================================================================================
                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                              WASHINGTON, DC 20549

                                   FORM 10-KSB

(Mark One)

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

      For the Fiscal Year ended  December 31, 1997

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

                         Commission File Number 0-28566

                             HENLEY HEALTHCARE, INC.
                 (Name of small business issuer in its charter)

      TEXAS                                            76-0335587
      (State or other jurisdiction of                 (IRS Employer
      incorporation or organization)                Identification No.)

      120 Industrial Boulevard, Sugar Land, Texas       77478-3128
      (Address of principal executive offices)          (Zip code)

      Issuer's telephone number:   281-276-7000

      Securities registered under Section 12(g) of the Exchange Act:

                          Common Stock, $.01 par value
                                (Title of Class)

        Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15 (d) of the 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 [ ]

        Check if there is no disclosure of delinquent filers pursuant to Item
405 of Regulation S-B contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [X]

The issuer's revenues for its most recent fiscal year are $24,257,014.

        The aggregate market value of voting stock held by non-affiliates of the
registrant on March 25, 1998, based upon the average bid and ask price as
reported on the Nasdaq SmallCap Market, was $23,259,534. The number of shares of
the issuer's common stock, $.01 par value, outstanding as of March 25, 1998 was
5,383,205.

Documents incorporated by reference: None.

Transitional Small Business Disclosure Format (check one): Yes [ ]  No [X]

================================================================================
<PAGE>
      THIS REPORT INCLUDES "FORWARD LOOKING STATEMENTS" WITHIN THE MEANING OF
SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED, AND SECTION 21E OF THE
SECURITIES EXCHANGE ACT OF 1934, AS AMENDED. ALL STATEMENTS OTHER THAN
STATEMENTS OF HISTORICAL FACT INCLUDED IN THIS REPORT ARE FORWARD LOOKING
STATEMENTS. SUCH FORWARD LOOKING STATEMENTS INCLUDE, WITHOUT LIMITATION,
STATEMENTS UNDER (a) "BUSINESS" REGARDING THE COMPANY'S EXPECTATIONS FOR FUTURE
PRODUCT DEVELOPMENT AND RELATED EXPENDITURES, AND (b) "MANAGEMENT'S DISCUSSION
AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS -- LIQUIDITY AND
CAPITAL RESOURCES" REGARDING THE COMPANY'S ESTIMATE OF SUFFICIENCY OF EXISTING
CAPITAL RESOURCES AND ITS ABILITY TO RAISE ADDITIONAL CAPITAL TO FUND CASH
REQUIREMENTS FOR FUTURE OPERATIONS AND ACQUISITIONS. ALTHOUGH THE COMPANY
BELIEVES THE EXPECTATIONS REFLECTED IN SUCH FORWARD LOOKING STATEMENTS ARE
REASONABLE, IT CAN GIVE NO ASSURANCE THAT SUCH EXPECTATIONS REFLECTED IN SUCH
FORWARD LOOKING STATEMENTS WILL PROVE TO HAVE BEEN CORRECT. THE ABILITY TO
ACHIEVE THE COMPANY'S EXPECTATIONS IS CONTINGENT UPON A NUMBER OF FACTORS WHICH
INCLUDE (i) ONGOING COST OF RESEARCH AND DEVELOPMENT ACTIVITIES, (ii) TIMELY
APPROVAL OF THE COMPANY'S PRODUCT CANDIDATES BY APPROPRIATE GOVERNMENTAL AND
REGULATORY AGENCIES, (iii) EFFECT OF ANY CURRENT OR FUTURE COMPETITIVE PRODUCTS,
(iv) THE COMPANY'S ABILITY TO MANUFACTURE AND MARKET ITS PRODUCTS COMMERCIALLY,
(v) THE RETENTION OF KEY PERSONNEL AND (vi) CAPITAL MARKET CONDITIONS. THIS
REPORT MAY CONTAIN TRADEMARKS AND SERVICE MARKS OF OTHER COMPANIES.

                                     PART I

ITEM 1. BUSINESS

GENERAL

      Henley Healthcare, Inc., formerly Lasermedics, Inc. (the "Company" or
"Henley"), was incorporated in November 1990 as a Texas corporation, and is a
manufacturer, provider and marketer of diversified products and services in the
pain management industry. The Company provides high quality products and
services to healthcare professionals and aims to become an industry leader by
consolidating the otherwise largely-fragmented pain management industry. The
Company has operating units which are categorized by the type of service
provided and type of product manufactured or distributed. The pain management
unit comprises the Clinical, Homecare and Microlight operations. The Clinical
operations manufacture and market a diversified line of pain management products
used in clinical settings for both physical therapy and rehabilitation as well
as other applications. The Homecare operations manufacture and market products
used for patient care in the home setting. The Microlight operations are
involved in the development and application of portable, hand-held,
battery-operated, low-energy laser devices used to treat soft tissue. The
training unit, Health Career Learning Systems ("HCLS"), provides training,
safety products and technical support necessary to meet federal Occupational
Safety and Health Act ("OSHA") compliance standards and also coordinates the
training of medical professionals in the use of various other products offered
by the Company.

      The Company's long-term strategic objectives are to (i) expand
distribution channels and explore new markets, (ii) consolidate the
highly-fragmented physical therapy and rehabilitation industry by pursuing
strategic acquisitions that complement existing product lines and increase
market share, (iii) maximize the utilization of existing facilities for
increased productivity, (iv) improve profitability, (v) reduce long-term
indebtedness, and (vi) obtain market clearance from the United States Food and
Drug Administration ("FDA") for the Microlight 830(TM).

ACQUISITIONS

      Prior to April 30, 1996, the Company was primarily engaged in the
development and application for marketing clearance of the Microlight830(TM). On
April 30, 1996, the Company acquired substantially all of the assets of (and
assumed certain

                                       2
<PAGE>
liabilities associated with) the Henley Healthcare Division (the "Henley
Division") of Maxxim Medical, Inc. ("Maxxim") a Delaware corporation, as more
fully described in the Notes to the Financial Statements. This acquisition
provided the Company with an expanded and stable base of products and customers
as well as manufacturing and marketing infrastructure. Beginning with the
acquisition of Maxxim's Henley Division, the Company has pursued a strategy of
consolidating the highly-fragmented physical therapy and rehabilitation
industry. Since that time, the Company has grown significantly as a result of
the acquisitions discussed below.

      On November 12, 1996, the Company acquired substantially all of the assets
of MJH Medical Equipment, Inc., a privately-held medical supplies and equipment
distributor, which added distribution channels to the Company's then existing
marketing outlets. On November 27, 1996, the Company acquired all of the issued
and outstanding common stock of Health Career Learning Systems, Inc., ("HCLSI"),
which provides training, safety products and technical support necessary to meet
OSHA compliance standards. The Company's HCLS training unit includes the
operations of HCLSI, which continues to expand its products and service
offerings to fully integrate all of the Company's training activities.

      During 1997, the Company continued to broaden and diversify its products
offering through acquisitions. In January 1997, the Company completed the
acquisitions of (i) all of the issued and outstanding common stock of Texas
T.E.N.S., Inc. ("Tens"), and (ii) the inventory, distribution systems and
customers associated with the Homecare (third-party billing) division of Gatti
Medical Supply, Inc. ("Gatti"). Both Tens and Gatti are engaged in the marketing
and distribution of medical supplies and devices.

      In May 1997, the Company acquired all of the issued and outstanding shares
of common stock of Med-Quip, Inc. ("Medquip"), a privately-owned Georgia
corporation, engaged in the marketing and distribution of physical therapy and
rehabilitation products.

      In October 1997, the Company acquired all of the ownership interests in
Summer Medical ("SM"), an unincorporated Florida sole proprietorship engaged in
the marketing and distribution of pain management and rehabilitation products.

      In September 1997, the Company entered into an agreement with Cybex
International, Inc., a New York corporation ("Cybex"), whereby it purchased
certain assets of (and assumed certain liabilities associated with) the
isokinetic rehabilitation product line of Cybex.

      In December 1997, the Company acquired all of the issued and outstanding
common stock of NCI, Inc., a Michigan corporation engaged in the training of
medical professionals.

      In January 1998, the Company acquired all of the outstanding shares of
common stock of Garvey Company, a Minnesota corporation engaged in the marketing
and distribution of pain management and rehabilitation products.

      In February 1998, the Company purchased substantially all of the assets
and assumed certain liabilities associated with AMC Acquisition Corp., a Texas
corporation engaged in the marketing and distribution of durable medical
equipment and devices.

      On March 6, 1998, the Company entered into a definitive purchase agreement
with Delft Instruments N.V., an international conglomerate with headquarters in
The Netherlands and key operations in medical, defense, aerospace, industrial
and scientific industries, to acquire its Enraf-Nonius, B.V. ("Enraf")
wholly-owned subsidiary. Enraf specializes in the development, manufacture and
sale of medical products, including ultra-sound and electrical stimulation, used
in pain management, physical therapy and rehabilitation. The proposed
acquisition is subject to various conditions including obtaining sufficient
financing by the Company and approvals of the Boards of Directors of both
companies. However, there can be no assurance that the Company will obtain the
necessary financing for the acquisition or that the acquisition will be
completed under its current terms, if at all.

                                       3
<PAGE>
OPERATIONS

      CLINICAL. The Company's Clinical operations market a line of physical
therapy and rehabilitation products, and develop, manufacture, distribute and
market various products and related accessories used for control of acute or
chronic pain delivered by non-invasive methods to facilitate the healing of
wounds. Physical therapy involves the treatment of disabilities or injuries with
therapeutic exercise and the application of various heat, hydrotherapy,
traction, ultrasound or other modalities. The Clinical products are marketed
principally through national and international sales forces consisting of
dedicated sales persons, dealers and sales representatives.

      HOMECARE. Henley's Homecare operations market and distribute a variety of
pain management and wound care products that are designed for patient care at
home. The Homecare products include a full range of nerve and muscle
stimulators, portable therapy units as well as drug delivery gels and pads.
Muscle stimulators are portable stimulators used to retard disuse atrophy and
enhance patient rehabilitation. Transcutaneous electrical nerve stimulation
therapy involves the transmission of electrical impulses on a localized basis as
a treatment for pain. The Homecare products are marketed principally through the
Company's distribution outlet in Ohio.

      MICROLIGHT. The Company's Microlight operations are engaged in the
development and application of the Microlight 830(TM) to treat soft tissue. The
Company is currently seeking approval from the FDA to sell the Microlight
830(TM) in commercial quantities for human application. See "Business-Government
Regulation." Based upon the results of recent studies, including those by
General Motors Corporation ("GM") and the Mayo Clinic, the Company believes,
although no assurances can be given, that the Microlight 830(TM) is an effective
treatment for carpal tunnel syndrome ("CTS"). See "Business-Research and
Development."

      The Microlight 830(TM) is manufactured by CB Svendsen a/s ("CBS"), a
Danish company, which has sold its low level laser devices in more than 20
foreign countries to physicians, physical therapists, dermatologists and
veterinarians, for use in connection with wound healing, pain reduction and
anti-inflammatory indications. The Company has worked on the development and
marketing of the Microlight 830(TM) with CBS since June 1991. In March 1997, the
Company and CBS entered into new agreements pursuant to which the Company paid
$100,000 to CBS and obtained unto perpetuity the sole and exclusive world-wide
distribution rights to all low level laser devices manufactured by or for CBS.
Also pursuant to the agreements, the Company obtained unto perpetuity the
exclusive world-wide manufacturing rights to all low level laser devices
manufactured by or for CBS subject to the payment to CBS of $175,000 by June 15,
1998.

      HEALTH CAREER LEARNING SYSTEMS. The Company's HCLS training unit provides
training, safety products and technical support necessary to meet OSHA
compliance standards. The HCLS system is designed to ease the task of
implementing OSHA requirements in the workplace by providing a simple,
thoroughly planned training program. The system consists of all needed
information relevant to Bloodborne Pathogens Standard, Hazard Communication
Standards, Safety Regulations and State-Specific Regulations. It is the
Company's intention that the Group will continue to expand its training
activities to include various other products offered by the Company.

