<PAGE>   1


                    U.S. 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 1934
               FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1996


   [ ]        TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE
                          SECURITIES EXCHANGE ACT 1934
             FOR THE TRANSITION PERIOD FROM _________ TO _________

                       COMMISSION FILE NUMBER 0-10521

                              QUEST MEDICAL, INC.
       -----------------------------------------------------------------        
       (Exact name of Small Business Issuer as specified in its charter)


             TEXAS                                       75-1646002
-------------------------------                      -------------------
(State or other jurisdiction of                       (I.R.S. Employer
 incorporation or organization)                      Identification No.)


                   ONE ALLENTOWN PARKWAY, ALLEN, TEXAS 75002          
                   -----------------------------------------
                    (Address of principal executive offices)
                                   (Zip Code)


                                 (214) 390-9800
                ------------------------------------------------              
                (Issuer's Telephone Number, including area code)

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

State the number of shares outstanding of each of the issuer's classes of
common equity, as of the latest practicable date:

                                              NUMBER OF SHARES OUTSTANDING AT
    TITLE OF EACH CLASS                               OCTOBER 26, 1996
----------------------------                  -------------------------------
COMMON STOCK, $.05 PAR VALUE                               8,315,080

<PAGE>   2
                      QUEST MEDICAL, INC. AND SUBSIDIARIES


                               TABLE OF CONTENTS



<TABLE>
<S>              <C>                                                    <C>
PART I.          FINANCIAL INFORMATION                                      2
                                                                    
                 Consolidated Balance Sheets                        
                   September 30, 1996 and December 31, 1995               3-4
                                                                    
                 Consolidated Statements of Operations              
                   For the Three Months and Nine Months             
                   ended September 30, 1996 and 1995                        5
                                                                    
                 Consolidated Statements of Cash Flows              
                   For the Nine Months ended                        
                   September 30, 1996 and 1995                              6
                                                                    
                 Consolidated Statements of Stockholders'           
                   Equity                                                   7
                                                                    
                 Notes to Condensed Consolidated                    
                   Financial Statements                                  8-15
                                                                    
                 Management's Discussion and Analysis of            
                   Financial Condition and Results of               
                   Operations                                           16-21
                                                                    
PART II.         OTHER INFORMATION                                         22
                                                                    
                 Item 6. Exhibits and Reports on                    
                   Form 8-K                                                22
                                                                    
SIGNATURES                                                                 23
</TABLE>





                                       1
<PAGE>   3





                                     PART I


                             FINANCIAL INFORMATION





                                       2
<PAGE>   4
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                    SEPTEMBER 30, 1996 AND DECEMBER 31, 1995

<TABLE>
<CAPTION>
                                                                             SEPTEMBER 30,              DECEMBER 31,
  ASSETS                                                                          1996                      1995
  ------                                                                     -------------              ------------
                                                                              (UNAUDITED)
                                                                                         
  <S>                                                                         <C>                       <C>
  Current assets:
     Cash and cash equivalents                                                $    358,022             $  1,325,630
     Marketable securities                                                       1,998,102                2,588,547
     Receivables:                                                                                        
       Trade accounts, less allowance for doubtful accounts of $114,337                                  
         in 1996 and $114,337 in 1995                                            5,031,639                4,955,235
      Interest and other                                                           149,057                  128,492
                                                                              ------------             ------------
           Total receivables                                                     5,180,696                5,083,727
                                                                              ------------             ------------
     Inventories:                                                                                        
       Raw materials                                                             3,692,992                2,743,702
       Work-in-process                                                           1,875,446                1,077,529
       Finished goods                                                            3,016,704                2,285,961
                                                                              ------------             ------------
            Total inventories                                                    8,585,142                6,107,192
                                                                              ------------             ------------
     Deferred income taxes                                                         488,911                  356,703
     Prepaid expenses and other current assets                                     854,994                1,226,268
                                                                              ------------             ------------
            Total current assets                                                17,465,867               16,688,067
                                                                              ------------             ------------
   Property, plant and equipment:                                                                        
     Land                                                                        1,930,289                1,930,289
     Building and improvements                                                   5,288,765                5,271,718
     Furniture and fixtures                                                      3,746,732                2,964,471
     Machinery and equipment                                                     4,580,378                3,879,802
                                                                              ------------             ------------
                                                                                15,546,164               14,046,280
     Less accumulated depreciation and                                                                  
       amortization                                                              4,533,214                3,784,510
                                                                              ------------             ------------
            Net property, plant and equipment                                   11,012,950               10,261,770
                                                                              ------------             ------------
  Cost in excess of net assets acquired, net of                                                         
      accumulated amortization of $686,668 in 1996                                                       
      and $340,300 in 1995                                                      13,285,693                9,546,298
  Patents, net of accumulated amortization of                                                            
      $1,255,525 in 1996 and $1,086,433 in 1995                                  1,119,874                1,288,966
  Purchased technology from acquisitions, net of                                                         
      accumulated amortization of $651,471 in 1996                                                       
      and $413,558 in 1995                                                       4,046,529                4,284,442
  Tradenames, net of accumulated amortization                                                            
      of $187,500 in 1996 and $93,750 in 1995                                    2,312,500                2,406,250
  Other assets, at cost, less accumulated amortization                                                   
      of $190,000 in 1996 and $178,667 in 1995                                       9,931                   19,964
                                                                              ------------             ------------
                                                                              $ 49,253,344             $ 44,495,757
                                                                              ============             ============
</TABLE>

  See accompanying notes to condensed consolidated financial statements


                                       3
<PAGE>   5
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS
                    SEPTEMBER 30, 1996 AND DECEMBER 31, 1995

<TABLE>
<CAPTION>
                                                                              SEPTEMBER 30,           DECEMBER 31,
   LIABILITIES AND STOCKHOLDERS' EQUITY                                           1996                    1995
   ------------------------------------                                       -------------          -------------
                                                                               (UNAUDITED) 
   <S>                                                                        <C>                    <C>
   Current liabilities:
     Accounts payable                                                         $   2,101,261          $   1,210,265
     Short-term notes payable and current maturities                                                   
        of long-term notes payable                                                9,937,402              1,616,311
     Accrued salary and employee benefit costs                                      748,893                630,908
     Accrued relocation costs                                                            --                291,370
     Other accrued expenses                                                         953,287                755,976
                                                                              -------------          -------------
           Total current liabilities                                             13,740,843              4,504,830
                                                                              -------------          -------------
   Notes payable                                                                  3,854,094              8,558,297
   Deferred income taxes                                                            462,706                562,580
   Stockholders' equity:                                                                               
     Common stock of $.05 par value.  Authorized                                                       
         25,000,000 shares in 1996 and 10,000,000 in 1995;                                             
         issued 8,285,080 shares in 1996 and 8,147,349 in 1995                      414,254                407,367
     Additional paid-in capital                                                  38,548,913             38,253,670
     Retained earnings (deficit)                                                 (7,553,426)            (7,579,925)
     Unrealized loss on marketable securities net of                                                   
         tax benefit of $110,263 in 1996 and $108,729 in 1995                      (214,040)              (211,062)
                                                                              -------------          ------------- 
           Total stockholders' equity                                            31,195,701             30,870,050
   Commitments and contingencies                                                                                  
                                                                              -------------          -------------
                                                                              $  49,253,344          $  44,495,757
                                                                              =============          =============
</TABLE>


