<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 June 30, 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 August 12, 1997 7,090,473 shares of the Issuer's Common Stock, no par 
value, were outstanding.
<PAGE>
 
                               TABLE OF CONTENTS

                         PART I: FINANCIAL INFORMATION
<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
<S>      <C>                                                               <C>
 
ITEM 1.  Financial Statements (unaudited)

         Condensed Consolidated  Balance Sheets -
          June 30, 1997 and September 30, 1996.............................  3

         Condensed Consolidated Statements of
          Operations - three and nine months ended
          June 30, 1997 and 1996...........................................  4

         Condensed Consolidated Statements of Cash
          Flows - nine months ended June 30, 1997 and 1996.................  5

         Notes to Condensed Consolidated Financial Statements..............  6

ITEM 2.  Management's Discussion and Analysis of
          Financial Condition and Results of Operations....................  7


OTHER    Risk Factors......................................................  9

                          PART II: OTHER INFORMATION

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

         Signatures........................................................ 15
 
</TABLE>

                                       2
<PAGE>
 
                             Photon Dynamics, Inc.

                     Condensed Consolidated Balance Sheets
                                 (In thousands)
                                  (Unaudited)
<TABLE>
<CAPTION>
                                          JUNE 30, 1997   SEPTEMBER 30, 1996
                                          -------------   ------------------
<S>                                       <C>             <C>
                 ASSETS
Current assets:
 Cash and cash equivalents                     $  5,366             $  5,108
 Short term investments                               -                4,066
 Accounts receivable, net of allowance     
  for doubtful accounts of $741            
  ($629 at September 30, 1996)                   10,517                8,652
 Inventories                                      4,899                4,125
 Prepaid expenses and other current assets          446                  518
                                               --------             --------
Total current assets                             21,228               22,469
 
Property, equipment, and leasehold                                           
 improvements, net                                2,300                1,849 
 
Other assets                                        790                  640
                                               --------             --------
Total assets                                   $ 24,318             $ 24,958
                                               ========             ========
 
    LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
 Accounts payable                              $  1,820             $  2,743
 Accrued expenses and other liabilities           2,703                2,067
 Customer deposits and deferred revenue              97                  353
 Line of credit                                     500                    -
 Current portion of long-term debt                    3                   16
                                               --------             --------
Total current liabilities                         5,123                5,179
 
Noncurrent portion of long-term debt                  7                    9
Commitments and contingencies
 
Shareholders' equity:
 Common stock                                    38,405               38,064
 Accumulated deficit                            (19,095)             (18,201)
 Foreign currency translation adjustment                                      
  and other                                          (1)                  (7) 
 Notes receivable from shareholders                (121)                 (86)
                                               --------             --------
Total shareholders' equity                       19,188               19,770
                                               --------             --------
Total liabilities and shareholders'                                          
 equity                                        $ 24,318             $ 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.

                                       3
<PAGE>
 
                             Photon Dynamics, Inc.

                Condensed Consolidated Statements of Operations
                    (In thousands, except per share amounts)
                                  (Unaudited)
<TABLE>
<CAPTION>
                                                 THREE MONTHS ENDED     NINE MONTHS ENDED
                                                      JUNE 30,               JUNE 30,
                                               ---------------------   --------------------
                                                 1997        1996        1997        1996
                                               ---------   ---------   --------   ---------
<S>                                            <C>         <C>         <C>        <C>
Revenue:
 Product revenue                                $6,821        $7,609    $17,002    $18,881
 Non product revenue                                 -           100      1,150      1,341
                                                ------        ------    -------    -------
                                                 6,821         7,709     18,152     20,222
Cost of revenue:
 Product revenue                                 3,455         4,064      9,442      9,883
 Non product revenue                                 -            46          -        962
                                                ------        ------    -------    -------
                                                 3,455         4,110      9,442     10,845
                                                ------        ------    -------    -------
Gross margin                                     3,366         3,599      8,710      9,377
 
Operating expenses:
 Research and development                        2,199         1,027      5,687      2,905
 Selling, general, and administrative            1,291         1,809      4,143      4,452
                                                ------        ------    -------    -------
Total operating expenses                         3,490         2,836      9,830      7,357
                                                ------        ------    -------    -------
Operating income (loss)                           (124)          763     (1,120)     2,020
 
Interest income                                     76           179        285        484
Interest expense and other                          92           (73)       (39)      (244)
                                                ------        ------    -------    -------
Income (loss) before provision for
 income taxes                                       44           869       (874)     2,260
 