PRINCIPAL PRODUCTS

      The Company develops, manufactures and markets a variety of products and
related accessories used for the control of acute or chronic pain by
non-invasive methods, to facilitate healing of wounds, for physical therapy and
in the treatment of disabilities or injuries with therapeutic exercise and the
application of various hydrotherapy, heat, traction, ultrasound or other
modalities. The Company also licenses products developed or manufactured by
other companies which are implemented into its existing and expanding
distribution system.

      FLUIDOTHERAPY  UNITS.  Fluidotherapy is a patented dry heat treatment
that uses finely divided cellulose

                                       4
<PAGE>
particles suspended and circulated in a heated air stream to apply heat,
stimulation and pressure to a specific area of the body. Patients receive such
therapy by placing the area to be treated (e.g., hand, ankle or knee) into the
unit in which the cellulose particles circulate at the appropriate temperature,
speed and density. Fluidotherapy enables physical therapists to provide their
patients with a combination of heat, stimulation, pressure and other therapies
designed to treat the symptoms of various ailments and conditions including
arthritis, circulatory disorders and certain sports-related injuries. The
Company currently manufactures, markets and distributes several models of
Fluidotherapy units.

      TRU-TRAC TRACTION MACHINES AND TABLES. The Company develops, manufactures,
markets and distributes its Tru-Trac line of intermittent traction machines,
currently consisting of four models, including a clinical model and three
portable models. The Company also manufactures, markets and distributes a
proprietary line of Tru-Trac traction and therapy tables used in a variety of
physical therapy applications.

      HYDRA-FITNESS EXERCISE AND REHABILITATION EQUIPMENT. Through its
Hydra-Fitness line of products, the Company develops, manufactures and sells
hydraulic exercise and rehabilitation systems. Hydraulic resistance is provided
by manipulating the size of the aperture in a patented, fluid-filled hydraulic
cylinder. Such hydraulic resistance provided by the machine is totally
accommodating throughout the full range of motion for each individual user and
the resistance stops when force is no longer applied. This contrasts with free
weight or weight stack equipment that must return to the starting point before
the resistance is zero. For this reason, Hydra-Fitness products can be utilized
for both medical and exercise purposes. The majority of the Company's sales of
Hydra-Fitness products is for medical use by handicapped and rehabilitating
patients and in geriatrics. The Company manufactures numerous models of
Hydra-Fitness machines.

      NORM(TM) TESTING AND REHABILITATION SYSTEM. In September 1997, the Company
acquired the manufacturing, marketing and distribution rights to the
multi-joint, isokinetic NORM(TM) testing and rehabilitation system, a
state-of-the-art extremity testing and rehabilitation system, from Cybex. The
Company began manufacturing, marketing and distributing this product shortly
thereafter. The system utilizes isokinetic resistance to provide accurate and
reproducible measurement of dynamic performance and functional capability.
Isokinetic resistance is an automatically accommodating resistance which varies
in opposition to the amount of force applied against it. NORM(TM), which stands
for Normative Outcomes for Rehabilitation Management, provides clinicians with
instant access to the world's largest on-line isokinetic normative database
which provides immediate objective documentation to assess patient needs. The
NORM(TM) and the other products acquired from Cybex are well established in the
market place. The Company makes available to customers extensive literature
including published results by accredited researchers attesting to the accuracy,
effectiveness, validity and reproducibility of the results of these products.

      ISOKINETIC ERGOMETERS. The Company began manufacturing, marketing and
distributing the Fitron isokinetic cycle ergometer ("Fitron") and the Upper Body
Ergometer ("UBE") in October 1997. Both the Fitron and UBE are designed with a
wide range of exercise speeds, work rates and anatomical range of motion for
physical therapy, athletic rehabilitation, performance training and
cardiovascular conditioning. The Fitron is principally a versatile lower-limb
cycle ergometer while the UBE incorporates all of the proven benefits of the
Fitron into a versatile ergometer for the upper body.

      KINETRON TRAINING SYSTEM. The Kinetron closed kinetic chain training
system ("Kinetron") is an exercise system for the treatment of patients
requiring gradual, stabilized and counterbalanced weight bearing exercise
treatment. Kinetron is designed to provide a safe, non-threatening exercise
environment for patients at any level. Speed and weight bearing conditions are
controlled by the clinician in order to allow rehabilitation to begin earlier
than with other body treatment systems. It is used to treat orthopedic,
neurological, acute care and sports medicine patients and can progress patients
in speed, force, range-of-motion, timing and coordination while building their
confidence. The Company began manufacturing, marketing and distributing the
Kinetron in October 1997.

                                       5
<PAGE>
      NERVE STIMULATORS. The Company markets and distributes nerve stimulators
that provide transcutaneous electrical nerve stimulation therapy, sometimes
known as "TENS" therapy. This treatment involves the continuous or intermittent
transmission of low voltage electrical impulses in different wave forms, on a
localized basis, as a treatment for chronic or acute pain resulting from a
variety of medical conditions. The therapy is provided through a small,
portable, battery-powered stimulator (resembling a paging device) connected by
wires to two or more small electrode pads placed at or near the site of the
patient's pain. For most patients, use of this therapy creates an analgesic
effect that assists in the reduction or elimination of localized pain. To the
extent this therapy is effective for a patient, it offers greater patient
comfort and mobility than competing remedies and elimination or reduction of
medications, and results in increased patient alertness, fewer side effects and
lower overall costs than prolonged medication. The Company currently sells
several different models of TENS devices and believes that the potential market
for these devices is growing. The Company purchases these nerve stimulators from
various suppliers.

      JELTRODE ELECTRODES. The Company manufactures, markets and distributes its
proprietary Jeltrode electrodes for use with the Company's nerve stimulators in
a variety of nerve and muscle stimulation and electrotherapy applications. The
Company believes that traditional electrodes used in these therapies often
irritate the skin, are messy to apply and painful to remove. A Jeltrode
electrode uses a unique adhesive gel, is hypoallergenic, virtually painless to
apply and remove and can be re-hydrated, cleaned and re-used. Since the adhesive
gel is water-based, electrical resistance between the electrode and skin is
reduced, resulting in enhanced product performance and prolonged battery life.

      IOTRODE IONTOPHORESIS ELECTRODES. Iontophoresis is a process which uses
electric current to assist drug transfer through the skin. The Company
manufactures, markets and distributes its Iotrode iontophoresis electrode for
use with its Dynaphor iontophoresis device. Using the electrodes, clinicians are
able to deliver small molecule drugs that can be ionized for the treatment of
pain and inflammation through the skin. For many applications, the use of
iontophoresis is superior because it is non-invasive, allows medications to be
dispersed over a wider range of tissue and avoids many of the systemic and
localized side effects associated with oral medications and injections.

      MEDIPADS/MEDIGELS. The Company's Medipads and Medigels are manufactured at
the Company's Sugar Land, Texas, facilities. These products are marketed and
distributed as drug-impregnated, water-based gels and gel pads used for delivery
of drugs directly through the skin on a localized basis. The Medipads and
Medigels can be used topically with various non-prescription dosages of drugs
such as hydrocortisone and lidocaine.

      WOUND CARE PRODUCTS. The Company recently obtained FDA market clearance
for the manufacture and sale of two sterile wound care products - Dermaheal gel
and Dermaheal impregnated gauze. These products are PVP/aloe vera-based,
ultrasound transparent and electrically conductive. The Company has not yet
begun to commercially manufacture these wound care products.

      THE MICROLIGHT 830(TM). The Microlight 830(TM) is a portable, hand-held,
battery-operated low energy laser with an output which does not exceed 100
milliwatts. The Company currently distributes the Microlight 830(TM) to various
clinicians participating in the Company's current research program under its
Investigational Device Exemption ("IDE") as allowed by FDA regulations. Lasers
that do not exceed 100 milliwatts have no thermal effect on living tissue.
However, depending on the wavelength, the low level laser light will penetrate
and act on the tissue underlying the skin. The specific wavelength of the laser
incorporated within the Microlight 830(TM) penetrates the dermis, epidermis and
subcutaneous layers of the skin entering surrounding tissue. Along its path, the
laser deposits photons into the cells, which is believed to stimulate nerve
regeneration, reduce swelling and improve micro-circulation by bringing
increased oxygen and blood flow to the problem area.

      The Company  believes,  although no assurances can be given, that the
Microlight 830(TM) is an effective

                                       6
<PAGE>
treatment for CTS, which is the tendon and nerve damage that results from the
fast, forceful wrist and hand motions that are repeated in production and
manufacturing workplaces many times in each day, such as operating a computer,
cutting meat, cutting or plucking poultry or assembling automobiles.
Conventional surgical and non-surgical treatments for CTS and other repetitive
stress injuries have been for the most part unsuccessful in allowing CTS
sufferers to continue with or return to productive employment. As a result of
the limited success of these treatments, CTS frequently results in temporary or
permanent disability at substantial economic costs. The Company believes that
the potential market for the Microlight 830(TM) could exceed two billion dollars
worldwide and encompasses hospitals, clinics, medical doctors, chiropractors,
physical therapists, dentists, veterinarians and, ultimately, individuals.
However, the Company has not yet received clearance from the FDA to sell the
Microlight 830(TM) in commercial quantities for human application.

DISTRIBUTION AND MARKETING

      The Company's products are marketed through a network of national and
international independent dealers and distributors, direct salespersons and
commissioned sales representatives to physicians, physical therapists,
chiropractors and their patients as well as to clinics and healthcare networks.
In conjunction with sales, marketing and manufacturing, the Company also has a
network for direct billing to insurance claims offices, Medicare carriers and
managed healthcare programs. The Company believes that its approach to sales and
marketing is supported by the desire of its customers to identify with
individual account managers and product specialists. This enables the Company to
provide better customer service and to maintain specialized expertise in each
product line. As medical products are increasingly being purchased on a national
account or centralized basis by healthcare networks, Company salespersons must
also maintain relationships with purchasing managers within these networks.

      The Company has product distribution centers in Ohio, Minnesota, Georgia
and Texas and approximately 160 dealers and distributors, 30 sales
representatives and 25 direct salespersons representing its product within the
United States. The Company has both telemarketing and direct-mail programs for
its HCLS-related products and services and for the marketing and distribution of
medical supplies related to its TENS, wound-healing and other products.

      Additionally, the Company sells many of its products to over 140
distributors and representatives in various countries around the world. The
products manufactured or sold by the Company in Europe are subject to the
European Community regulations for medical devices, including product
certification ("CE Marking"). The European Community has imposed a deadline of
June 1998, after which products without a CE Marking may not be sold in Europe.
The Company has obtained CE Marking on all of its traction machines and
anticipates obtaining the CE Marking prior to the deadline, on the remainder of
its products that are sold in the European Community. The Company believes that
its network of international distributors will enhance its marketing and
distribution efforts as it seeks to extend its market share of the international
marketplace.

      The Company began marketing the LASERMEDICS VMD 830(TM) laser for
veterinary application in November 1993. Sales are made to veterinarians through
a network of distributors and sales representatives for use in wound healing and
the treatment of muscle afflictions on horses and other animals. Research
studies have demonstrated the positive photobiostimulation effects of the
LASERMEDICS VMD 830(TM) cold laser technology on animal muscle ailments such as
bowed tendon, check ligament and plantar desmitis. Clinical results also show
that soft tissue healing on horses is accelerated with repeated applications of
the LASERMEDICS VMD 830(TM).

MANUFACTURING

      The Company operates two manufacturing facilities in Belton and Sugar
Land, Texas. Most of the Company's Clinical products are manufactured at the
Belton, Texas facility while the manufacturing operations for some of the
Company's Homecare products are located at the Sugar Land, Texas facility.

                                       7
<PAGE>
COMPETITION

      Competition in the medical device and physical medicine markets is
intense. The Company's products compete with the products of many other
companies in the business of developing, manufacturing, distributing and
marketing physical therapy and rehabilitation products. Many of these companies
may have substantially greater financial and other resources than the Company,
and may have established reputations for success in the development, sale and
service of their products. The Company believes that the principal competitive
factors in each of its markets are product features and benefits, customer
service and pricing. Although the Company's products are not the lowest-priced
in its markets, the Company endeavors to maintain a competitive edge by
emphasizing overall value through a combination of competitive pricing, product
quality and customer service.

