial Statements.............    5


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

         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................................................   13

ITEM 6.  Exhibits and Reports on Form 8-K.................................   13

         Signatures.......................................................   14

                                       1
<PAGE>
 
                             Photon Dynamics, Inc.
 
                     Condensed Consolidated Balance Sheets
                                (In thousands)
                                  (Unaudited)
<TABLE>
<CAPTION>
                                                           DECEMBER 31,         SEPTEMBER 30,
                                                               1996                  1996
                                                           ------------         -------------
<S>                                                      <C>                  <C>
                      ASSETS
Current assets:
  Cash and cash equivalents..........................          $  7,023              $  5,108
  Short term investments.............................             2,538                 4,066
  Accounts receivable, net of allowance
   for doubtful accounts of $629,
   ($629 at September 30, 1996)......................             8,073                 8,652

  Inventories........................................             4,262                 4,125
  Prepaid expenses and other current assets..........               695                   518
                                                           ------------         -------------
Total current assets.................................            22,591                22,469

Property, equipment, and leasehold
  improvements, net..................................             2,294                 1,849

Other assets.........................................               575                   640
                                                           ------------         -------------
Total assets.........................................          $ 25,460              $ 24,958
                                                           ============         =============
         LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
  Accounts payable...................................          $  2,696              $  2,743
  Accrued expenses and other liabilities.............             2,698                 2,067
  Customer deposits and deferred revenue.............               255                   353
  Current portion of long-term debt..................                10                    16
                                                           ------------         -------------
Total current liabilities............................             5,659                 5,179

Noncurrent portion of long-term debt.................                 8                     9

Commitments and contingencies

Shareholders' equity:
  Common stock.......................................            38,076                38,064
  Accumulated deficit................................           (18,149)              (18,201)
  Foreign currency translation adjustment and other..                 8                    (7)
  Notes receivable from shareholders.................              (142)                  (86)
                                                           ------------         -------------
Total shareholders' equity...........................            19,793                19,770
                                                           ------------         -------------
Total liabilities and shareholders' equity...........          $ 25,460              $ 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 Income
                    (In thousands, except per share amounts)
                                  (Unaudited)
<TABLE>
<CAPTION>
                                                    THREE MONTHS ENDED 
                                                        DECEMBER 31,
                                                   1996             1995
                                                  ------           ------

<S>                                            <C>              <C>
Revenue........................................   $6,246           $6,205
Cost of revenue................................    3,173            3,401
                                                  ------           ------
Gross margin...................................    3,073            2,804

Operating expenses:
  Research and development.....................    1,636              903
  Selling, general, and administrative.........    1,386            1,266
                                                  ------           ------
Total operating expenses.......................    3,022            2,169
                                                  ------           ------
Operating income...............................       51              635

Interest income................................      111               71
Interest expense and other.....................     (107)            (111)
                                                  ------           ------
Income before provision for income taxes.......       55              595

Provision for income taxes.....................        3               32
                                                  ------           ------
Net income.....................................   $   52           $  563
                                                  ------           ------

Net income per share...........................   $ 0.01           $ 0.09
                                                  ======           ======
Shares used in computing net income per share..    7,622            6,554
                                                  ======           ======

</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>
                                                                  THREE MONTHS ENDED
                                                                      DECEMBER 31,
                                                                1996                1995
                                                               ------              ------
<S>                                                            <C>                 <C>
OPERATING ACTIVITIES
Net Income................................................      $   52               $   563
Adjustments to reconcile net income to net cash provided
 by operating activities:
   Depreciation and amortization..........................         237                   128
   Changes in operating assets and liabilities:
     Accounts receivable..................................         579                   331
     Inventories..........................................        (137)                  628
     Prepaid expenses and other current assets............        (177)                 (234)
     Other assets.........................................          80                    44
     Accounts payable.....................................         (47)                   (7)
     Accrued expenses and other liabilities...............         631                   341
     Customer deposits and deferred revenue...............         (98)                 (367)
                                                                ------               -------
Net cash provided by operating activities.................       1,120                 1,427

INVESTING ACTIVITIES
Acquisition of property and equipment.....................        (682)                 (783)
Maturities of short term investments......................       1,528                     -
Acquisition of short term investments.....................           -                (1,697)
                                                                ------               -------
Net cash provided by/(used in) investing activities.......         846                (2,480)

FINANCING ACTIVITIES
Repayment of lines of credit..............................           -                (2,325)
Principal payments under capital leases...................          (7)                   (7)
Proceeds from issuance of common stock,
  net of issuance costs...................................          12                16,955
Issuance of note receivable from shareholders.............         (56)                    -
Payment of notes payable..................................           -                   (52)
Payment of other short-term debt..........................           -                   (71)
                                                                ------               -------
Net cash (used in)/provided by financing activities.......         (51)               14,500
                                                                ------               -------
Net increase in cash and cash equivalents.................       1,915                13,447
Cash and cash equivalents at beginning of period..........       5,108                   298
                                                                ------               -------
Cash and cash equivalents at end of period................      $7,023               $13,745
                                                                ======               =======
</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 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 months ended December 31, 1996 are not
necessarily indicative of the results that may be expected for the fiscal year
ended September 30, 1997.  For further information, refer to the audited
financial statements and footnotes thereto included in the Company's Annual
Report on Form 10-KSB for the fiscal year ended September 30, 1996.
 