   See accompanying notes to condensed consolidated financial statements





                                       4
<PAGE>   6
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
               CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
     FOR THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1995


<TABLE>
<CAPTION>
                                                      THREE MONTHS ENDED              NINE MONTHS ENDED
                                                         SEPTEMBER 30,                  SEPTEMBER 30,
                                                  --------------------------     -----------------------------
                                                      1996           1995            1996             1995
                                                  ----------      ----------     -----------      ------------
<S>                                               <C>             <C>            <C>              <C>
Net revenue                                       $6,486,521      $6,818,923     $19,305,266      $ 18,122,057
                                                                                                   
Cost of revenue                                    2,699,883       2,850,038       8,089,737         7,760,528
                                                  ----------      ----------     -----------      ------------
         Gross profit                              3,786,638       3,968,885      11,215,529        10,361,529
                                                  ----------      ----------     -----------      ------------
Operating expenses:                                                                                
   Marketing                                       1,788,939       1,158,818       4,850,522         2,752,388
   General and administrative                      1,149,198       1,120,697       3,504,544         3,038,450
   Research and development                          724,252       1,145,863       2,493,440         3,639,506
   Purchased research and development                     --              --              --        10,500,000
                                                  ----------      ----------     -----------      ------------
                                                   3,662,389       3,425,378      10,848,506        19,930,344
                                                  ----------      ----------     -----------      ------------
         Earnings (loss) from operations             124,249         543,507         367,023        (9,568,815)
                                                  ----------      ----------     -----------      ------------ 
Other income (expenses):                                                                           
   Interest expense                                 (198,287)       (552,002)       (571,375)       (1,282,973)
   Interest and other income                          48,250          67,674         162,485           285,630
   Gain on sale of marketable securities                                                           
      and assets                                      61,352          31,362         123,881            43,393
                                                  ----------      ----------     -----------      ------------
                                                     (88,685)       (452,966)       (285,009)         (953,950)
                                                  ----------      ----------     -----------      ------------ 
         Earnings (loss) before income taxes          35,564          90,541          82,014       (10,522,765)
Income taxes                                          28,816              --          55,515                --
                                                  ----------      ----------     -----------      ------------
         Net earnings (loss)                      $    6,748      $   90,541     $    26,499      $(10,522,765)
                                                  ==========      ==========     ===========      ============ 
Net earnings (loss) per common and                                                                 
   common equivalent share:                       $       --      $      .01     $        --      $      (1.69)
                                                  ==========      ==========     ===========      ============ 
Weighted average number of common and                                                              
   common equivalent shares used In computing                                                      
   earnings (loss) per share:                      8,707,989       7,158,275       8,601,470         6,211,975
</TABLE>


See accompanying notes to condensed consolidated financial statements


                                       5
<PAGE>   7
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
               CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
             FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1996 AND 1995

<TABLE>
<CAPTION>
                                                                                        NINE MONTHS ENDED
                                                                                          SEPTEMBER 30,
                                                                               ------------------------------------
                                                                                   1996                    1995
                                                                               -----------            -------------
    <S>                                                                        <C>                    <C>
    Cash flows from operating activities:
       Net earnings (loss)                                                     $    26,499            $ (10,522,765)
                                                                               -----------            ------------- 
       Adjustments to reconcile net earnings (loss) to
          net cash used by operating activities:
           Depreciation and amortization                                         1,607,160                1,317,294
           Purchased research and development                                           --               10,500,000
           Gain on sale of assets and marketable
             securities                                                           (125,686)                 (47,373)
           Deferred income taxes                                                   (99,874)                      --
           Changes in assets and liabilities, net of assets acquired
             and liabilities assumed:
               Receivables                                                         (96,969)                (728,839)
               Inventories                                                      (2,477,950)                (906,745)
               Prepaid expenses and other assets                                   371,274                 (549,370)
               Accounts payable                                                    890,996                  (21,029)
               Other                                                                (1,300)                  11,556
               Accrued expenses                                                   (571,909)                 149,025
                                                                               -----------            -------------
                Total adjustments                                                 (504,258)               9,724,519
                                                                               -----------            -------------
                Net cash used in operating activities                             (477,759)                (798,246)
                                                                               -----------            ------------- 
    Cash flows from investing activities:
      Purchases of marketable securities                                        (1,231,940)              (1,129,896)
      Proceeds from sales of marketable securities                               1,941,754                3,538,126
      Acquisition of Neuromed, Inc.                                                     --              (15,947,338)
      Additions to property, plant and equipment                                (1,499,884)              (1,313,422)
      Net proceeds from sale of assets                                               1,805                    6,626
                                                                               -----------            -------------
                Net cash used by investing activities                             (788,265)             (14,845,904)
                                                                               -----------            ------------- 
    Cash flows from financing activities:
      Exercise of stock options                                                    405,276                  314,210
      Proceeds from short-term obligations                                         328,881                  597,787
      Proceeds of long-term debt                                                        --               16,900,000
      Payment of long-term debt                                                   (111,834)              (1,057,143)
      Payment of short-term obligations                                           (220,761)                (474,433)
      Debt issuance costs                                                               --                 (468,767)
      Redemption of rights plan                                                   (103,146)                      --
      Issuance of treasury stock                                                        --                      529
                                                                               -----------            -------------
                Net cash provided by financing activities                          298,416               15,812,183
                                                                               -----------            -------------
      Net increase (decrease) in cash and cash equivalents                        (967,608)                 168,033

    Cash and cash equivalents at beginning of year                               1,325,630                   87,963
                                                                               -----------            -------------
    Cash and cash equivalents at September 30                                  $   358,022            $     255,996
                                                                               -----------            -------------
    Supplemental cash flow information is presented below:
    Income taxes paid                                                          $        --            $          --
                                                                               ===========            =============
    Interest paid                                                              $   530,600            $   1,232,999
                                                                               ===========            =============
</TABLE>