Provision for income taxes                          17            44         20        121
                                                ------        ------    -------    -------
Net income (loss)                               $   27        $  825    $  (894)   $ 2,139
                                                ======        ======    =======    =======
Net income (loss) per share:                    $ 0.00        $ 0.11    $ (0.13)   $  0.29
                                                ======        ======    =======    =======
Shares used in computing net income                
 (loss) per share                                7,571         7,717      7,016      7,315
                                                ======        ======    =======    =======
</TABLE>

See accompanying notes to condensed consolidated financial statements

                                       4
<PAGE>
 
                             Photon Dynamics, Inc.
                                        
                Condensed Consolidated Statements of Cash Flows
                                 (In thousands)
                                  (Unaudited)
<TABLE>
<CAPTION>
                                          NINE MONTHS ENDED JUNE 30,
                                              1997          1996
                                          -----------   ------------
<S>                                       <C>           <C>
OPERATING ACTIVITIES
Net Income (loss)                             $  (894)      $ 2,139
Adjustments to reconcile net income
 (loss) to net cash used in operating
 activities:
 Depreciation and amortization                    849           506
 Changes in operating assets and
  liabilities:
   Accounts receivable                         (1,865)       (5,221)
   Inventories                                   (774)          240
   Prepaid expenses and other current
    assets                                         72          (112)
   Other assets                                  (144)           58
   Accounts payable                              (923)          412
   Accrued expenses and other
    liabilities                                   636           715
   Customer deposits and deferred
    revenue                                      (256)       (1,035)
                                              -------       -------
Net cash used in operating activities          (3,299)       (2,298)
 
INVESTING ACTIVITIES
Acquisition of property and equipment          (1,753)       (1,109)
Disposal of property and equipment                453             -
Maturities of short term investments            6,811        (9,547)
Acquisition of short term investments          (2,745)        4,540
                                              -------       -------
Net cash (used in) provided by
 investing activities                           2,766        (6,116)
 
FINANCING ACTIVITIES
Borrowings/(repayment) under line of
 credit                                           500        (2,325)
Principal payments under capital leases           (15)          (22)
Proceeds from issuance of common stock,
 net of issuance costs                            341        17,020
Issuance of note receivable from
 shareholders                                     (56)            -
Payment of note receivable from
 shareholders                                      21             -
Payment of notes payable                            -          (304)
                                              -------       -------
Net cash provided by financing
 activities                                       791        14,369
 
Net increase in cash and cash
 equivalents                                      258         5,955
Cash and cash equivalents at beginning
 of period                                      5,108           298
                                              -------       -------
Cash and cash equivalents at end of
 period                                       $ 5,366       $ 6,253
                                              =======       =======
</TABLE>
See accompanying notes to condensed consolidated financial statements

                                       5
<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 nine months ended June 30,
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)     June 30, 1997  September 30, 1996
                           -------------  ------------------
        Raw Materials           $1,397              $1,970
        Work-in-process          2,672               1,247
        Finished goods             830                 908
                                ------              ------ 
                                $4,899              $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 nine months ended June 30, 1996 of $0.01 and $0.04, respectively.  There is
no material impact for the three and nine months ended June 30, 1997.  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.

                                       6
<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 risks and uncertainties.  The Company's future 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 third quarter of fiscal 1997 decreased 12% to
$6.8 million from $7.7 million in the third quarter of fiscal 1996. Total
revenues for the first nine months of fiscal 1997 was $18.2 million, a decrease
of 10% from $20.2 million in the comparable period of 1996.  Product revenue
decreased 10% to $6.8 million in the third quarter of fiscal 1997 from $7.6
million in the third 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 is also in the process of announcing and
shipping new products which have significantly improved throughput and testing
specifications, decreasing demand for the Company's existing systems.

  Non product revenue decreased to zero in the third quarter of fiscal 1997 from
$100,000 in the third 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 nine 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.

  The Company has also entered into a new memorandum of understanding with
Ishikawajima-Harima Heavy Industries Co., Ltd. ("IHI"), under which it is
intended that IHI will sell and service all three of the Company's product lines
in Japan.  Previously the Company marketed its FIS and ILW systems directly
through its subsidiary, KKPD.    In the quarter ended June 30, 1997 the Company
shipped its first FIS and ILW systems to IHI.  The final agreement is expected
to be signed during the next six months.