2.   INVENTORIES

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

<TABLE>
<CAPTION>
 
                                    December 31,       September 30, 
                                       1996                1996
                                    ------------       ------------
        <S>                          <C>                 <C>
        Raw materials                   $1,665               $1,970
        Work-in-process                  1,923                1,247
        Finished goods                     674                  908
                                    ------------       ------------
                                        $4,262               $4,125
                                    ==========         ============
</TABLE>

                                       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
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.

RESULTS OF OPERATIONS

    Revenue.  Revenue increased marginally to $6.25 million in the first 
    ------- 
quarter of fiscal 1997 from $6.21 million in the first quarter of fiscal 1996.
Revenue 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. Overall product mix was similar between the first quarter of
fiscal 1997 and fiscal 1996. Revenue from development contracts decreased to
$150,000 in the first quarter of fiscal 1997 from $761,000 in the first quarter
of fiscal 1996. The decrease in development revenue was due to the completion of
a development contract with a government agency in the first quarter of fiscal
1996.

    Gross Margin.  Gross margin as a percent of revenue increased to 49% in the
    ------------
first quarter of fiscal 1997 from 45% in the first quarter of fiscal 1996.  This
increase in gross margins was due to the relative decrease in development
contract revenue, with associated lower gross margins, as a percentage of total
revenue. Gross margins improved due to the initial fee paid by a value added
reseller (see above), offset by higher overhead related to investments in
infrastructure including customer service. Overall product gross margins will
fluctuate on a quarterly basis as the Company's product mix fluctuates.

    Research and Development.  The Company increased its research and 
    ------------------------
development expenses on an absolute dollar basis to $1.6 million in the first
quarter of fiscal 1997, or 26% of revenue, from $903,000 in the first quarter of
fiscal 1996, or 15% of revenue. In addition to these research and development
expenses incurred for product development, the Company spent $590,000 in the
first quarter of fiscal 1996 in performance of its obligations under third
party development contracts, as compared with no expenditure in the first
quarter of fiscal 1997. The combination of research and development expenses
and costs incurred on development contracts was $1.5 million or 24% of revenue
in the first quarter of fiscal 1996. 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 these combined 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 first quarter of fiscal 1997 increased to $1.4 million, or 22%
of revenue, from the first quarter of fiscal 1996 level of $1.3 million, or 20%
of revenue.  The increase reflects an overall increase in product related
revenue and the associated incremental selling costs as well as the
administration costs associated with being a public company.   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
based on the Company's product and territory sales mix, which have different
sales channels and associated cost structures.

    Interest income/expense. Interest income in the first quarter of fiscal 1997
    -----------------------
increased  to $111,000 from the first quarter of fiscal 1996 level of $71,000 as
a result of interest received on the proceeds from the Company's Initial Public
Offering ("IPO") in November 1995.

    Provision for Income Taxes.  The Company's effective tax rate for the three
    --------------------------
months ended December 31, 1996 and December 31, 1995 was 5%.  This is lower than
the statutory rate of 34% due to the utilization of loss carryforwards.

                                       6
<PAGE>
 
LIQUIDITY AND CAPITAL RESOURCES

    As of December 31, 1996, the Company had working capital of $16.9 million of
which $7.0 million was cash or cash equivalents.

    Cash provided by operating activities was $1.1 million for the three months
ended December 31, 1996.  Working capital items that significantly impacted cash
balances in the quarter were accounts receivable and accruals.  The Company's
accounts receivable balance decreased $579,000 to $8.1 million. The Company's
credit terms to customers typically have a small portion of the payment extended
for a period of months after shipment.  During the quarter ended December 31,
1996, the Company collected some older extended receivables resulting in a lower
account receivable balance.  Accruals increased by $631,000 due to the timing of
compensation related and external commission payments.

    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 cash and cash equivalents and cash flow from
operations will be sufficient to satisfy working capital requirements and
capital equipment needs for the next 12 months. As of December 31, 1996, the
Company had no material outstanding commitments to purchase or lease capital
equipment.

    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. 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 currently do not perform the type of FPD
test or inspection offered by the Company's products or utilize alternative

                                       8
<PAGE>
 
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 December 31, 1996. 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 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 

                                       9
<PAGE>
 
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
------------------------------------------------------------

          None.

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 FORMS 8-K

                     None.

                                      13
<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: February 14, 1997                  /s/ Vincent Sollitto
                                         ------------------------------------
                                         Vincent Sollitto
                                         Chief Executive Officer and Director
                                         (Principal Executive Officer)
 
 
 
 
                                         /s/ Howard Bailey 
Date: February 14, 1997                  ------------------------------------
                                         Howard Bailey
                                         Chief Financial Officer and Secretary
                                         (Principal Financial and Accounting
                                         Officer)
 

                                      14