    See accompanying notes to condensed consolidated financial statements


                                       6
<PAGE>   8
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY


<TABLE>
<CAPTION>
                                                                                      Unrealized   
                                      Common Stock      Additional      Retained       loss on                       Total stock-
                                 --------------------    paid-in        earnings      marketable       Treasury         holders'
                                   Shares     Amount     capital       (deficit)      securities        stock           equity
                                 ---------   --------  -----------    ------------    ----------     ------------    -----------
 <S>                             <C>         <C>       <C>            <C>              <C>           <C>             <C>         
 Balance at December 31, 1992    7,871,543   $393,577  $18,484,031    $  4,613,941     $      --      $(5,852,194)   $17,639,355 
   Shares issued upon exercise                                                                                                  
     of stock options               67,898      3,395      116,361              --            --               --        119,756
   Purchase of 100,000 common                        
     shares, at cost                    --         --           --              --            --         (349,004)      (349,004)
   Issuance of 1,490 common                          
     shares                             --         --           --              --            --            7,402          7,402
   Tax effect of stock                                                                                                            
     option exercise                    --         --      187,236              --            --               --        187,236
   Adjustment to unrealized                                                                                                       
     losses on marketable                                                                                                       
     securities                         --         --           --              --      (169,308)             --        (169,308) 
   Net earnings                         --         --           --         816,345            --              --         816,345
                                 ---------   --------  -----------    ------------    ----------     ------------    -----------
 Balance at December 31, 1993    7,939,441    396,972   18,787,628       5,430,286      (169,308)      (6,193,796)    18,251,782  
   Shares issued upon exercise                       
     of stock options               43,057      2,153      134,894              --            --               --        137,047
   Issuance of 1,882 common                                                                                                     
     shares from treasury               --         --        5,595              --            --            4,075          9,670
   Adjustment to unrealized                                                                                                       
     losses on marketable                                                                                                      
     securities                         --         --           --              --      (748,236)              --       (748,236)
   Stock dividend                       --         --      586,054        (916,975)           --          330,921             --
   Net loss                             --         --           --      (1,719,193)           --               --     (1,719,193) 
                                 ---------   --------  -----------    ------------    ----------     ------------    -----------
 Balance at December 31, 1994    7,982,498    399,125   19,514,171       2,794,118      (917,634)      (5,858,800)    15,930,980  
   Shares issued upon exercise                                                                                             
     of stock options              160,422      8,021      361,429              --            --               --        369,450
   Issuance of 245 common                                                                     --                                  
     shares from treasury               --         --        1,216              --            --              529          1,745
   Adjustment to unrealized                                                                                                       
     losses on marketable                                                                                                      
     securities                         --         --           --              --       706,572               --        706,572  
   Issuance of 1,033,333                                                                                               
     common shares from                                                                                                        
     treasury for acquisition           --         --    6,779,285              --            --        2,237,246      9,016,531
   Sale of treasury and new                                                                                                       
     common shares in public                                                                 --                                  
     offering, net of                                                                                                            
     offering costs                  4,429        221   11,597,569              --            --        3,621,025     15,218,815  
   Net loss                             --         --           --     (10,374,043)           --               --    (10,374,043)
                                 ---------   --------  -----------    ------------    ----------     ------------    -----------
 Balance at December 31, 1995    8,147,349    407,367   38,253,670      (7,579,925)     (211,062)              --     30,870,050  
   Shares issued upon exercise                                                                                                    
     of stock options              137,731      6,887      398,389              --            --               --        405,276
   Redemption of rights plan            --         --     (103,146)             --            --               --        (13,146)
   Adjustment to unrealized                                                                                                       
     losses on marketable                                                                                                       
     securities                         --         --           --              --        (2,978)              --         (2,978)  
   Net earnings                         --         --           --          26,499            --               --         26,499
                                 ---------   --------  -----------    ------------    ----------     ------------    -----------
 Balance at September 30, 1996   8,285,080   $414,254  $38,548,913    $(7,553,426)    $ (214,040)    $         --    $31,195,701 
                                 =========   ========  ===========    ===========     ==========     ============    =========== 
</TABLE>


           See accompanying notes to condensed consolidated financial statements


                                      7
<PAGE>   9

                     QUEST MEDICAL, INC. AND SUBSIDIARIES
             NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(1)      BUSINESS

         Quest Medical, Inc. and its subsidiaries (the "Company") design,
         develop, manufacture and market a variety of healthcare products used
         primarily in cardiovascular surgery, interventional pain management
         and intravenous fluid delivery applications. The Company's revenues
         are derived primarily from sales throughout the United States, Europe
         and Australia.

         The research and development, manufacture, sale and distribution of
         medical devices is subject to extensive regulation by various public
         agencies, principally the Food and Drug Administration and
         corresponding state, local and foreign agencies. Product approvals and
         clearances can be delayed or withdrawn for failure to comply with
         regulatory requirements or the occurrence of unforeseen problems
         following initial marketing. While the Company received clearance for
         the MPS system during March 1996, for example, there can be no
         assurance that such clearance will not be withdrawn in the future.

         In addition, the Company's products are purchased primarily by
         hospitals and other users which then bill various third party payors
         including Medicare, Medicaid, private insurance companies and managed
         care organizations. These third party payors reimburse fixed amounts
         for services based on a specific diagnosis. The impact of changes in
         third party payor reimbursement policies and any amendments to
         existing reimbursement rules and regulations which restrict or
         terminate the eligibility of the Company's products could have an
         adverse impact on the Company's financial condition and results of
         operations.

(2)      CONDENSED FINANCIAL STATEMENTS

         The unaudited consolidated financial information contained in this
         report reflects all adjustments (consisting of normal recurring
         accruals) considered necessary, in the opinion of management, for a
         fair presentation of results for the interim periods presented. The
         preparation of financial statements in conformity with generally
         accepted accounting principles requires management to make estimates
         and assumptions that affect the reported amounts of assets and
         liabilities and disclosure of contingent assets and liabilities at the
         date of the financial statements and the reported amounts of revenues
         and expenses during the reporting period. Actual results could differ
         from these estimates.

         Certain information and footnote disclosures normally included in
         financial statements prepared in accordance with generally accepted
         accounting principles have been condensed or omitted. These financial
         statements should be read in conjunction with the financial statements
         and notes thereto included in the Company's December 31, 1995 Annual
         Report on Form 10-KSB. The results of operations for periods ended
         September 30 are not necessarily indicative of operations for the full
         year.

         The consolidated financial statements include the accounts of Quest
         Medical, Inc. and subsidiaries (the "Company"). All significant
         intercompany balances and transactions have been eliminated in
         consolidation.

         Revenue from product sales is recognized at the time the product is
         shipped.


                                       8
<PAGE>   10
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


         Cash equivalents include certificates of deposit and short-term,
         highly liquid debt instruments with original maturities of three
         months or less.

         The Company's marketable equity and debt securities are classified as
         available-for-sale and are carried at fair value, with the unrealized
         gains and losses reported in a separate component of stockholders'
         equity. The amortized cost of debt securities in this category is
         adjusted for amortization of premiums and accretion of discounts to
         maturity. Such amortization is included in investment income. Realized
         gains and losses and declines in value judged to be
         other-than-temporary are included in other income. The cost of
         securities sold is based on the specific identification method.
         Interest and dividends are included in investment income.

         Inventories are recorded at the lower of standard cost or market.
         Standard cost approximates actual cost determined on the first-in,
         first-out (FIFO) basis.

         Property, plant and equipment are stated at cost. Major renewals and
         betterments are capitalized; maintenance and repairs are charged to
         operations as incurred. Provisions for depreciation and amortization
         of property, plant and equipment are computed using the straight-line
         method using estimated useful lives of 3 to 30 years.

         The excess of costs over the net assets of businesses acquired is
         amortized on a straight line basis over the estimated useful lives of
         20 to 25 years. The Company assesses the recoverability of this
         intangible asset, as well as other intangible assets, primarily based
         on its current and anticipated future undiscounted cash flows.  At
         September 30, 1996, the Company does not believe there has been any
         impairment of its intangible assets.

         Cost of purchased patents is amortized on a straight-line basis over
         the estimated useful lives (4 to 14 years) of such patents. Costs of
         patents which are the result of internal development are charged to
         current operations.

         The cost of purchased technology related to acquisitions is based on
         appraised values at the date of acquisition and is amortized on a
         straight-line basis over the estimated useful lives (10 to 15 years)
         of such technology.

         The cost of purchased tradenames is based on appraised values at the
         date of acquisition and is amortized on a straight-line basis over the
         estimated useful life (20 years) of such tradenames.