  Gross Margin. Gross margins on product revenue as a percent of revenue were
49% and 44%, for the three and nine month periods ended June 30, 1997,
respectively, compared to 47% and 48% for the comparable periods of the prior
fiscal year. The increase in margins in the third quarter of fiscal 1997 was
primarily due to the shipment of a new product with associated higher margins as
well as a more favorable product mix.

  Research and Development.  The Company increased its research and development
spending to $2.2 million in the third quarter of  fiscal 1997, or 32% of
revenue, from $1.0 million in the third quarter of fiscal 1996, or 13% of
revenue. Research and development expenses for the first nine months of fiscal
1997 were $5.7 million, an increase from $2.9 million in the comparable period
of 1996, 31% and 14% of revenue respectively.  The increase of combined research
and development spending primarily 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 during the remainder of fiscal 1997.

  Selling, General and Administrative.  Selling, general and administrative
expenses in the third quarter of fiscal 1997 decreased to $1.3 million, from
$1.8 million in the third quarter of fiscal 1996, 19% and 23% of revenue,

                                       7
<PAGE>
 
respectively. Total selling, general and administrative expenses for the first
nine months of fiscal 1997 were $4.1 million, a decrease from $4.5 million in
the comparable period of fiscal 1996, representing 23% and 22% of revenue,
respectively.   Selling expenses typically fluctuate based on the Company's
product and territory sales mix, due to different sales channels and associated
cost structures.  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.

  Interest income/expense and other.  Interest income in the third quarter of
fiscal 1997 decreased  to $76,000 from $179,000 in the third quarter of fiscal
1996.  The decrease was the result of lower cash and investment balances in the
third quarter of fiscal 1997 compared to the third quarter of fiscal 1996.
Interest expense and other for the three and nine months ended June 30, 1997
includes a $95,000 foreign exchange gain.

  Provision for Income Tax.  The Company's effective tax rate for the three and
nine months ended June 30, 1997 is lower than the statutory rate of 34% due to
the utilization of loss carryforwards and foreign income tax charges.

LIQUIDITY AND CAPITAL RESOURCES

  The Company has financed its operations primarily from a combination of
amounts raised in equity financings, loans, lines of credit from a bank and cash
flows from operations. As of June 30, 1997, the Company had working capital of
$16.1 million of which $5.4 million was cash or cash equivalents and short term
investments.

  Cash used in operating activities was $3.3 million for the nine months ended
June 30, 1997.  Cash was primarily used to finance the net loss, an increase in
accounts receivable and other working capital requirements. The Company's credit
terms to customers typically have a portion of the payment extended for a period
of months after shipment, this combined with the growth in product sales in the
third quarter of fiscal 1997 compared to the fourth quarter of fiscal 1996, and
the near quarter end timing of such product shipments result in a larger
accounts receivable balance.  The Company also has entered into a $7.5 million
line of credit with Bank of the West, under which there was $500,000 outstanding
at June 30, 1997.  Borrowings under this line of credit bear interest at the
prime rate. The line of credit is secured by the Company's trade receivables and
contains certain financial and other covenants.

  Capital expenditures during the first nine months of  fiscal 1997 were $1.8
million compared to $1.1 million in the first nine 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.

                                       8
<PAGE>
 
                                  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
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.

                                       9
<PAGE>
 
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 nine 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 and
ultra-high resolution cameras used in its products from single source suppliers,
including Kodak 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's existing relationship with IHI expired June 1, 1997.  Under that
arrangement IHI will retain certain manufacturing and sales rights with respect
to the IPT systems, including the IPT-MPS, for Japan, Korea, and a number of
other Asian countries.  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.  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 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 sales and support of IPT systems in Japan.

The Company has entered into a new memorandum of understanding with IHI, under
which it is intended that IHI will sell and service all three of the Company's
product lines in Japan.  Previously the Company marketed its FIS and ILW systems
directly through its subsidiary, KKPD.  The final agreement is expected to be
signed during the next six months.  Under the anticipated terms of the agreement
IHI will be the sole distributor of the Company's products in Japan.  Any
termination or delay in the signing of this agreement could result a period of
reduced sales in Japan while the Company creates another sales channel.

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 

                                       10
<PAGE>
 
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.

                                       11
<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 substantially all of the terms of the Company's memorandum of
understanding with IHI are not signed as an final agreement, 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.

                                       12
<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.

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

                                       15