      There are several foreign as well as U.S. manufacturers of low energy
lasers using similar technology to the Microlight 830(TM). However, these
competitive lasers may emit light of a different wavelength, are not generally
portable and may be more expensive than the Company's product. Consequently, the
Company anticipates future competition relating to the Microlight 830(TM).
Furthermore, there may be no effective barrier to competitors using other
wavelengths of low-level laser light inasmuch as the manufacture of the
Microlight 830(TM) does not incorporate any patented inventions, and qualified
companies could reverse engineer such product and market it, subject to
obtaining the requisite FDA pre-marketing approval ("PMA"), for human use.
Although there may be no absolute barriers to entry for competitive lasers, the
Company believes that, pursuant to specific FDA regulations, the safety and
efficacy data submitted to the FDA by one entity supporting such entity's PMA
application cannot be used by another entity in its PMA application. Generally,
this means that another entity desiring to submit a PMA application for a laser
similar to the Microlight 830(TM) cannot rely on the Company's clinical trial
results to support such entity's PMA application, but must conduct its own
trials and gather its own data. Although no assurances can be given, this
provision could increase the length of time for a competitor of the Company to
obtain FDA approval to commercially sell a similar product in the United States
for human application.

PATENTS AND PROPRIETARY RIGHTS

      The Company actively pursues a policy of seeking patent protection both in
the U.S and abroad for its proprietary technology. The Company owns several U.S.
issued patents and various foreign counterparts. The Company also has one patent
application pending in the U.S. The Company also relies on trade secrets and
un-patented know-how in connection with the use of the Microlight 830(TM), but
the Company may be vulnerable to competitors who attempt to copy the laser
technology used in such product or to gain access to the Company's trade secrets
and know-how. Although the Company has conducted a search to discover any
patents which the Microlight 830(TM) or its use may infringe, the Company is not
aware of any patents which may be infringed by this product.

      Litigation, which could result in substantial cost to and diversion of
effort by the Company, may be necessary to enforce any patent issued to the
Company, to protect trade secrets or know-how owned by the Company or to
determine the scope and validity of the proprietary rights of others. Adverse
findings in any proceeding could subject the Company to significant liabilities
to third parties, require the Company to seek licenses from third parties and
adversely affect the Company's ability to sell its product.

GOVERNMENT REGULATION

      All medical devices are subject to FDA regulation under the Medical Device
Amendments of the Food, Drug and Cosmetic Act, as amended ("FDCA".) Pursuant to
the FDCA, a medical device is ultimately classified as either a Class I, Class
II or Class III device. Class I devices are subject only to general controls
which are applicable to all devices. Such controls include regulations regarding
FDA inspections of facilities, Quality Systems Regulations (formerly known as
Good Manufacturing Practices), labeling, maintenance of

                                       8
<PAGE>
records and filings with the FDA. Class II devices must meet general performance
standards established by the FDA. Class III devices are subjected to a more
stringent PMA process by the FDA before they can be commercially marketed and
must adhere to such standards once on the market. Such PMA can involve extensive
testing to prove safety and efficacy of the devices. Most of the Company's
products are Class II devices. FDA marketing clearance of these devices is
obtained under Section 510 (k) of the FDCA, which provides for FDA clearance for
products that can be shown to be substantially equivalent to devices in commerce
prior to May 1976 (the month and year of enactment of the FDCA) or which have
subsequently been granted market clearance. Most of the Company's remaining
products are Class I devices (i.e., treatment tables and fitness and exercise
equipment.)

      Currently, all of the Company's products and manufacturing facilities are
subject to pervasive and continuing regulation by the FDA. All phases of the
manufacturing and distribution process are governed by FDA regulation. Products
must be produced in registered establishments and be manufactured in accordance
with Quality Systems Regulations, as such term is defined under the Code of
Federal Regulations. In addition, all such devices must be periodically listed
with the FDA. Labeling and promotional activities are subject to scrutiny by the
FDA and, in certain instances, by the Federal Trade Commission. The export of
devices is also subject to regulation in certain instances. The FDA conducts
inspections periodically to ensure compliance with these regulations.

      The FDA's mandatory Medical Device Reporting ("MDR") regulation obligates
the Company to provide information to the FDA on injuries alleged to have been
associated with the use of a product or in connection with certain product
failures which could cause serious injury or death. If as a result of FDA
inspections, MDR reports or other information, the FDA believes that the Company
is not in compliance with regulations, the FDA can institute proceedings to
detain or seize products, enjoin future violations, or assess civil or criminal
penalties against the Company, its officers or employees. Although the Company
and its products have not been the subject of such FDA enforcement action, any
such action by the FDA could result in a disruption of the Company's operations
for an undetermined time.

      In addition to the foregoing, foreign countries in which the Company's
products may be sold, as well as state governments and other federal and local
agencies within the U.S., may impose additional regulatory requirements on the
Company, and such actions could have a material adverse effect on the Company's
ability to do business.

      There can be no assurance that the FDA will grant PMA clearance for the
MicroLight 830(TM) for the treatment of CTS on a timely basis, if at all. Until
it obtains FDA market clearance, the Company is unable to sell the product in
commercial quantities for human application in the U.S. market.

      The Company is not required to notify or obtain approval from the FDA
regarding any of its devices sold for veterinarian applications. However, the
Company is required to obtain, prior to commencing any sales activities, a
radiological health registration number and to file an Initial Report for all
models of its devices. With no objection from the FDA to the introduction of the
LASERMEDICS VMD 830(TM) into commerce, the Company continues to market this
product in the veterinary market, although much of the Company's efforts is
focused on the marketing and distribution of its many other products.

THIRD-PARTY REIMBURSEMENT AND HEALTHCARE REFORM

      Healthcare providers, such as hospitals and physicians, that purchase
medical products for use on patients generally rely on third party payors,
principally Medicare, Medicaid and private health insurance plans, to reimburse
all or part of the costs and fees associated with the products used, procedures
performed or services provided. The Company's products are purchased by
hospitals, corporations, clinics and private physicians. These customers then
bill various third-party payors for the healthcare services provided to their
patients with use of the Company's products. These payors include Medicare,
Medicaid and private insurance payors. Generally, government agencies reimburse
hospitals and other healthcare providers for patient medical care at a fixed
rate according to diagnosis-related groups (DRGs) as mandated by Congress.

                                       9
<PAGE>
Reimbursements are dependent on many factors which may include the payor's
determination that a service or procedure was not experimental and was used for
an approved indication.

      During the 3rd quarter of 1997, the Company commenced an extensive
analysis of its accounts with particular emphasis on its accounts receivable
which relate to the Company's third-party billing operations. In conjunction
with the analysis, the Company intensified its collection efforts. The third
party billing business, by its nature, demands longer-than-average time to bill
and much longer-than-average time to collect. Upon further scrutiny in the
fourth quarter and on the basis of the analysis, management revised its
estimates of collectibility of the Company's accounts receivable for the third
party billing operations and increased its reserve for doubtful accounts by
approximately $2,000,000. The Company has also changed certain procedures in the
collection process in order to improve the future collectibility of the accounts
receivable. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations".

      The Company believes that the nature of the non-intrusive utilization of
its products in patient care and the advantages of their relative cost and ease
of use may be positive factors in reducing health care costs. However, the
Company cannot predict the ultimate effect of the current governmental focus on
healthcare reform on the sale of its products. Although the market for some of
the Company's products could be adversely affected by changes in governmental
and private third-party payors' policies, the Company believes that healthcare
legislation may have some beneficial effect on its business by increasing the
availability of healthcare, emphasizing less invasive surgery and increasing the
need for efficiency by healthcare personnel.

RESEARCH AND DEVELOPMENT

      GENERAL. The Company is continually conducting, researching and developing
new products by utilizing a team approach involving the engineering,
manufacturing and marketing resources. These research and development efforts
are designed primarily to apply state-of-the-art technology and the Company's
expertise to the treatment of wide-ranging medical conditions. Although the
Company has developed a number of its products, such as the original
Fluidotherapy device, Medipads and others, most of its research and development
efforts are directed towards product improvement and enhancement of previously
developed or acquired products. Such enhancement may involve updating and
redesigning existing products to improve features, performance and reliability.

      The Company is also involved in the development and application of various
new products many of which are in early stages of development and will require
additional development work, FDA approval, clinical or other testing or market
research and development efforts prior to commercial introduction. In this
regard, the Company is continuing its clinical research and investigation using
the Microlight 830(TM) under its IDE. Expenses incurred in connection with
research and development in 1997 and 1996 amounted to approximately $395,000 and
$314,000, respectively.

      The Company also estimates that it will incur expenditures approximating
$500,000 for research and development, in the event it obtains FDA approval for
human application of the Microlight 830(TM), for which no assurance can be
given. Such research and development effort will primarily emphasize additional
photobiostimulation applications for the Microlight 830(TM), such as pain
suppression, wound healing and sports injuries, in various medical disciplines
including general medicine, dentistry, veterinary medicine, physical therapy,
orthopedic surgery, dermatology and re-constructive and cosmetic surgery.

      CLINICAL TRIALS FOR THE MICROLIGHT 830(TM). The Microlight 830(TM), a
Class III medical device, has been defined by the FDA as a "non-significant
risk" device. The Company is allowed to conduct clinical trials under an
approved IDE using the Microlight 830(TM). In August 1997, the FDA accepted the
Company's Pre-IDE Clinical Investigation Plan for a multi-center, double-blind,
randomized, clinical study to evaluate the efficacy of the Microlight 830(TM) in
the treatment of CTS. These clinical trials are subject to IDE regulations,
including record keeping, adverse event reporting and other clinical study
requirements. Pursuant to IDE regulations the Company's clinical researchers are
required to be reviewed and approved by an Institutional

                                       10
<PAGE>
Review Board (IRB) to treat human patients for research purposes. The objective
of these clinical trials is to evaluate the therapeutic effects of low-level
laser energy in pain management, soft tissue trauma (including RSI) and dental
applications. The Company is sponsoring independent research studies on the
effects of the Microlight 830(TM) at various clinical sites in the U.S.

      No assurance can be given that (i) the results of the various research
studies that are being or have been conducted using the Microlight 830(TM), will
demonstrate to the FDA's satisfaction the safety and effectiveness of the
Microlight 830(TM) in treating CTS, (ii) the FDA will agree that the design of
the studies is satisfactory, (iii) the FDA will not require additional clinical
studies, or (iv) the Company can obtain the necessary FDA marketing clearance
for the Microlight 830(TM) on a timely basis, if at all. The FDA's rejection of
the clinical design or the data generated could lead to rejection of the
application for commercial marketing of the Microlight 830(TM) and/or the need
to conduct additional clinical trials.

PRODUCT LIABILITY AND INSURANCE

      The Company's business includes the risk of product liability claims.
Although the Company has not experienced any product liability claims to date,
any such claims could have an adverse impact on the Company. The Company
currently maintains product liability insurance covering up to $3,000,000 in
liability claims, but does not intend to seek additional coverage until after
such time, if ever, as it obtains marketing approval from the FDA for human
application of the Microlight 830(TM).

EMPLOYEES

      As of March 16, 1998, the Company had approximately 376 full-time and 5
part-time employees. None of the Company's employees are represented by a union,
and management believes that its relations with its employees are good. The
Company believes that the success of its business will depend, in part, on its
ability to attract and retain qualified personnel.

ITEM 2. PROPERTIES

      The Company owns three buildings of which two are located in Sugar Land,
Texas, and the other in Belton, Texas. The addresses of these owned facilities
are 120 Industrial Boulevard, Sugar Land, Texas 77478, 140 Industrial Boulevard,
Sugar Land, Texas 77478 and 2121 Industrial Park Road, Belton, Texas 76513. The
Company's principal executive and administrative offices are located at the 120
Industrial Boulevard, Sugar Land, facility consisting of approximately 25,000
square feet. Electronics manufacturing and warehouse operations for the
Company's pain management products and certain administrative functions are
located at the 140 Industrial Boulevard, Sugar Land, facility consisting of
approximately 50,000 square feet. The manufacturing and warehouse facilities for
much of the Company's physical therapy and fitness products are located at the
Belton facility consisting of approximately 59,000 square feet.