         Product development costs including start-up, research and
         development, advertising and promotional costs are charged to
         operations in the year in which such costs are incurred.

         Primary and fully diluted earnings per share for the three months and
         nine months ended September 30, 1996 are based upon 8,707,989 and
         8,601,470 common and common equivalent shares outstanding,
         respectively. Primary and fully diluted earnings (loss) per share for
         the three months and nine months ended September 30, 1995 are based
         upon 7,158,275 and 6,211,975 common and common equivalent shares
         outstanding, respectively. Common stock equivalents are outstanding
         stock options and are included in


                                       9                            (Continued)
<PAGE>   11
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


         average common and common equivalent shares outstanding using the
         treasury stock method except during periods where their effect would
         be antidilutive.

         Deferred income taxes are recorded based on the liability method and
         represent the tax effect of the differences between the financial and
         tax basis of assets and liabilities other than costs in excess of the
         net assets of businesses acquired.

(3)      ACQUISITION

         On March 31, 1995, the Company acquired for $15,403,263 cash
         (excluding $1,062,414 of related acquisition and financing costs) and
         833,333 shares of Quest common stock valued at $6,458,331, all of the
         capital stock of Neuromed, Inc. ("Neuromed"). The transaction also
         provided for contingent consideration over the following two years,
         payable in a combination of cash and additional shares of Quest common
         stock in January 1996 and January 1997, depending on sales of
         Neuromed's products reaching certain objectives. Financing for the
         cash portion of the purchase price was provided by a bank. (See Note
         5.)

         In July 1995, the sales objectives for 1995 were reached which
         triggered a liability for the 1995 contingent consideration payments
         with regard to the Neuromed acquisition. The Company recorded the
         additional "earn-out" consideration of 200,000 shares of Quest common
         stock valued at $2,558,200 and a $1,500,000 liability. In addition, in
         September 1995, the Company amended certain terms of the acquisition
         agreement whereby the Company agreed to accelerate issuance of the
         200,000 shares for the 1995 earn-out and the seller relinquished
         certain rights from the previous agreement.

         In October 1996, the sales objectives for 1996 were reached which
         triggered a liability for the 1996 contingent consideration payment
         with regard to the Neuromed acquisition. The Company recorded the
         additional "earn-out" consideration of $3,370,000 on the September 30,
         1996 balance sheet. The cash payment is due and payable in January
         1997 under the acquisition agreement.

         The acquisition was accounted for by the purchase method of
         accounting. The allocation of the purchase price among identifiable
         tangible and intangible assets was based upon a risk adjusted income
         approach. The cost in excess of net assets acquired is being amortized
         on a straight line basis over twenty years.

         Purchased in-process research and development was identified and
         valued through extensive interviews and analysis of data concerning
         Neuromed's products under development. Expected future cash flows for
         products under development were discounted taking into account
         economic risks associated with the inherent difficulties and
         uncertainty in completing the products, and thereby achieving
         technological feasibility, and risks related to the viability of and
         potential changes in future target markets. This resulted in
         $10,500,000 of purchased research and development which had not yet
         achieved technological feasibility and does not have alternative uses.
         Therefore, in accordance with generally accepted accounting
         principles, the $10,500,000, with no related tax benefit, was charged
         to expense during the nine months ended September 30, 1995.


                                       10                            (Continued)
<PAGE>   12
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


         The purchase price allocation for the acquisition of Neuromed is
         summarized below:

<TABLE>
         <S>                                               <C>
         Tradenames                                        $ 2,500,000
         Purchased technology                                4,000,000
         Cost in excess of net assets acquired              12,959,154
         Purchased research and development                 10,500,000
         Net tangible assets acquired                          174,889
         Deferred financing costs                              468,767
                                                           -----------
                                                           $30,602,810
                                                           ===========
</TABLE>

         In connection with the purchase, the Company determined that the
         operations of Neuromed would be relocated to the Company's facility in
         Allen, Texas by the end of the first quarter of 1996. The relocation
         was completed in March 1996 and the Company incurred $1,234,335 of
         relocation costs which were recorded as an adjustment to cost in
         excess of net assets acquired.

         The following unaudited pro forma summary presents the results of
         operations for the nine months ended September 30, 1995 as if the
         acquisition had occurred on January 1, 1995. This summary does not
         purport to be indicative of what would have occurred had the
         acquisition been made as of this date or of results which may occur in
         the future. This method of combining the companies is for the
         presentation of unaudited pro forma summary results of operations.
         Actual statements of operations of Quest Medical and of Neuromed have
         been combined from the effective date of the acquisition forward.

<TABLE>
<CAPTION>
                                                               NINE MONTHS
                                                                  ENDED
                                                           SEPTEMBER 30, 1995
                                                           ------------------
         <S>                                                   <C>
         Pro forma revenue                                     $20,529,356
         Pro forma earnings from operations                      1,847,148
                                                               -----------
         Pro forma net earnings                                    167,220
                                                               -----------
         Pro forma net earnings per common                      
             and equivalent share                              $       .02
                                                               ===========
</TABLE>

         The pro forma operations information excludes the charge of
         $10,500,000 ($1.72 per share) related to purchased in-process research
         and development which was expensed at the date of acquisition.


                                       11                            (Continued)
<PAGE>   13
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(4)      MARKETABLE SECURITIES

         The following is a summary of available-for-sale securities at
         September 30, 1996:

<TABLE>
<CAPTION>
                                                         GROSS       GROSS
                                                      UNREALIZED  UNREALIZED     ESTIMATED
                                            COST         GAINS      LOSSES      FAIR VALUE
                                         ----------   ----------  ----------    ----------
         <S>                             <C>           <C>        <C>           <C>
         Investment grade preferred     
           securities                      $885,600    $  115     $(161,692)    $  724,023
         Publicly traded limited                        
           partnerships                     200,000     1,250            --        201,250
         Real estate investment                         
           trusts                           617,780        --      (103,803)       513,977
         Other                              619,025     4,188       (64,361)       558,852
                                         ----------    ------     ---------     ----------
                                         $2,322,405    $5,553     $(329,856)    $1,998,102
                                         ==========    ======     =========     ==========
</TABLE>

         At September 30, 1996, no individual security represented more than
         15% of the total portfolio or 1% of total assets. The Company did not
         have any investments in derivative financial instruments at September
         30, 1996.

(5)      CURRENT AND LONG-TERM DEBT

         On March 31, 1995, the Company entered into a loan agreement (the
         "Loan Agreement") with a bank providing for $15 million in senior term
         financing, which was utilized to pay substantially all of the cash
         portion of the Neuromed purchase price and a working capital line of
         up to $5 million. Borrowings under both facilities bore interest at
         prime plus 125 basis points, or at the Company's option, LIBOR plus
         300 basis points. During December 1995, the Company repaid in its
         entirety the senior term loan utilizing net proceeds it received from
         a public offering (See Note 7).