      The Company also leases three regional warehouse and distribution
facilities in Akron, Ohio, St. Paul, Minnesota and Atlanta, Georgia, of
approximately 15,000, 5000 and 5,550 square feet, respectively. The Company also
leases approximately 4,900 and 4,500 square feet of office space in Plymouth,
Michigan, and Happauge, New York, respectively, as principal operations center
for its HCLS training unit and customer service operations for the recently
acquired Cybex products, respectively.

      The Company believes that its facilities, whether leased or owned, are
adequate to meet its current needs and should continue to be adequate for the
foreseeable future.

ITEM 3. LEGAL PROCEEDINGS

      There are no material legal proceedings to which the Company is party or
of which any of its property is the subject other than ordinary, routine claims
incidental to the Company's business.

                                       11
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

      None.

                                     PART II

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

      The Company's Common Stock currently trades in and is quoted on The Nasdaq
SmallCap Market under the symbol "HENL." The following table sets forth the
range of high and low bid prices on the Company's Common Stock for calendar
years 1997 and 1996 on The Nasdaq SmallCap Market:

      CALENDAR PERIOD                     HIGH                         LOW
      ---------------                     ----                         ---
      1997:
      First Quarter                      $6.500                    $ 4.125
      Second  Quarter                     7.750                      4.375
      Third Quarter                       7.500                      4.937
      Fourth Quarter                      9.000                      5.187

      CALENDAR PERIOD                     HIGH                         LOW
      ---------------                     ----                         ---
      1996:
      First Quarter                       8.750                      4.250
      Second Quarter                      8.875                      6.000
      Third Quarter                       8.125                      4.750
      Fourth Quarter                     $6.875                     $5.750

      The Company has authorized 20,000,000 shares of common stock, par value
$.01 per share. As of March 16, 1998, there were 5,383,205 shares issued and
outstanding and 303 shareholders of record, although the Company believes that
there are other persons who are beneficial owners of the Company's securities
held in "street" names. All shares of Common Stock currently outstanding are
validly issued, fully paid and non-assessable.

      The Company has neither declared nor paid any dividends on common stock
since its inception and presently anticipates that no dividends will be declared
in the foreseeable future. Any future dividends will be subject to the
discretion of the Company's Board of Directors and will depend upon, among other
things, future earnings, the operating and financial condition of the Company,
its capital requirements, debt obligation agreements, general business
conditions and other pertinent facts. Therefore, there can be no assurance that
any dividends on the Common Stock will be paid in the future.

RECENT SALES OF UNREGISTERED SECURITIES

      The following sales of unregistered securities occurred during the year
ended December 31, 1997, in private transactions in which the Company, unless
otherwise indicated, relied on the exemption from registration available under
Section 4(2) of the Securities Act of 1993, as amended (the "Securities Act"):

      In January 1997, the Company acquired substantially all of the inventory,
distribution systems and customers associated with the Homecare (third-party
billing) division of Gatti Medical Supply, Inc. In connection with the
acquisition, the Company issued to the sellers a total of 51,117 shares of the
Company's common stock.

                                       12
<PAGE>
      In connection with a non-compete agreement entered in September 1997 with
a former employee, the Company issued to the former employee 10,000 shares of
the Company's common stock.

      In October 1997, the Company entered into an agreement with the sole owner
of Summer Medical ("SM"), an unincorporated sole proprietorship, pursuant to
which the Company acquired all of the owner's interests in SM and assumed
certain business-related liabilities associated with SM. In connection with the
acquisition, the Company issued to the owner 10,000 shares of the Company's
common stock.

      In December 1997, the Company acquired all of the issued and outstanding
common stock of NCI, Inc., a Michigan corporation. In connection with the
acquisition, the Company issued to the seller 188,847 shares of the Company's
common stock.

      In October 1997, the Company offered to exchange Amended and Restated
Class J Warrants with the holders of the then outstanding Class J Warrants in a
transaction exempt from registration under Section 3(a)(9) of the Securities
Act. Of the 104,941 Class J Warrants then outstanding, the holders of an
aggregate of 65,341 agreed to exchange their original Class J Warrants for
Amended and Restated Class J Warrants. In December 1997, the Company undertook
to redeem the Amended and Restated Class J Warrants pursuant to the terms
thereof. Upon receipt of the Notice of Redemption, certain holders of the
Company's Amended and Restated Class J Warrants exercised their rights under the
Warrants and purchased shares of the Company's common stock. In connection with
this transaction, the Company issued an aggregate of 61,341 shares of its common
stock and redeemed 4,000 Amended and Restated Class J Warrants.


ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

GENERAL

      The Company's principal business strategies are to (i) expand distribution
channels and explore new markets, (ii) consolidated the highly-fragmented
physical therapy and rehabilitation industry by pursuing strategic acquisitions
that complement existing product lines and increase market share, (iii) maximize
the utilization of existing manufacturing facilities for increased productivity,
(iv) improve profitability, (v) reduce long-term indebtedness, and (vi) obtain
market clearance from the FDA for the Microlight 830(TM).

      Prior to April 30, 1996, the Company was primarily engaged in the
development and application for marketing clearance of the Microlight 830(TM).
Beginning with the acquisition of Maxxim's Henley Division, the Company has
pursued a strategy of consolidating the highly-fragmented physical therapy and
rehabilitation industry. Since that time, the Company has grown significantly as
a result of additional acquisitions. See "Business --Acquisitions." All
acquisitions were accounted for under the purchase method of accounting for
business combinations and accordingly, the results of operations for such
acquisitions are included in the Company's financial statements only from the
applicable date of acquisition. As a result, the Company believes that its
historical results of operations for the periods presented may not be directly
comparable. The Company believes the historical results of operations do not
fully reflect the operating efficiencies and improvements that are expected to
be achieved by integrating the acquired businesses and product lines.

      The Company intends to continue its evaluation of acquisitions, and a
period of rapid growth could place a significant strain on the Company's
management, operations and other resources. There can be no assurance that the
Company will continue to be able to identify attractive or willing acquisition
candidates, or that the Company will be able to acquires such candidates on
economically acceptable terms. The Company's ability to grow through
acquisitions and manage such growth will require the Company to continue to
invest in its operational, financial and management information systems and to
attract, retain, motivate and effectively manage its employees. The inability of
the Company's management to

                                       13
<PAGE>
manage growth effectively would have a material adverse effect on the financial
condition, results of operations and business of the Company. As the Company
pursues its acquisition strategy in the future, its financial position and
results of operations may fluctuate significantly from period to period.

      The following discussion should be read in conjunction with the
consolidated financial statements and the related notes thereto and other
detailed information appearing elsewhere herein.

RESULTS OF OPERATIONS

FISCAL 1997 COMPARED TO 1996

      The Company achieved record sales in fiscal 1997, with total revenue of
approximately $24,257,000 reflecting an increase of approximately $11,771,000 or
94% over the amount reported for fiscal year 1996. The increase was primarily
due to increased sales from the acquired operations. Net loss for fiscal 1997
amounted to approximately $2,124,000 compared to a net loss of approximately
$879,000 in fiscal 1996. The increase in net loss resulted primarily from the
effect of the one-time adjustment to the allowance for doubtful accounts.

      The Company's gross profit for fiscal 1997 was approximately $12,530,000
compared to approximately $6,770,000 for fiscal 1996. Gross margin as a
percentage of sales in 1997 decreased to 52% from 54% in 1996. The decrease in
the 1997 gross margin percentage compared with 1996 was primarily the result of
lower margin products representing a larger portion of sales in 1997.

      Operating expenses in 1997 increased approximately $6,618,000 over the
amount of approximately $6,727,000 reported for 1996. As a percent of sales,
operating expenses in 1997 increased to approximately 55% compared to
approximately 54% a year earlier. The increase in operating expenses was due to
increased relative costs of operating the acquired businesses. Also contributing
to the increase in operating expenses in 1997, was the effect of the Company's
fourth quarter revision of its estimates of collectibility of the accounts
receivable, which increased operating expenses (and the reserve for
uncollectible accounts) by approximately $2,000,000. Excluding the effect of
this one-time adjustment, operating expenses in 1997, as a percent of sales,
decreased to approximately 47% reflecting the effects of larger overall sales
from the acquired businesses and product lines. The Company will continue to
face the challenge of managing expense growth as it seeks to expand distribution
channels and explore new markets while moving towards the consolidation of the
highly-fragmented physical therapy and rehabilitation industry.

      Interest expense for 1997 amounted to approximately $1,148,000 compared to
approximately $815,000 in 1996. The increase in interest expense was primarily
due to the interest-bearing notes issued to finance the Company's acquisitions.

      As of December 31, 1997, the Company had net operating loss carryforwards
for income tax purposes of approximately $6,324,000 available to offset future
taxable income. The carryforwards will begin to expire in 2005. A valuation
allowance was provided to fully reserve the net deferred tax asset due to
realization uncertainties regarding future operating results.

FISCAL 1996 COMPARED TO 1995

      Total revenue for fiscal year 1996 amounted to approximately $12,486,000
reflecting an increase of approximately $11,959,000 over the amount reported for
fiscal year 1995. The increase is primarily due to increased sales from the
acquired operations acquired from Maxxim Medical, Inc. Net loss decreased about
38% from approximately $1,420,000 in fiscal 1995 to approximately $879,000 in
fiscal 1996. The decrease in net loss is due to achievement of more profitable
operations during the second six-month period of fiscal 1996.

      The Company's gross profit for fiscal 1996 was approximately $6,770,000
compared to approximately $183,000 for fiscal 1995. Product gross margin as a
percentage of sales in 1996 increased to

                                       14
<PAGE>
54% from 35% in 1995. The increase in the 1996 gross margin percentage compared
with 1995 resulted primarily from sales of many high margin products acquired
from Henley.

      Operating expenses in 1996 increased approximately $5,196,000 over the
amount of approximately $1,530,000 reported for 1995. However, as a percent of
sales, operating expenses in 1996 decreased to 54% compared to 290% a year
earlier. The increase in operating expenses is due to increased relative costs
of operating the acquired businesses. However, the decreased operating expenses
as a percent of sales reflects the effects of larger overall sales from the
acquired products and certain cost containment measures undertaken following the
Henley acquisition. The Company will continue to face the challenge of managing
expense growth as it seeks to expand distribution channels and explore new
markets while moving towards the consolidation of the highly-fragmented physical
therapy and rehabilitation industry.

      Interest expense for 1996 amounted to approximately $815,000 compared to
approximately $84,000 in 1995. The increase in interest expense was primarily
due to the interest-bearing notes issued to finance the Company's acquisition of
the Henley Division, which was partially offset by the effects of the conversion
of certain interest-bearing notes into shares of the Company's common stock.

      For the year ended December 31, 1996, the amount of other income and
expense, net included certain non-recurring employee relocation and severance
costs which were not incurred in 1995.

LIQUIDITY AND CAPITAL RESOURCES

      At December 31, 1997, the Company had cash and cash equivalents in the
amount of $123,620 as compared to $507,892 at December 31, 1996. The decrease in
cash and cash equivalents resulted primarily from expenses incurred in pursuing
the Company's overall growth strategy.

      In March 1998, the Company sold 1,825 shares of its Series A Convertible
Preferred Stock (the "Preferred Stock") at $1000 per share in a private
offering, resulting in net proceeds of approximately $1.8 million. The Preferred
Stock is convertible into the Company's common stock at the lesser of (i) 75% of
the average closing bid price for the Company's common stock as reported on The
Nasdaq SmallCap Market for the 5 trading days prior to conversion, or (ii) $6.50
per share. In connection with the transaction, the Company also issued to the
investors a 5-year warrant to purchase up to 146,000 shares of the Company's
common stock at exercise prices ranging from $7.125 per share to $9.619 per
share. The Company has agreed to file a registration statement covering the
resale of the shares of Common Stock issuable upon the conversion of the
Preferred Stock and exercise of the warrants sold to the investors described
above. As a result of the Securities and Exchange Commission's position
regarding the accounting for preferred stock with a floating conversion rate,
the Company will incur a dividend expense in the future for the conversion of
the Preferred Stock. Such dividend expense is calculated as the discount over
fair market value as of the date the Preferred Stock was sold to the investors.
This discount amount of $456,250 will be treated as a dividend to the holders of
the Preferred Stock and will be ratably charged to operations upon each
conversion of the Preferred Stock.

      The Company's current sources of liquidity consist primarily of (i) funds
from operations, (ii) proceeds from the sale of the Preferred Stock, (iii) funds
held at the end of fiscal year 1997 and (iv) the amounts, if any, available
under the Amended Loan Agreement with Comerica. The Amended Loan Agreement with
Comerica provides for (i) a one-year revolving loan ("Line of Credit"), which
permits borrowings up to $8,000,000 through January 1999 and (ii) three term
loans in the amounts of $1,430,000 ("Term Note A"), $1,616,000 ("Term Note B")
and $1,260,000 ("Term Note C"). Term Note A, Term Note B and Term Note C are
payable in monthly installments of $23,833, $8,978 and $7,000, respectively,
plus interest through September 2002, May 2011 and February 2013, respectively.
The Line of Credit also includes a $250,000 letter of credit facility. Interest
on the Line of Credit and the three term loans is payable monthly and is
calculated at a rate equal to the Prime Rate plus one-half of one percent per
annum. Term Note B is callable by Comerica beginning on the fifth anniversary of
the Amended Loan Agreement. All of the borrowings from Comerica are secured by
substantially all of the assets of the Company. As of December 31,

                                       15
<PAGE>
1997, the Company had approximately $894,000 available for borrowing under the
Line of Credit. The total amount available for borrowing under the Line of
Credit is the lesser of (i) $8,000,000 and (ii) a variable borrowing base
calculated based on the amount and type of outstanding accounts receivable and
the value of certain items of inventory. At December 31, 1997, the Company had
working capital of approximately $2,637,000 and its current ratio was 1.2 to 1
as compared to $5,592,000 and 2.2 to 1 at December 31, 1996. This decrease in
the current ratio is primarily due to the increase in the amount of outstanding
line of credit, consistent with the Company's growth strategy. At December 31,
1997, the Company had no material capital expenditure commitment.

      In connection with an agreement entered into in April 1996 with Maxxim
Medical, Inc. ("Maxxim"), the Company issued to Maxxim a convertible
subordinated promissory note in the principal amount of $7 million (the "Note").
The Note is due and payable on March 1, 2003 with interest payable semi-annually
on November 1 and May 1 of each calendar year and calculated at a rate equal to
2% per annum and increasing annually 2% per annum. The Company may redeem all or
any portion of the outstanding principal amount of the Note at redemption prices
ranging from 104% to 110% of the principal amount being redeemed, depending on
when the redemption occurs as set forth in the Note. In addition, the Note is
subject to mandatory redemption in annual installments of $1.4 million
commencing on March 1, 1999 at premiums starting at 7% and decreasing 1% each
year. The Company is also required to redeem 40% of the Note upon the completion
of a public offering. The Note is convertible into common stock at an initial
conversion price of $2 per share, provided that upon the occurrence of any
default under the Note, the conversion price will be automatically adjusted to
an amount equal to the lesser of the conversion price then in effect or 80% of
the average market price for the Company's common stock for the 30 trading days
immediately preceding the event of default. The conversion price is also subject
to adjustment upon the occurrence of certain events (including certain issuances
of common stock for less than the conversion price) to provide anti-dilution
protection.

      In February and March 1998, the Company entered into agreements with
Maxxim pursuant to which Maxxim converted an aggregate of $4,000,000 of the Note
into an aggregate of 2,000,000 shares of the Company's common stock, par value
$.01 per share. The conversions were based on the current conversion price of
$2.00 per share under the Note. The agreements also provide that the entire $4
million of the Note so converted reduces the principal amount of the Note and
such sum shall be applied to the Company's full redemption obligation due in the
year 2003 and partially to the Company's redemption obligation due in the year
2002 as provided in the Note. The Company has agreed to file a registration
statement covering the resale of the shares of Common Stock issued to Maxxim as
a result of the conversions described above.

      The Company is currently assessing the potential impact of the present
computer technology issue generally referred to as the "Year 2000 Problem." The
year 2000 Problem, which is common to most corporations, relates to the
inability of information systems, primarily computer software programs, to
properly recognize and process date sensitive information related to the year
2000 and beyond. The Company is currently evaluating the expected costs to be
incurred in connection with the Year 2000 Problem, and expects that such costs
will not be material.

      Management believes that the funds generated from operations, along with
the Company's current working capital position and bank credit will be
sufficient to satisfy the Company's capital requirements for the Company's
existing operations for the foreseeable future. However, the Company will need
to obtain significant additional capital to finance its acquisition strategy,
including the Enraf-Nonius acquisition. See "Business -- Acquisitions." If the
Company's operating cash flows are inadequate or if the Company is unable to
raise sufficient financing, there can be no assurance that the Company will be
able to successfully fund its current operations or implement its acquisition
strategy. The Company believes that its success in obtaining the necessary
financing will depend upon, among other factors, successfully operating the
recently acquired businesses. Sources of additional financing may include
additional bank debt or the public or private sale of equity or debt securities.
There can be no assurance that the Company will be successful in arranging such
financing at all or on terms commercially acceptable to the Company.

                                       16
<PAGE>
ITEM 7. FINANCIAL STATEMENTS

      The information  required hereunder is included in this report as set
forth in the "Index to Financial Statements."

                       INDEX TO FINANCIAL STATEMENTS

                                                                 PAGE
                                                                 ----
Reports of Independent Public Accountants                        18-19

Consolidated Balance Sheet                                          20

Consolidated Statements of Operations                               21

Consolidated Statements of Stockholders' Equity                     22

Consolidated Statements of Cash Flows                               23

Notes to Consolidated Financial Statements                       24-38

                                       17
<PAGE>
      REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


      To the Board of Directors
      Henley Healthcare, Inc.:


      We have audited the accompanying consolidated balance sheet of Henley
      Healthcare, Inc., a Texas corporation, and Subsidiaries as of December 31,
      1997, and the related consolidated statements of operations, stockholders'
      equity and cash flows for the year then ended. These financial statements
      are the responsibility of the Company's management. Our responsibility is
      to express an opinion on these financial statements based on our audit.

      We conducted our audit in accordance with generally accepted auditing
      standards. Those standards require that we plan and perform the audit to
      obtain reasonable assurance about whether the financial statements are
      free of material misstatement. An audit includes examining, on a test
      basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles
      used and significant estimates made by management, as well as evaluating
      the overall financial statement presentation. We believe that our audit
      provides a reasonable basis for our opinion.

      In our opinion, the financial statements referred to above present fairly,
      in all material respects, the financial position of Henley Healthcare,
      Inc. and Subsidiaries as of December, 31, 1997 and the results of their
      operations and their cash flows for the year then ended in conformity with
      generally accepted accounting principles.


      ARTHUR ANDERSEN LLP

      Houston, Texas
      March 13, 1998

                                       18
<PAGE>
      INDEPENDENT AUDITOR'S REPORT


      To the Board of Directors
      Henley Healthcare, Inc.


      We have audited the accompanying consolidated statements of operations,
      stockholders' equity and cash flows of Henley Healthcare, Inc. and
      Subsidiary (formerly Lasermedics, Inc.) for the year ended December 31,
      1996 (prior to the effects on such financial statements of the adoption of
      Statement of Financial Accounting Standards No. 128, "Earnings per Share,
      and the resultant restatement of the Company's earnings per share for the
      year ended December 31, 1996 as discussed in Note 1). These financial
      statements are the responsibility of the Company's management. Our
      responsibility is to express an opinion on these financial statements
      based on our audit.

      We conducted our audit in accordance with generally accepted auditing
      standards. Those standards require that we plan and perform the audit to
      obtain reasonable assurance about whether the financial statements are
      free of material misstatement. An audit includes examining, on a test
      basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles
      used and significant estimates made by management, as well as evaluating
      the overall financial statement presentation. We believe that our audit
      provides a reasonable basis for our opinion.

      In our opinion, the financial statements referred to above present fairly,
      in all material respects, the results of operations and cash flows of
      Henley Healthcare, Inc. and Subsidiary for the year ended December, 31,
      1996 (prior to the effects on such financial statements of the adoption of
      Statement of Financial Accounting Standards No. 128, "Earnings per Share,
      and the resultant restatement of the Company's earnings per share for the
      year ended December 31, 1996 as discussed in Note 1) in conformity with
      generally accepted accounting principles.


      GOLDSTEIN GOLUB KESSLER & COMPANY, P.C.

      New York, New York
      February 23, 1997

                                       19
<PAGE>
                                                         HENLEY HEALTHCARE, INC.

                                                      CONSOLIDATED BALANCE SHEET
--------------------------------------------------------------------------------
DECEMBER 31,                                                            1997
--------------------------------------------------------------------------------
ASSETS

CURRENT ASSETS
  Cash and cash equivalents                                        $    123,620
  Accounts receivable, net of allowance for doubtful
     accounts of $2,165,124                                           6,675,800
  Inventory                                                           8,147,357
  Prepaid expenses                                                      228,165
  Other current assets                                                   71,960
--------------------------------------------------------------------------------
         TOTAL CURRENT ASSETS                                        15,246,902

PROPERTY, PLANT AND EQUIPMENT, net                                    3,994,231
GOODWILL AND OTHER INTANGIBLES, net                                   5,670,004
OTHER ASSETS, net                                                     1,244,580
--------------------------------------------------------------------------------
         TOTAL ASSETS                                              $ 26,155,717
================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
  Line of credit                                                   $  7,105,868
  Current maturities of long-term debt                                  433,763
  Accounts payable                                                    3,970,270
  Accrued expenses and other current liabilities                      1,099,572
--------------------------------------------------------------------------------
         TOTAL CURRENT LIABILITIES                                   12,609,473

INTEREST PAYABLE                                                        536,667
LONG-TERM DEBT, net of current maturities                             9,466,179
--------------------------------------------------------------------------------
         TOTAL LIABILITIES                                           22,612,319

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS' EQUITY:
  Preferred stock - $.10 par value; authorized
    2,500,000 shares; none issued and outstanding                          --
  Common stock - $.01 par value; authorized
    20,000,000 shares; issued 3,473,897 shares                           34,738
  Additional paid-in-capital                                         14,117,079
  Accumulated deficit                                               (10,382,240)
--------------------------------------------------------------------------------
                                                                      3,769,577
  Treasury stock, at cost, 279,000 common shares                       (226,179)
--------------------------------------------------------------------------------
        TOTAL STOCKHOLDERS' EQUITY                                    3,543,398

        TOTAL LIABILITIES AND STOCKOLDERS' EQUITY                  $ 26,155,717
================================================================================

              The accompanying notes are an integral part of this
                       consolidated financial statement.

                                       20
<PAGE>
                                                         HENLEY HEALTHCARE, INC.