         In February 1996, the Company amended the working capital line of
         credit and added a $15 million acquisition line of credit with the
         same bank. Under the amended agreement, the working capital line of
         credit is collateralized by the Company's accounts receivable and
         inventory and the acquisition line, if drawn upon, will be
         collateralized by the Company's remaining unencumbered assets. These
         facilities will expire on December 31, 1997 and will bear interest at
         the prime rate plus 25 basis points or LIBOR plus 200 basis points, at
         the Company's discretion. The interest rate can be reduced based on
         the Company achieving certain ratios of senior bank debt to EBITDA.
         Advances under the acquisition line are immediately converted to a
         five-year term loan.  The Company is subject to certain covenants
         related to these facilities. Significant covenants include the
         maintenance of minimum ratios of current maturities coverage ratio, a
         fixed charge ratio and a total liabilities to tangible net worth ratio
         (as defined). The Company is also restricted on the payment of cash
         dividends to 75% of annual net earnings if no draws exist under the
         acquisition line and 25% of annual net earnings if the acquisition
         line has been drawn upon. As of September 30, 1996, the Company was
         not in compliance with certain financial covenants in its loan
         agreement, but NationsBank has waived such non-compliance until
         December 31, 1996. As a consequence, the Company has reclassified the
         indebtedness in the amount of $4.55 million under the working capital
         line of credit from long-term notes payable to short-term notes
         payable at September 30, 1996. Such indebtedness would have otherwise
         been classified as short-term indebtedness by the terms of the loan
         agreement on December 31, 1996. The weighted average interest rate on
         such debt was 7.19% at September 30, 1996. The Company and NationsBank
         are negotiating an amendment of the loan agreement to provide for
         amended financial covenants acceptable to both the bank and the
         Company and based on preliminary discussions with the bank, the
         Company believes it will be successful in doing so. The Company has 
         not drawn upon the acquisition line of credit.



                                       12                            (Continued)
<PAGE>   14
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


         At September 30, 1996, the Company had notes payable in the amounts of
         $1,500,000 and $3,370,000 related to "earn-out" consideration for
         Neuromed, Inc. (See Note 3). Although the $1,500,000 note was due and
         payable in January 1996 and was non-interest bearing, the Company has
         withheld payment of the note pending the outcome of arbitration
         proceedings related to certain purchase price adjustment disputes
         between the Company and Neuromed's former principal owner, Mr. William
         Borkan. The $3,370,000 note is due and payable in January 1997 and is
         non-interest bearing. Payment of this note will similarly depend on
         the resolution of the arbitration.

         On December 28, 1993, the Company entered into two agreements for
         long-term financing on its principal office and manufacturing facility
         in the amount of $4,355,071. The first agreement, in the amount of
         $3,000,000, is related to the building. This loan bore interest
         through 1995 at an adjustable rate based on the 30-day commercial
         paper rate plus 300 basis points. Effective January 1996, the Company
         fixed the rate of interest for the remainder of the term of the loan
         at 8.59%. This note has a 25-year amortization. The Company has the
         option of prepaying this note during years 6-10, subject to certain
         provisions. The loan is collateralized by the Allen facility building
         and land and has an unpaid balance of $2,934,364 at September 30,
         1996. The second agreement, in the amount of $1,355,071, is related to
         certain equipment and furnishings. This loan bore interest through
         1995 at an adjustable rate based on the 30-day commercial paper rate
         plus 250 basis points.  Effective January 1996, the Company fixed the
         rate of interest for the remainder of the term of the loan at 7.94%.
         This note has a 10-year amortization. This loan is collateralized by
         the equipment and furnishings purchased with the proceeds and has an
         unpaid balance of $1,078,410 at September 30, 1996.

         At September 30, 1996, the Company had a 7.75% note payable for
         $108,120. This note was secured by certain of the Company's marketable
         securities investments, held by an investment company, which had a
         carrying value of $755,688. Borrowings under this note are restricted
         to 50% of the market value of the Company's marketable securities held
         by the investment company. At September 30, 1996, the amount available
         for additional borrowing under this note was $269,724.

(6)      FEDERAL INCOME TAXES

         At September 30, 1996, general business credits of $838,582 and
         alternative minimum tax credits of $152,620 are available to offset
         future tax liabilities. If unused, the general business credits expire
         in various amounts beginning in 1997 through 2010.

(7)      STOCKHOLDERS' EQUITY

         On August 26, 1996, the Board of Directors voted to redeem the
         Company's then outstanding stock purchase rights at $0.01 per share.
         The redemption price for the outstanding rights was paid on September
         27, 1996 to shareholders of record as of September 12, 1996.


                                       13                            (Continued)
<PAGE>   15
                      QUEST MEDICAL, INC. AND SUBSIDIARIES
              NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


         Also on August 26, 1996, the Board of Directors adopted a new
         Shareholder's Rights Plan in which rights to purchase shares of the
         Company's common stock were distributed as a dividend, one right per
         share, to shareholders of record as of September 12, 1996. The rights
         are not exercisable or transferable apart from the common stock until
         ten business days following the date that a person or group acquires
         more than 15% of the Company's common stock or announces a tender or
         exchange offer for more than 20% of the Company's common stock.  Upon
         becoming exercisable generally, each right entitles the holders to
         purchase one share of common stock for $30.00. If the rights become
         exercisable because a person or group acquires more than 15% of the
         common stock (an "Acquiring Person"), however, the purchase price and
         number of shares purchasable will be adjusted so that the holder will
         have the right to receive, upon the exercise of the right at the
         applicable exercise price, that number of shares of the Company's
         common stock having a market value equal to two times the applicable
         exercise price of the right. If the Company is acquired in a merger or
         other business combination transaction, or 50% or more of its
         consolidated assets or earning power are sold, provision will be made
         so that each holder of a right will have the right to receive, upon
         the exercise of the right at the applicable exercise price, that
         number of shares of the acquiring company's common stock having a
         market value of two times the applicable exercise price of the right.
         Until a right is exercised, the holder of a right, as such, will have
         no rights as a stockholder of the Company, including, without
         limitation, the right to vote as a stockholder or receive dividends.
         Under the Rights Plan, the number of shares issuable upon exercise of
         the rights is subject to adjustment by the Company to prevent
         dilution. After a person becomes an Acquiring Person, the Company's
         board of directors may exchange the rights, other than those owned by
         the Acquiring Person, in whole or in part, at an exchange ratio of one
         share of common stock per right, subject to adjustment. The rights may
         be redeemed in whole by the Company at a price of $0.01 per right at
         any time prior to their expiration on September 12, 2006, or prior to
         the point at which they become exercisable.

         In the fourth quarter of 1995, the Company sold 1,676,667 shares in a
         public offering. Net proceeds to the Company were $15.2 million of
         which $13.9 million was used to repay the senior term bank debt
         incurred in connection with the Neuromed acquisition.

(8)      COMMITMENTS AND CONTINGENCIES

         The Company has no material commitments under noncancellable operating
         leases. Total rent expense under operating leases for the three months
         ended September 30, 1996 and 1995 was $13,923 and $36,789,
         respectively, and $65,548 and $84,459 for the nine months ended
         September 30, 1996 and 1995, respectively.


                                       14                            (Continued)
<PAGE>   16



         As a consequence of the Neuromed Acquisition in March 1995, the
         Company is currently a party to certain product liability claims
         related to SCS devices sold by Neuromed prior to the acquisition.
         Product liability insurers have assumed responsibility for defending
         the Company against these claims, subject to reservation of rights in
         certain cases. Although the Company is entitled to contractual
         indemnification from Neuromed's former owner with respect to any
         losses exceeding its product liability insurance coverage, there can
         be no assurances that the Company will not incur significant monetary
         liability to the claimants if such insurance or indemnification is
         unavailable or inadequate for any reason, or that the Company's SCS
         business and new SCS product lines will not be adversely affected by
         these product liability claims.