                                           CONSOLIDATED STATEMENTS OF OPERATIONS
--------------------------------------------------------------------------------

YEAR ENDED DECEMBER 31,                                1997             1996
--------------------------------------------------------------------------------
NET SALES                                          $ 24,257,014    $ 12,485,961
COST OF SALES                                        11,726,802       5,716,156
--------------------------------------------------------------------------------
GROSS PROFIT                                         12,530,212       6,769,805

OPERATING EXPENSES                                   10,173,362       5,306,174
PROVISION FOR DOUBTFUL ACCOUNTS                       3,171,163       1,420,518
--------------------------------------------------------------------------------
INCOME (LOSS) FROM OPERATIONS                          (814,313)         43,113

INTEREST EXPENSE                                     (1,147,842)       (814,636)
OTHER INCOME (EXPENSE), net                            (162,278)       (107,814)
--------------------------------------------------------------------------------
NET LOSS                                           $ (2,124,433)   $   (879,337)
================================================================================
NET LOSS PER COMMON SHARE - basic and diluted      $      (0.71)   $      (0.44)
================================================================================
WEIGHTED AVERAGE SHARES OUTSTANDING                   3,000,119       1,995,388
================================================================================

              The accompanying notes are an integral part of these
                        consolidated financial statements

                                       21
<PAGE>
                             HENLEY HEALTHCARE, INC.
                 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY

                 FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1997
<TABLE>
<CAPTION>
                                                                                                 TREASURY STOCK
                                              COMMON STOCK      ADDITIONAL                    ---------------------   STOCKHOLDERS'
                                           -------------------   PAID-IN     ACCUMULATED                ACQUISITION     EQUITY
                                             SHARES  PAR VALUE    CAPITAL       DEFICIT        SHARES       COST        (DEFICIT)
                                           ---------   -------   -----------   ------------    --------    ---------    -----------
<S>                                        <C>         <C>       <C>           <C>             <C>         <C>          <C>
BALANCE AT DECEMBER 31, 1995               1,761,225   $17,612   $ 7,232,691   $ (7,378,470)   (281,000)   $(227,800)   $  (355,967)

Issuance of common stock for services
  in February 1996                              --        --           6,379           --         2,000        1,621          8,000

Subscriptions for common stock at $3.00
  per share in January through June 1996     644,670     6,447     1,927,577           --          --           --        1,934,024

Issuance of common stock for services         33,333       333        99,667           --          --           --          100,000

Issuance of common stock on conversion
  of Bridge Notes                            176,773     1,768       528,552           --          --           --          530,320

Issuance of common stock on the
  exercise of warrants                        75,000       750         6,750           --          --           --            7,500

Issuance of common stock for
  equipment                                    4,000        40        11,960           --          --           --           12,000

Issuance of common stock for
  acquisitions                               121,170     1,211       748,789           --          --           --          750,000

Issuance of common stock related to
  employment agreement                       205,268     2,053        97,947           --          --           --          100,000

Net loss                                        --        --            --         (879,337)       --           --         (879,337)
                                           ---------   -------   -----------   ------------    --------    ---------    -----------
BALANCE AT DECEMBER 31, 1996               3,021,439    30,214    10,660,312     (8,257,807)   (279,000)    (226,179)     2,206,540

Issuance of common stock for acquisitions    361,117     3,611     2,907,229           --          --           --        2,910,840

Issuance of common stock for non-compete
  agreement                                   10,000       100        53,025           --          --           --           53,125

Exercise of common stock options              20,000       200       159,800           --          --           --          160,000

Exercise of common stock warrants             61,341       613       336,713           --          --           --          337,326

Net loss                                        --        --            --       (2,124,433)       --           --       (2,124,433)
                                           ---------   -------   -----------   ------------    --------    ---------    -----------
BALANCE AT DECEMBER 31, 1997               3,473,897   $34,738   $14,117,079   $(10,382,240)   (279,000)   $(226,179)   $ 3,543,398
                                           =========   =======   ===========   ============    ========    =========    ===========
</TABLE>
                 The accompanying notes are an integral part of
                    these consolidated financial statements
                                       22
<PAGE>
                                                         HENLEY HEALTHCARE, INC.

                                           CONSOLIDATED STATEMENTS OF CASH FLOWS

--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,                                                        1997           1996
--------------------------------------------------------------------------------------------------------
<S>                                                                         <C>             <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net loss                                                                  $ (2,124,433)   $  (879,337)
--------------------------------------------------------------------------------------------------------
  Adjustments to reconcile net loss
    to net cash provided by (used in) operating activities:
     Depreciation and amortization expense                                       716,264        283,746
     Amortization of discount on notes payable                                      --          151,667
     Interest expense imputed on notes payable                                   284,667        294,820
     Provision for doubtful accounts                                           3,171,163      1,420,518
     Shares issued for public relations agreement                                   --            8,000
     Shares issued for equipment                                                    --           12,000
     Shares issued for services/with employment agreement                           --          200,000
     Shares issued for compensation                                              160,000           --
     Shares issued for non-compete agreement                                      53,125           --
     Changes in operating assets and liabilities:
       Increase in accounts receivable                                        (4,289,785)    (2,623,498)
       (Increase) decrease in inventory                                         (367,533)     1,381,689
       (Increase) decrease in prepaid expenses and other current assets           88,115       (149,693)
       Increase in other assets                                                 (290,209)       (16,447)
       Increase in accounts payable and accrued liabilities                    2,464,591        500,785
--------------------------------------------------------------------------------------------------------
              Total adjustments                                                1,990,398      1,463,587
--------------------------------------------------------------------------------------------------------
              NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES               (134,035)       584,250
--------------------------------------------------------------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Acquisitions, net of cash acquired of $68,600 and $46,270, respectively     (4,862,371)    (6,603,046)
  Capital expenditures                                                          (356,533)      (140,570)
--------------------------------------------------------------------------------------------------------
             NET CASH USED IN INVESTING ACTIVITIES                            (5,218,904)    (6,743,616)
--------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
  Net proceeds from issuance of common stock                                        --        1,941,524
  Net proceeds from exercise of common stock warrants                            337,326           --
  Proceeds from line of credit                                                13,891,049      2,187,071
  Payments on line of credit                                                  (8,972,251)          --
  Proceeds from long-term debt                                                 1,430,000      2,509,000
  Principal payments on long-term debt                                        (1,717,457)      (173,701)
--------------------------------------------------------------------------------------------------------
            NET CASH PROVIDED BY FINANCING ACTIVITIES                          4,968,667      6,463,894
--------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents                            (384,272)       304,528

Cash and cash equivalents at beginning of period                                 507,892        203,364
--------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period                                  $    123,620    $   507,892
========================================================================================================
Supplemental disclosures of cash flow information:
Cash paid during the year for:

    Interest                                                                $    796,643    $   325,136
========================================================================================================
</TABLE>
                 The accompanying notes are an integral part of
                    these consolidated financial statements

                                       23
<PAGE>
                          HENLEY HEALTHCARE, INC.
                NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.    PRINCIPAL  BUSINESS  ACTIVITY AND SUMMARY OF  SIGNIFICANT  ACCOUNTING
POLICIES:

      NATURE OF OPERATIONS:
      Henley Healthcare, Inc. (formerly Lasermedics, Inc.) and Subsidiaries
      (collectively, the "Company") is a manufacturer, provider and marketer of
      diversified products and services in the physical therapy and
      rehabilitation industry. Substantially all of the Company's customers are
      located throughout the United States. The Company, organized in November
      1990, was in the development stage through April 30, 1996, and for the
      years ended December 31, 1997 and 1996, is considered an operating
      company.

      The Company achieved substantial growth over the last 18 months through
      acquisition of businesses and product lines. Consequently, the Company
      continues to face the challenge of successfully integrating the operations
      of the acquired businesses and implementing the acquired product lines
      into its overall marketing strategy. The Company's future success is
      dependent on many factors which include, among others, generating
      sufficient sales volume to achieve and maintain profitability, obtaining
      sufficient financing to fund its stated business objectives, competition
      and technological changes. The Company will continue to seek to expand the
      market for its products. However, markets for the Company's current and
      future products are highly competitive and subject to continuing
      technological change and development. Future sales growth will depend to
      some extent upon the ability of the Company to successfully market its
      current and future products in this competitive environment. Additionally,
      some of the Company's products are regulated by the FDA, and the Company
      is required to secure clearance from the FDA prior to marketing certain
      new products. Lack of clearance or delays in securing such clearance could
      have a negative impact on sales of such new products.

      Following is a summary of the Company's significant accounting policies:

      BASIS OF PRESENTATION:
      The consolidated financial statements include the accounts of Henley
      Healthcare, Inc. and its wholly-owned subsidiaries. Inter-company
      transactions and balances have been eliminated in consolidation.

      REVENUE RECOGNITION:
      Revenue is recognized when title passes to the buyer, typically when the
      product is shipped or services have been rendered. Service revenues are
      not presented separately in the financial statements because they are not
      material. The Company sells a wide range of products to a diversified base
      of customers around the world. The Company has agreements with third-party
      payors that provide payment at varying rates, and net revenue is reported
      at the estimated net realizable amount from customers and third-party
      payors.

      CASH EQUIVALENTS:
      The Company considers all highly liquid investments purchased with an
      original maturity of three months or less to be cash equivalents. The
      Company maintains cash in bank deposit accounts which, at times, exceed
      federally insured limits. The Company has not experienced any losses on
      these accounts.

      INVENTORY:
      Inventory is stated at the lower of cost, determined by the first-in,
      first-out (FIFO) valuation method, or market. Cost includes the
      acquisition of raw materials and components, direct labor and overhead.

                                       24
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      PROPERTY, PLANT AND EQUIPMENT:
      The amount of property, plant and equipment is stated at cost less
      accumulated depreciation. Depreciation and amortization of property, plant
      and equipment is provided using the straight-line method over the
      estimated useful lives of the assets. Maintenance, repairs and minor
      replacements are charged to expense as incurred; significant renewals and
      betterments are capitalized.

      RECLASSIFICATION:
      Certain reclassifications have been made to prior year data in the
      consolidated financial statements to conform to the current year's
      presentation.

      INCOME TAXES:
      The Company employs the liability method of accounting for income taxes
      pursuant to Statement of Financial Accounting Standards ("SFAS") No. 109,
      under which method recorded deferred income taxes reflect the tax
      consequences on future years of temporary differences (differences between
      the tax basis of assets and liabilities and their financial amounts at
      year-end). The Company provides a valuation allowance that reduces
      deferred tax assets to their estimated net realizable value based on an
      evaluation of the likelihood of the realization of those tax benefits.

      LOSS PER SHARE:
      The Company adopted SFAS No. 128, Earnings Per Share, in the 4th quarter
      of 1997, and has retroactively revised the presentation of net loss per
      share in historical financial statements to present both basic and diluted
      net loss per share as required by SFAS No. 128. Basic net loss per common
      share is based on the weighted average number of shares outstanding during
      the period, while diluted net loss per common share considers the dilutive
      effect of stock options and warrants reflected under the treasury stock
      method. The Company's net loss per share presented in the accompanying
      financial statements, calculated under SFAS No. 128, is the same as net
      loss per share calculated under the provisions of APB Opinion No. 15. Both
      basic net loss per share and diluted net loss per share are the same since
      the Company's outstanding stock options and warrants have not been
      included in the calculation because their effect would have been
      anti-dilutive.

      USE OF ESTIMATES:
      The preparation of financial statements in conformity with generally
      accepted accounting principles requires the use of estimates and
      assumptions by management affecting the reported amounts of assets and
      liabilities and revenue and expenses and the disclosure of contingent
      assets and liabilities. Actual results could differ from those estimates.

      STOCK OPTIONS:
      The Company measures compensation cost using APB Opinion No. 25 ("APB 25")
      as permitted by SFAS No. 123, "Accounting for Stock-Based Compensation."
      Pursuant to APB 25, the Company records deferred compensation expense for
      stock-based compensation arrangements based on the excess of the market
      value of the common stock on the measurement date over the exercise price
      of the common stock option/warrant granted. The deferred compensation is
      amortized over the vesting period of each unit of stock-based
      compensation. No compensation expense is recorded if the exercise price of
      the stock-based compensation grant is equal to the market price of the
      Company's common stock on the date of grant.

      RESEARCH AND DEVELOPMENT:
      Expenditures relating to research and development are expensed as
      incurred. The amount charged to operations was approximately $395,000 and
      $314,000 for the years ended December 31, 1997 and 1996, respectively.

                                       25
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      GOODWILL AND INTANGIBLES:
      Goodwill represents the excess of the aggregate purchase price paid by the
      Company over the fair market value of the tangible and identifiable
      intangible net assets acquired, arising from business acquisitions
      accounted for under the purchase method. Goodwill and intangibles are
      amortized on a straight-line basis over their estimated useful lives of 15
      years for goodwill and for periods ranging from 2 to 7 years for
      identifiable intangibles. Accumulated amortization at December 31, 1997
      was $374,092.

      OTHER ASSETS:
      Other assets consists principally of acquired trade name rights, which are
      being amortized over the shorter of the life of the rights or 7 years.
      Accumulated amortization at December 31, 1997 was $38,000.

      LICENSE AGREEMENTS:
      The Company has executed licensing agreements under which it has secured
      the rights provided under certain patents and trade names. License fees
      and royalties, payable under the terms of these agreements, are expensed
      as incurred.

      IMPAIRMENT OF LONG-LIVED ASSETS:
      The Company has adopted SFAS No. 121, Accounting for the Impairment of
      Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, which
      requires that long-lived assets and certain identifiable intangibles held
      and used by a company be reviewed for possible impairment whenever events
      or changes in circumstances indicate that the carrying amount of an asset
      may not be recoverable. The Company periodically assesses the
      realizability of its long-lived assets pursuant to the provisions of SFAS
      No. 121.