         Except for such product liability claims and other ordinary routine
         litigation incidental or immaterial to its business, the Company is
         not currently a party to any other pending legal proceeding. The
         Company maintains general liability insurance against risks arising
         out of the normal course of business.

(9)      FINANCIAL INSTRUMENTS, RISK CONCENTRATION, AND MAJOR CUSTOMERS

         In the United States, the Company's accounts receivable are due
         primarily from hospitals and distributors located throughout the
         country. Internationally, the Company's accounts receivable are due
         primarily from distributors located in Europe and Australia. The
         Company generally does not require collateral for trade receivables.
         The Company maintains an allowance for doubtful accounts based upon
         expected collectibility. Any losses from bad debts have historically
         been within management's expectations.

(10)     EMPLOYEE BENEFIT PLANS

         The Company has a defined contribution retirement savings plan (the
         "Plan") available to substantially all employees. The Plan permits
         employees to elect salary deferral contributions of up to 15% of their
         compensation and requires the Company to make matching contributions
         equal to 50% of the participants' contributions, to a maximum of 6% of
         the participants' compensation. The expense of the Company's
         contribution was $38,250 and $25,050 for the three months ended
         September 30, 1996 and 1995, respectively, and $114,750 and $75,150
         for the nine months ended September 30, 1996 and 1995, respectively.





                                       15
<PAGE>   17



                 ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS
                OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


The following discussion of the financial condition and results of operations
of the Company should be read in conjunction with the Condensed Consolidated
Financial Statements of the Company and the related Notes thereto.

RESULTS OF OPERATIONS

COMPARISON OF THE THREE MONTHS AND NINE MONTHS ENDED SEPTEMBER 30, 1996
AND 1995

Revenues. Net revenue of $6.49 million for the three months ended September 30,
1996, was $332,000, or 4.9% below the level for the comparable 1995 period of
$6.82 million. This decrease was primarily the result of lower unit sales
volume at the Company's Advanced Neuromodulation Systems, Inc. ("ANS")
subsidiary, formerly Neuromed, which was acquired on March 31, 1995, and
provides electronic spinal cord stimulation ("SCS") devices used to manage
chronic severe pain. See Note 3 of the Notes to Condensed Consolidated
Financial Statements. SCS revenue decreased 10.3%, or $334,000, during the
three months ended September 30, 1996 compared to the prior year same period.
Of such decrease, approximately $191,000 resulted from the return of
inventories from certain stocking distributors of ANS products whose
distributor agreements the Company decided to terminate early. The Company made
the strategic decision to market its products through commissioned sales agents
rather than distributors in certain areas of the United States. During the
third quarter of 1996, the Company completed clinical validation of the MPS
brand of myocardial system and began commercial shipments during September
1996. Revenue from sales of the MPS system and related products was $170,000
during the three months ended September 30, 1996, and management believes such
sales should begin to ramp up during the fourth quarter of 1996.  Net revenue
from sales of the Company's other products decreased 4.7%, or $168,000, during
the three months ended September 30, 1996 compared to the corresponding period
a year ago, primarily due to lower unit sales volume from the Company's
specialized tubing sets. For the nine months ended September 30, 1996, net
revenue of $19.31 million was $1.18 million, or 6.5%, above the comparable 1995
level of $18.12 million. This increase during 1996 compared to 1995 was
attributable to revenue generated by ANS, which provided nine months of revenue
during the 1996 period compared to only six months during the 1995 period. Net
revenue from sales of the Company's other products decreased 5.3%, or $602,000,
primarily due to lower unit sales volume from the Company's specialized tubing
sets.

During the third quarter of 1996, management continued to execute its
previously announced plans of building the infrastructure at ANS, which
management believes is necessary to transform ANS into an industry leader and
compete effectively in the SCS market. Management believes it has taken major
steps in improving the current products of ANS.  This effort is continuing
through the remainder of this year and into the first quarter of 1997.
Management believes that these efforts should return ANS to sustained and
profitable revenue growth during 1997.





                                       16
<PAGE>   18



Gross Profit. Gross profit of $3.79 million for the three months ended
September 30, 1996 was $182,000, or 4.6% below the level for the comparable
1995 period of $3.97 million. As a percentage of net revenue, gross profit
remained level during the three months ended September 30, 1996 as compared to
1995, 58.4% in 1996 compared to 58.2% during 1995. The dollar decrease in gross
profit during 1996 compared to 1995 was attributable to the decrease in revenue
generated by ANS as discussed above. For the nine months ended September 30,
1996, gross profit increased to $11.22 million from $10.36 million for the
comparable 1995 period. As a percentage of net revenue, gross profit increased
during the nine months ended September 30, 1996 to 58.1% as compared to 57.2%
for the comparable 1995 period. This increase in gross profit and gross profit
margin during the nine-month period of 1996 compared to 1995 was attributable
to the revenue generated by ANS, since the 1996 period includes nine months of
revenue, while the 1995 period includes only six months of revenue from the
acquisition date of March 31, 1995, and ANS products contribute higher gross
profit margins than the Company's other product lines.

Operating Expenses. Research and development expense decreased to $724,000
during the three months ended September 30, 1996, compared to $1.15 million for
the same period a year ago, and decreased as a percentage of net revenue from
16.8% in 1995 to 11.2% in 1996. Research and development expense decreased to
$2.49 million during the nine months ended September 30, 1996, compared to
$3.64 million for the same period during 1995, and decreased as a percentage of
net revenue from 20.1% in 1995 to 12.9% in 1996. This decrease during both
periods of 1996 compared to 1995 was the result of a reduction in salary and
contract labor expense from staffing reductions due to the completion of the
development of the MPS system. Separately, the Company has devoted significant
engineering resources and has taken major steps in improving the current ANS
products during the past two quarters of 1996. This effort is continuing
through the remainder of 1996 and into the first quarter of 1997. Management
expects research and development expenditures to approximate $800,000 for the
remainder of 1996. The Company plans to focus 60% of the $3.0 million it is
budgeting for fiscal 1997 on developing the next generation of ANS products for
market introduction during 1998. The remainder of the planned 1997 expenditures
will be directed toward continued developments in the myocardial protection
system. Management expects that most of its research and development activities
will continue to be financed through internally-generated funds.

In connection with the March 31, 1995 acquisition of Neuromed, $10.5 million of
the aggregate purchase price was identified as purchased, in-process research
and development. In accordance with generally accepted accounting principles,
an expense of $10.5 million was recorded during the nine-month period ending
September 30, 1995, with no related tax benefit.

Marketing, general and administrative expenses, as a percentage of net revenue,
increased to 45.3% for the three months ended September 30, 1996, compared to
33.4% for the comparable period during 1995, while the dollar amount increased
by $659,000. Marketing expense, as a percentage of net revenue, increased to
27.6% for the 1996 period compared to 17.0% during the same period in 1995, and
the dollar amount increased by $630,000. Of such increase, $335,000 was
additional marketing expense of ANS primarily related to higher salary, benefit
and commission expense from personnel additions, increased travel, and samples
and promotional expense. During 1996, the Company has reorganized part of its
distribution network for ANS products and replaced several distributors in
certain areas of the United States, replacing them with seven direct
salespersons and sales agents who are principally





                                       17
<PAGE>   19



compensated on commission. The Company has also begun designing training,
customer support and sales and marketing materials and videos and will continue
those efforts during the remainder of 1996 and early 1997. The Company has
recently reestablished relationships with key implanters who had discontinued
using the ANS products prior to the Company's acquisition. The remainder of the
increase in marketing expense during the 1996 period compared to 1995 was
primarily the result of additional salary, benefit and travel expense from four
additional direct salespersons hired during the fourth quarter of 1995 in
preparation of the commercial introduction of the MPS system. The Company
currently employs five direct salespersons to market the MPS system and related
products. As previously mentioned, the Company began commercial shipments
during September 1996. Currently, the Company has evaluations in twelve
hospitals and expects evaluations to begin in seven additional hospitals during
mid-November 1996. Over 400 surgical cases have been performed using MPS to
date. Management believes that initial trends indicate that cardiovascular
surgeons who have used or seen the system are ready to change protocols quickly
to take advantage of the MPS features, and that hospitals with multiple
surgical suites, if adopting the MPS system, will purchase multiple systems.
One major challenge, in the opinion of management, is controlling the
purchasing approval process post-clinical evaluation of the MPS. Management
anticipates hiring additional salespersons during 1997 to market the MPS system
and related products as circumstances warrant.  Management has decided to focus
most of its efforts for MPS during 1997 on the U.S. and Canadian markets, and
does not anticipate introduction of MPS internationally until fiscal 1998. For
the nine months ended September 30, 1996, marketing expense increased as a
percentage of net revenue to 25.1% compared to 15.2% for the same period during
1995, and the dollar amount increased by $2.1 million. Of such increase, $1.47
million was additional marketing expense of ANS, again primarily related to
additional salary, benefit, commission, travel, samples and promotional
expense. The 1995 nine-month period included only six months of marketing
expense of ANS since the acquisition date occurred on March 31, 1995, while the
1996 period included nine months of expense. The remainder of the increase in
marketing expense during the nine-month 1996 period compared to 1995 of
$624,000, was primarily the result, as mentioned earlier, of additional salary,
benefit and travel expense from four additional direct salespersons hired
during the fourth quarter of 1995 in preparation for the commercial
introduction of the MPS system and related products.

General and administrative expense as a percentage of net revenue increased to
17.7% for the three months ended September 30, 1996, compared to 16.4% for the
comparable period during 1995, and the dollar amount increased by $29,000
solely due to additional amortization expense of ANS intangibles. For the nine
months ended September 30, 1996, general and administrative expense increased
$466,000 compared to the same period in 1995, and as a percentage of net
revenue, increased from 16.8% in 1995 to 18.2% during 1996. Of such increase,
$318,000 was attributable to higher amortization expense of ANS intangibles,
and the 1995 period included amortization expense for only six months since the
acquisition occurred on March 31, 1995, while the 1996 period included nine
months of amortization expense. The remainder of the increase during 1996
compared to 1995 was primarily the result of higher recruiting, relocation,
franchise tax and 401(k) Company match expenses.

Earnings (Loss) from Operations. Earnings from operations decreased to $124,000
during the three months ended September 30, 1996, compared to $544,000 for the
comparable 1995 period. Lower revenue and gross profit from the ANS subsidiary,
combined with increased marketing expense, led to this decrease. For the nine
months ended September 30, 1996, earnings from operations increased to $367,000
compared to a loss from operations of $9.57





                                       18
<PAGE>   20



million during the comparable period during 1995, due to the $10.5 million
expense in 1995 for purchased research and development incurred in connection
with the Neuromed acquisition. Excluding such charge, however, earnings from
operations decreased from $931,000 in 1995 to $367,000 during 1996 primarily
due to higher marketing expense.

Other Income (Expense). Other expense decreased to $89,000 during the three
months ended September 30, 1996, compared to an expense of $453,000 during the
same 1995 period, a reduction of $364,000. For the nine months ended September
30, 1996, other expense decreased to $285,000 compared to $954,000 for the same
period in 1995, a reduction of $669,000.  This decrease in other expense during
both periods of 1996 compared to the 1995 periods was attributable, for the
most part, to lower levels of interest expense, since the 1995 periods included
interest expense on $15 million of bank debt incurred in connection with the
Neuromed acquisition, which was repaid in the fourth quarter of 1995 from the
proceeds of a public offering. See Notes 3 and 5 of the Notes to Condensed
Consolidated Financial Statements. Interest income decreased $19,000 and
$123,000, respectively, for the three months and nine months ended September
30, 1996 compared to the same periods in 1995 due to reduced funds available
for investment.

Income Taxes. The Company recorded income tax expense of $29,000 and $56,000
for the three months and nine months ended September 30, 1996, respectively.
The amortization expense of costs in excess of net assets acquired (goodwill)
is not deductible for tax purposes, thus explaining the relatively high rate of
tax for the 1996 periods compared to the U.S.  statutory income tax rate
applicable to corporations of 34%. No income tax expense or benefit was
recorded during the 1995 periods.

Net Earnings (Loss). Net earnings decreased to $6,700 for the three months
ended September 30, 1996, compared to net earnings of $91,000 for the
comparable 1995 period, primarily due to the decrease in revenue and gross
profit contributed by ANS and the increased level of marketing expense. Net
earnings increased to $26,000 for the nine months ended September 30, 1996,
compared to a net loss of $10.52 million for the comparable 1995 period due to
the expense of $10.5 million for purchased research and development incurred in
connection with the Neuromed acquisition during 1995.  Excluding such charge,
net earnings would have been equivalent during the nine month periods, $26,000
in 1996 compared to $23,000 in 1995.

LIQUIDITY AND FINANCIAL POSITION

The Company's working capital of $3.73 million at September 30, 1996 decreased
from the December 31, 1995 level of $12.18 million principally due to increased
short-term notes payable from the second "earn-out" consideration related to
the Neuromed acquisition, the reclassification of $4.55 million indebtedness
under the Company's working capital line from long-term to short-term and a
reduction in the Company's cash, cash equivalents and marketable securities
(see "Cash Flows" below). The ratio of current assets to current liabilities
was 1.27:1 at September 30, 1996, compared to 3.7:1 at December 31, 1995. Cash,
cash equivalents and marketable securities totaled $2.36 million at September
30, 1996, a decrease of $1.56 million from 1995 year end.

In connection with the acquisition of Neuromed, the Company agreed to pay
contingent consideration in January 1996 and January 1997 depending on
Neuromed's attainment of certain sales objectives. At year end 1995, the
Company had a note payable in connection with the 1995 earn-out consideration
in the amount of $1.5 million, payable in January 1996. The Company has


                                       19
<PAGE>   21



withheld payment of the $1.5 million pending arbitration of certain purchase
price and other disputes between the Company and Neuromed's former principal
owner, William Borkan. In October 1996, the sales objectives for the 1996 earn-
out were reached and the Company recorded a note payable in the amount of $3.37
million at September 30, 1996, which is due and payable in January 1997.
Payment of this note will similarly depend on the resolution of the
arbitration.  With NationsBank's assent, which, based on preliminary
discussions with the bank, management believes it could obtain, the Company may
utilize a portion of its acquisition line of credit to fund the payment of any
necessary earn-out payments.