2.    INVENTORY:
      Inventory at December 31, 1997, included the following:

                  Raw material                        $3,599,132
                  Work-in-process                         28,875
                  Finished goods                       4,519,350
                                                      ----------
                                                      $8,147,357
                                                      ==========

      Substantially all of the Company's inventory is pledged as collateral for
      the Company's long-term debt.

3.    PROPERTY, PLANT  AND EQUIPMENT:
      At December 31, 1997, property, plant and equipment consisted of the
      following:

                                                                     ESTIMATED
                                                                    USEFUL LIFE
                                                                    -----------
                  Land                                 $  190,000
                  Buildings                             1,932,311   25 years
                  Machinery and equipment               2,231,435   3 to 7 years
                  Office furniture and fixtures           238,016   5 years
                  Automobile                                6,000   5 years
                                                       ----------
                                                        4,597,762
                  Less accumulated depreciation          (603,531)
                  Property, plant  and equipment, net  $3,994,231
                                                       ==========

                                       26
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      Substantially all of the Company's property, plant and equipment is
      pledged as collateral for the Company's long-term debt.

4.    GOODWILL AND OTHER INTANGIBLES:
      At December 31, 1997, goodwill and other intangibles consisted of the
      following:
                                                                     ESTIMATED
                                                                    USEFUL LIFE
                                                                    -----------
                  Goodwill                              $5,647,297   15 years
                  Patents                                  203,674    7 years
                  Covenant  not to compete                 193,125    2 years

                                                         6,044,096
                  Less accumulated amortization           (374,092)
                                                        ----------
                  Goodwill and other intangibles, net   $5,670,004
                                                        ==========
5.    ACQUISITIONS:

      BUSINESSES:

      On April 30, 1996 the Company entered into an agreement with Maxxim,
      whereby the Company purchased certain assets of (and assumed certain
      liabilities associated with) the Henley Division of Maxxim for an
      estimated purchase price of approximately $13.5 million including related
      acquisition costs of approximately $650,000. The assets acquired consist
      of real property; tangible personal property including machinery,
      equipment, furniture and fixtures; general intangibles; contracts;
      business licenses; accounts receivable; inventory; and prepaid expenses.
      The purchase price was paid by the issuance of the Company's convertible
      subordinated promissory note in the principal amount of $7,000,000 (the
      "Note") with the balance of the purchase price paid in cash

      The Company obtained the cash portion of the purchase price pursuant to
      financing arrangements entered into with Comerica Bank - Texas, a Texas
      banking corporation ("Comerica"), which financing is secured by
      substantially all of the assets of the Company including the Henley assets
      acquired from Maxxim.

      On November 12, 1996, the Company purchased substantially all of the
      assets of (and assumed certain liabilities associated with) MJH Medical
      Equipment, Inc. ("MJH") for an estimated purchase price of approximately
      $435,000 including related acquisition costs of approximately $45,000. The
      assets acquired consist of tangible personal property including equipment,
      furniture and fixtures; contracts; business licenses; accounts receivable;
      inventory; and prepaid expenses. The purchase price was paid by the
      issuance of the Company's promissory note in the principal amount of
      approximately $120,000 and 39,063 shares of common stock, with the balance
      of the purchase price paid in cash.

      On November 27, 1996, the Company, through a wholly-owned subsidiary,
      acquired all of the outstanding shares of common stock of Health Career
      Learning Systems, Inc., a Michigan corporation, for an estimated purchase
      price of approximately $680,000 including related acquisition costs of
      approximately $80,000. The purchase price was paid by the issuance of
      82,107 shares of common stock with the balance of the purchase price paid
      in cash.

                                       27
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      These 1996 acquisitions have been accounted for as purchases for
      accounting purposes, and the results of operations of the acquisitions
      have been included in the consolidated statement of operations from the
      dates of acquisition. The estimated purchase price in excess of the
      estimated fair value of the net assets acquired, aggregated approximately
      $2,261,000 for all of the acquisitions. Assuming these acquisitions had
      occurred on January 1, 1996, pro forma net sales, net loss and net loss
      per common share for the year ended December 31, 1996 would amount to
      $20,120,000, $(1,462,000) and $(.73), respectively. These amounts reflect
      adjustments for interest on the Note and the financing arrangements with
      Comerica, amortization of goodwill, compensation related to an employment
      agreement and depreciation on re-valued property, plant and equipment.

      In January 1997, the Company entered into an agreement pursuant to which
      it acquired all of the issued and outstanding common stock of Texas
      T.E.N.S., Inc., a privately-owned Texas corporation, for an estimated
      purchase price of approximately $850,000 plus related acquisition costs of
      approximately $65,000. The purchase price was paid by the Company's
      issuance of a subordinated promissory note in the principal amount of
      $400,000 (the "Tens Note") with the balance of the purchase price paid in
      cash. In August 1997, the principal balance on the Tens Note plus all
      accrued and unpaid interest due on the Note was paid.

      In May 1997, the Company entered into an agreement pursuant to which it
      acquired all of the issued and outstanding shares of common stock of
      Med-Quip, Inc. ("Medquip"), a privately-owned Georgia corporation, for an
      estimated purchase price of approximately $1,418,000 plus related
      acquisition costs of approximately $56,000. The purchase price was paid by
      the issuance of an aggregate of 300,000 shares of the Company's common
      stock and the payment of approximately $40,000 in cash.

      In October 1997, the Company entered into an agreement with the sole owner
      of Summer Medical ("SM"), an unincorporated sole proprietorship, pursuant
      to which the Company acquired all of the owner's interests in SM and
      assumed certain business-related liabilities associated with SM. Under the
      agreement, the Company issued to the owner 10,000 shares of common stock
      and agreed to issue an additional 20,000 shares by the second anniversary
      of the agreement. The estimated fair market value of the additional 20,000
      shares is being recorded as compensation expense over the term until the
      second anniversary.

      In December 1997, the Company acquired all of the issued and outstanding
      common stock of NCI, Inc., a Michigan corporation, for an estimated
      purchase price of $1,190,000 plus estimated acquisition costs of $5,000.
      The purchase price was paid by the issuance to the seller of 188,847
      shares of the Company's common stock.

      These 1997 acquisitions of businesses have been accounted for as purchases
      for accounting purposes, and the results of operations of the acquired
      companies have been included in the consolidated statement of operations
      from the respective dates of acquisition to December 31, 1997. Pro forma
      financial information is not provided because the amounts are not
      materially different from 1997 and 1996 results. The estimated purchase
      price in excess of the estimated fair value ("FV") of the net assets
      acquired aggregates approximately $3,047,000 for the acquisitions as shown
      below:

                                       28
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
                                       TENS       MEDQUIP         SM            NCI         TOTAL
                                    ----------   ----------   -----------    ----------   ----------
<S>                                 <C>          <C>          <C>            <C>          <C>
Purchase price                      $  850,000   $1,417,500   $    56,625    $1,189,736   $3,507,861
Acquisition costs                       65,000       56,000        15,000         5,000      141,000
                                    ----------   ----------   -----------    ----------   ----------
                                       915,000    1,473,500        71,625     1,194,736    3,648,861
                                    ----------   ----------   -----------    ----------   ----------
FV of assets acquired                  613,095      637,216        72,019           -0-    1,322,330
FV of liabilities assumed              114,355      504,619       101,908           -0-      720,882
                                    ----------   ----------   -----------                 ----------
Net assets (liabilities) acquired      498,740      132,597       (29,889)          -0-      601,448
                                    ----------   ----------   -----------                 ----------
Excess of cost over
 fair value of net assets
 acquired (goodwill)                $  416,260   $1,340,903   $   101,514    $1,194,736   $3,047,413
                                    ----------   ----------   -----------    ----------   ----------
</TABLE>
      OTHER ACQUISITIONS:

      In January 1997, the Company also purchased substantially all of the
      inventory, distribution systems and customers associated with the Homecare
      (third-party billing) division of Gatti Medical Supply, Inc., a
      privately-owned Pennsylvania corporation, for a purchase price of
      approximately $302,000 plus related acquisition costs of approximately
      $28,000. The Company paid the purchase price by issuing to the sellers a
      total of 51,117 shares of common stock. The Company also agreed to issue
      up to an aggregate of 50,117 additional shares of common stock subject to
      the achievement of specific terms and conditions in the agreement. Such
      additional shares will be recorded as compensation expense based on the
      market value of the shares, if and when they are probable of being issued.

      In March 1997, the Company entered into new agreements with CB Svendsen
      a/s ("CBS"), the Danish company with whom the Company has worked on the
      development and marketing of the Microlight 830(TM) since June 1991.
      Pursuant to the new agreements, the Company paid $100,000 to CBS and
      obtained unto perpetuity the sole and exclusive world-wide distribution
      rights to all low level laser devices manufactured by or for CBS. . In
      connection with these agreements, the Company is required to pay a 3
      percent royalty on revenue generated by the Company on sales of the
      applicable products. Also pursuant to the agreements, the Company obtained
      unto perpetuity the exclusive world-wide manufacturing rights to all low
      level laser devices manufactured by or for CBS subject to the payment to
      CBS by June 15, 1998, of $175,000.

      In September 1997, the Company entered into an agreement with Cybex
      International, Inc., a New York corporation ("Cybex"), whereby it
      purchased certain assets of (and assumed certain liabilities associated
      with) the isokinetic rehabilitation product line (the "Product Line") of
      Cybex for an estimated purchase price of approximately $3.2 million. The
      assets acquired consist of tangible personal property including machinery,
      equipment, furniture and fixtures; specific intangibles; contracts;
      intellectual property; business licenses; inventory; and prepaid expenses.
      The purchase price was allocated as follows: approximately $2,700,000 to
      inventory, $500,000 to property, plant and equipment, and $1,000,000 to
      patents and trade names.

                                       29
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6.    LONG-TERM DEBT:
      The following table summarizes the Company's long-term debt at December
      31, 1997, which is described below:

                  Note payable - Maxxim     (a)       $7,000,000
                  Term Note A - Comerica    (b)        1,382,334
                  Term Note B - Comerica    (b)        1,445,422
                  Note payable - MJH        (c)           72,186
                                                      ----------
                                                       9,899,942
                  Less:  Current maturities              433,763
                                                      ----------
                                                      $9,466,179
                                                      ==========

      (a) The Note which the Company issued to Maxxim in connection with the
      acquisition of the Henley Division in April 1996, is due and payable on
      March 1, 2003 with interest payable semi-annually on November 1 and May 1
      of each calendar year and payable at a rate equal to 2% per annum and
      increasing 2% annually on May 1. However, the Company accrues interest
      related to the Note on a straight-line basis at an average rate of 7.4%
      per annum. Accordingly, $536,667 of accrued interest has been classified
      as long-term in the accompanying balance sheet. The Company may redeem all
      or any portion of the outstanding principal amount of the Note at
      redemption prices ranging from 104% to 110% of the principal amount being
      redeemed, depending on when the redemption occurs as set forth in the
      Note. In addition, the Note is subject to mandatory redemption in annual
      installments of $1.4 million commencing on March 1, 1999 at premiums
      starting at 7% and decreasing 1% each year. These installment premiums are
      recognized as interest expense on a straight line basis over the term of
      the Note. The Company is also required to redeem 40% of the Note upon the
      completion of a public offering.

      (b) In connection with the acquisition of the Henley Division from Maxxim,
      the financing arrangements ("Loan Agreement") with Comerica provided for
      (i) a two-year revolving loan arrangement which permitted borrowings up to
      $4,000,000 through April 1998, pursuant to a monthly borrowing base
      calculation derived from the Company's accounts receivable and inventory
      and (ii) two term loans in the amount of $893,000 ("Term Note A") and
      $1,616,000 ("Term Note B"), respectively. Term Note A and Term Note B are
      payable in monthly installments plus interest. The revolving loan also
      includes a $250,000 letter of credit facility. Interest on the revolving
      loan and the two term loans is payable monthly at a rate equal to the
      Prime Rate (8.50% at December 31, 1997) plus one-half of one percent per
      annum. Term Note B is callable by Comerica beginning on its fifth
      anniversary. In June 1997, the Company entered into an Amended and
      Restated Loan Agreement with Comerica which, among other things, permitted
      borrowings up to $5,000,000 on the revolving loan arrangement.