In February 1996, the Company amended its working capital line of credit and
added a $15 million acquisition line of credit with NationsBank of Texas, N.A.
Under the amended agreement, the working capital line of credit is
collateralized by the Company's accounts receivable and inventory. The
acquisition line, if drawn upon, is collateralized by the Company's remaining
unencumbered assets. Both facilities will expire on December 31, 1997, and bear
interest at the prime rate plus 25 basis points or LIBOR plus 200 basis points,
at the Company's discretion. The interest rate can be reduced based upon the
Company achieving certain ratios of senior bank debt to EBITDA. Advances under
the acquisition line are immediately converted to a five-year term loan. The
Company is subject to certain covenants related to the facilities, including a
current maturities coverage ratio, fixed charge ratio and total liabilities to
tangible net worth ratio (as defined). The Company is also restricted on the
payment of dividends to 75% of annual net earnings if no draws exist under the
acquisition line and 25% of annual net earnings if the acquisition line has
been drawn upon. As of September 30, 1996, the Company was not in compliance
with certain of the financial covenants under the loan agreement, but
NationsBank has waived such non-compliance until December 31, 1996. As a
consequence, the Company has reclassified the indebtedness in the amount of
$4.55 million under the working capital line of credit from long-term notes
payable to short-term notes payable at September 30, 1996. Such indebtedness
would have otherwise been classified as short-term indebtedness by the terms of
the loan agreement on December 31, 1996. The weighted average interest rate on
such debt was 7.19% at September 30, 1996. The Company and NationsBank are
negotiating an amendment of the loan agreement to provide for amended financial
covenants acceptable to both the bank and the Company and based on preliminary
discussions with the bank, the Company believes it will be successful in doing
so. The Company has not drawn upon the acquisition line of credit.

Management believes that its current cash, cash equivalents and marketable
securities, funds generated from operations, and if necessary, funds provided
by the working capital line of credit will be sufficient to satisfy normal cash
operating requirements and capital requirements for the remainder of 1996, with
the exception of the earn-out payments discussed above.

CASH FLOWS

Net cash used by operating activities for the nine months ended September 30,
1996 was $478,000. During 1996, the Company increased its investment in
inventories by $2.48 million substantially all of which relates to the MPS
system and related disposables. As previously mentioned, the Company began
commercial shipments of MPS during September 1996 and expects inventories to
decrease during the next two quarters due to this market introduction.

Investing activities for the first nine months of 1996 resulted in a net use of
cash of $788,000. The Company used cash of $1.5 million for capital
expenditures for additional manufacturing tooling and equipment and an upgraded
management information system. The Company anticipates capital expenditures of
$200,000 for the remainder of 1996. The Company was a net seller of marketable
securities during the nine months ended September 30, 1996, which provided net
cash of $710,000.

Financing activities during the first nine months of 1996 provided $298,000 of
cash. Primary sources of cash from financing activities was $405,000 from the
exercise of stock options and net


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<PAGE>   22



short-term borrowings of $108,000. The Company utilized $112,000 for repayment
of long-term debt during the first nine months of 1996 and $103,000 was
utilized for redemption of the rights outstanding under the 1989 Shareholder
Rights Plan during September 1996.

FORWARD LOOKING STATEMENTS

The following is a "safe harbor" statement under the Private Securities
Litigation Reform Act of 1995: Other than historical information, the matters
discussed in this Management's Discussion and Analysis of Financial Condition
and Results of Operations are forward-looking statements that are based on
management assumptions and involve risks and uncertainties, including but not
limited to the Company's ability to develop, clinically validate or gain market
acceptance for new products, including the MPS system, new generation ANS
products and other products; successfully developing the infrastructure at ANS,
redirecting ANS marketing efforts and redesigning ANS products such that the
Company will be able to grow the business into a solid player in the SCS
market; government regulation; competition and technological changes that may
render the Company's products obsolete or noncompetitive; general domestic and
international economic conditions; and other risks detailed from time to time
in the Company's SEC public filings.  Consequently, if such management
assumptions prove to be incorrect or such risks or uncertainties materialize,
the Company's actual results could differ materially from the results
forecasted in the forward-looking statements.

IMPACT OF INFLATION AND CHANGING PRICES

The Company attempts to minimize the impact of inflation on manufacturing and
operating costs through on-going quality and productivity programs. The Company
considers the impact of inflation on its operations to be insignificant as the
rate of inflation has remained low in recent years. When material price
increases have been experienced by the Company, it has generally attempted to
pass such cost increases on to customers through its prices, to the extent
permitted by competition.

CURRENCY FLUCTUATIONS

Substantially all of the Company's international sales are denominated in U.S.
dollars. Fluctuations in currency exchange rates in other countries could
reduce the demand for the Company's products by increasing the price of the
Company's products in the currency of the countries in which the products are
sold, although management does not believe currency fluctuations have had a
material effect on the Company's results of operations.





                                       21
<PAGE>   23




                                    PART II

                               OTHER INFORMATION




<TABLE>
<CAPTION>

ITEM 6.          EXHIBITS AND REPORTS ON FORM 8-K
                 --------------------------------
         <S>     <C>
         (a)     Exhibits

                 27.1 -- Financial Data Schedule

         (b)     The Company filed a current report on Form 8-K, dated September 3, 1996, reporting pursuant to Item 5.
                 "Other Events," that on August 26, 1996, the Company's Board of Directors voted to redeem the rights
                 outstanding under the Rights Agreement between the Company and KeyCorp Shareholder Services, Inc. dated
                 October 12, 1989 (as amended), and adopted a new Rights Agreement pursuant to which Rights to purchase
                 shares of the Company's Common Stock were distributed as a dividend, one Right per share, to record
                 owners of the Company's Common Stock as of the close of business on September 12, 1996.  The Rights
                 Agreement was not adopted in response to any known offers for the Company. See Note 7 of the Notes to
                 Condensed Consolidated Financial Statements.

                 The Company also filed pursuant to Item 7. "Financial Statements, Pro Forma Financial Information and
                 Exhibits," the following documents as exhibits to the report:

                     Exhibit 4.1    Rights Agreement between Quest Medical, Inc. and KeyCorp Shareholder 
                                    Services, Inc. as Rights Agent.

                     Exhibit 20.1   Press Release dated August 30, 1996.

                     Exhibit 20.2   Letter to Shareholders of Quest Medical, Inc. dated August 30, 1996, 
                                    including attached Summary of Rights to Purchase Shares of Quest 
                                    Medical, Inc. Common Stock.
</TABLE>





                                       22
<PAGE>   24



                                   SIGNATURES


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


                                    QUEST MEDICAL, INC.


 DATE:  NOVEMBER 14, 1996           BY: /S/  F. ROBERT MERRILL III    
                                        -------------------------------------
                                        F. ROBERT MERRILL III
                                        SENIOR VICE PRESIDENT FINANCE
                                        CHIEF FINANCIAL OFFICER AND TREASURER


                                       23
<PAGE>   25



                              INDEX TO EXHIBITS


<TABLE>
<CAPTION>

EXHIBIT
NUMBER                   DESCRIPTION
-------                  -----------
<S>           <C>
  27           --  Financial Data Schedule

</TABLE>