                                       30
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      (b) In connection with the acquisition of the Product Line from Cybex in
      September 1997, the Company obtained the cash purchase price pursuant to
      an amendment to its Amended and Restated Loan Agreement (the "Amended Loan
      Agreement") entered into with Comerica. The Amended Loan Agreement
      provides for a revolving loan which permits borrowings up to $8,000,000
      pursuant to a borrowing base calculation derived from the Company's
      accounts receivable and inventory. The revolving loan had an outstanding
      balance of $7,105,868 at December 31, 1997, and is subject to interest at
      the Prime Rate (8.50% at December 31, 1997) plus one-half of one percent
      per annum, payable monthly. In connection with the Amended Loan Agreement,
      the Company paid off its Term Note A with Comerica in the amount of
      $893,000 and issued a substitute Term Note A in the amount of $1,430,000.
      The revolving loan's maturity date is February 1, 1999, while the
      $1,430,000 Term Note A is due on September 30, 2002. All of the borrowings
      from Comerica are secured by substantially all of the assets of the
      Company. The Amended Loan Agreement also contains a number of affirmative
      covenants, negative covenants and financial covenants with which the
      Company must comply including a minimum tangible net worth, leverage
      ratio, working capital ratio, fixed charge ratio and interest coverage
      ratio. The Company, among other provisions, is also limited in the amount
      of its capital expenditures, research and development expenditures and
      dividends and all future acquisitions and major corporate transactions
      require approval of Comerica, as do offerings of securities by the
      Company.

      (c) In connection with the acquisition of MJH Equipment, Inc. in November
      1996, the Company issued a note payable to the seller, in the amount of
      approximately $120,000. The note is payable in monthly principal
      installments of $3,336 plus interest at a bank's prime lending rate plus
      2% per annum through November 1999.

      The estimated fair value of the Maxxim Note amounted to $7,000,000
      pursuant to a valuation by an investment banking firm. Based on borrowing
      rates currently available to the Company for loans with similar terms and
      average maturities the fair value of the Company's other long-term debt
      approximates the carrying amount.

      Aggregate maturities of long-term debt are as follows:

      For the year ending December 31, 1998      $   433,763
                                       1999        1,825,883
                                       2000        1,793,729
                                       2001        1,793,729
                                       2002        1,746,083
                        2003 and thereafter        2,306,755
                                                   ---------
                                                 $ 9,899,942
                                                   =========

7.    RELATED PARTY TRANSACTIONS:
      In May 1996, the Company entered into an agreement with Mezzanine
      Financial Relations, Inc., ("Mezzanine") a financial relations company,
      which agreement the parties amended in November 1996, whereby Mezzanine
      agreed to provide financial consulting services with regard to potential

                                       31
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      mergers and acquisitions in consideration for a monthly fee of $10,000.
      The agreement terminated on January 31, 1997. The Executive Vice
      President, Chief Financial Officer and a director of the Company is a
      shareholder of Mezzanine and its Chairman of the Board.

8.    ACCRUED EXPENSES AND OTHER CURRENT LIABILITIES:
      The following are included in accrued expenses and other current
      liabilities at December 31, 1997:


      Property taxes                        $   169,716
      Sales taxes                                61,761
      Payroll and commissions                   344,140
      Interest payable                          148,420
      Accrued acquisition costs                  19,771
      Accrued professional and other fees        88,749
      Other                                     267,015
                                            -----------
                                             $1,099,572
                                            ===========

9.    INCOME TAXES:
      The following is an analysis of the Company's deferred tax assets at
      December 31, 1997:

      Deferred tax assets:
        Accrued expenses and other         $    34,000
        Allowance for doubtful accounts        699,000
        Deferred compensation                  494,000
        Net operating loss carryforwards     2,150,000
                                             ----------
                                             3,377,000
      Deferred tax liability:
        Depreciation and amortization          (49,000)

        Net deferred tax asset before
         valuation allowance                 3,328,000
      Valuation allowance                   (3,328,000)
      Net deferred tax asset               $     -0-
                                           ===========

      The components of the Company's income tax provision for the years ended
      December 31, 1997 and 1996 were as follows:

                                               1997           1996
                                            ----------     ----------
            Current                         $ (666,000)    $ (132,000)
            Deferred                           666,000        132,000
                                            ----------     ----------
            Provision for income taxes      $    -0-       $     -0-
                                            ==========     ==========

      Differences between the Company's effective income tax rate and the
      statutory federal rate for the years ended December 31, 1997 and 1996 are
      as follows:

                                       32
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                                          1997        1996
                                                      ----------   ----------
            Provision at the statutory rate           $ (722,000)  $ (132,000)
            Permanent differences and other               71,000       56,000
            Increase in valuation allowance              651,000       76,000
                                                      ----------   ----------
            Total tax provision                       $     -0-    $     -0-
                                                      ==========   ==========

      As of December 31, 1997, the Company had net operating loss carryforwards
      for income tax purposes of approximately $6,324,000 available to offset
      future taxable income. The carryforwards will begin to expire in 2005.
      Between January 1993 and December 1997, the Company completed an initial
      public offering, had warrants exercised, completed private offerings of
      securities and made acquisitions of established businesses or product
      lines. Under the Internal Revenue Code Section 382 these activities
      effected an ownership change and thus severely limit on an annual basis,
      the Company's ability to utilize its net operating loss carryforwards. A
      valuation allowance was provided to fully reserve the net deferred tax
      asset due to realization uncertainties regarding future operating results.

10.   STOCKHOLDERS' EQUITY:
      In connection with an agreement the Company entered into with a public
      relations firm, the Company issued to the firm, in February 1996, 2,000
      shares of its treasury common stock as compensation for services. The
      Company recognized $8,000 in related compensation expense at December 31,
      1996, based on the market price of the common stock on the date of the
      agreement. During the year ended December 31, 1996, the Company issued
      33,333 shares of common stock to a director of the Company for his
      services in connection with the Company's pre-market approval application
      submission to the FDA. The Company recognized approximately $100,000 in
      related expense based on the market price of the common stock on the date
      of the related agreement.

      In connection with the Gatti acquisition in January 1997, the Company
      issued 51,117 shares of its common stock as consideration for the
      acquisition. In May 1997, the Company issued 300,000 shares of its common
      stock as consideration for the acquisition of Med-Quip; and in October
      1997, the Company issued 10,000 shares of its common stock for the
      acquisition of Summer Medical.

      The Company issued to a former employee, in October 1997, 10,000 shares of
      its common stock as partial consideration for a non-compete agreement. The
      Company has capitalized $53,125 in related costs based on the market price
      of the common stock on the date of the agreement.

      Also, in October 1997, the Company issued to a former employee, 20,000
      shares of its common stock pursuant to the exercise of stock options and
      in connection with the settlement of a contract dispute. In connection
      with the settlement, the Company has recognized $160,000 in related
      compensation expense based on the market price of the common stock on the
      date of the settlement.

      In connection with the Amended Loan Agreement with Comerica relating to
      the acquisition of the Product Line from Cybex, the Company entered into
      an amendment to a Subordination Agreement (the "Subordination Amendment")
      by and among Maxxim, Comerica and the Company. Pursuant to the
      Subordination Amendment, the maximum amount of the Company's debt with
      Comerica that can be issued senior to the Note was increased from
      $10,000,000 to $12,000,000. In exchange for Maxxim's execution of the
      Subordination Amendment, the Company entered into a note modification
      agreement with Maxxim in which the Conversion Price (as defined in the
      Note) was reduced from $3.00 to $2.00. The modification of the Note
      increased the number of shares of the Company's common stock, par value
      $.01 per share ("Common Stock"), beneficially owned by Maxxim from
      2,333,333 (approximately 43%) to 3,500,000 (approximately 53%). (See Note
      16 below). The Note is convertible into Common Stock at any time at
      Maxxim's option. The conversion price is also subject to adjustment upon
      the occurrence of certain events (including certain issuances of common
      stock for less than the conversion price) to provide anti-dilution
      protection. Such conversion could, depending on the fair market value of
      the Company's common stock at the time of conversion, result in
      substantial dilution to holders of the Company's common stock. The
      Company's common stock issuable upon conversion of the Note is subject to
      the terms of a registration rights agreement entered into by the Company
      and Maxxim whereby Maxxim (and certain subsequent holders) shall retain
      certain demand and piggyback registration rights with respect to those
      shares of common stock.

      In December 1997, the Company acquired all of the issued and outstanding
      common stock of NCI, Inc., a Michigan corporation. As consideration for
      the acquisition, the Company issued to the seller 188,847 shares of the
      Company's common stock.

11.   STOCK OPTIONS AND WARRANTS:
      Pursuant to the provisions of the 1996 Non-Employee Director Stock Option
      Plan (the "Director Stock Plan") and the 1996 Incentive Stock Plan (the
      "Incentive Plan"), certain of the Company's directors were granted stock
      options during fiscal 1997 as discussed below. At December 31, 1997,

                                       33
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      there were 95,000 and 1,180,000 shares available for issuance under the
      Director Stock Plan and the Incentive Plan, respectively. A summary of the
      Company's options and warrants as of December 31, 1997 and 1996 and
      changes during the years then ended is presented below:
<TABLE>
<CAPTION>
                                                    1997                      1996
                                          ------------------------  -------------------------
                                                     WEIGHTED AVG.              WEIGHTED AVG.
                                           SHARES   EXERCISE PRICE    SHARES   EXERCISE PRICE
                                           ------   --------------    ------   --------------
      <S>                                 <C>            <C>          <C>          <C>
      Outstanding at beginning of year    1,811,502      $5.24        962,726      $3.81
      Canceled/expired                      (91,385)      5.53        (50,000)      0.10
      Granted                                60,000       5.83        973,776       6.02
      Exercised                             (91,341)      4.57        (75,000)      0.10
                                          ---------      -----      ---------      -----
      Outstanding at end of year          1,688,776      $5.24      1,811,502      $5.24
                                          =========                 =========
      Options and warrants exercisable
         at year-end                      1,688,776      $5.24      1,811,502      $5.24
                                          =========                 =========
      Weighted-average fair value
         of options and warrants
         granted during the year                         $4.31                     $1.26
      ==================================================================================
</TABLE>
      The following table summarizes the information about stock options and
      warrants outstanding at December 31, 1997:

                           OPTIONS AND WARRANTS OUTSTANDING AND EXERCISABLE
                           ------------------------------------------------
                                            WEIGHTED
                           NUMBER           AVERAGE
            RANGE OF       OUTSTANDING      REMAINING     WEIGHTED
            EXERCISE       AT DECEMBER 31,  CONTRACTUAL   AVERAGE
            PRICES         1997             LIFE          EXERCISE PRICE
            ---------------------------------------------------------------
            $1.00-$3.00    205,000          2.0           $  3.00
            $4.00-$5.50    515,000          4.4           $  4.49
            $6.00-$7.88    968,776          3.4           $  6.11
                         ---------
                         1,688,776          3.7           $  5.24
                         =========

      The Company has elected. in accordance with the provisions of Statement of
      Financial Accounting Standards No. 123 ("SFAS No. 123") to apply APB
      Opinion No. 25 and related interpretations in accounting for stock options
      granted to employees, and accordingly, has presented the disclosure-only
      information as required by SFAS No. 123. If the Company had elected to
      recognize compensation cost based on the fair value of the options granted
      at the grant date as prescribed by SFAS No. 123, the Company's net loss
      and net loss per common share for the years ended December 31, 1997 and
      1996 would approximate the pro forma amounts shown in the table below.

                                       34
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      Year ended December 31,                      1997             1996
                                                -----------      -----------
      Net loss - as reported                    $(2,124,433)     $  (879,337)
      Net loss - pro forma                      $(2,286,913)     $(1,023,837)
      Net loss per common share - as reported   $      (.71)     $      (.44)
      Net loss per common share - pro forma     $      (.76)     $      (.51)
      ======================================================================

      For the year ended December 31, 1997, the pro forma values were calculated
      using the Black-Scholes option pricing model and included the following
      weighted average assumptions: zero dividends, expected stock price
      volatility of 80.7 percent, risk-free interest rate of 6.4 percent and an
      expected life of 7.3 years. For the year ended December 31, 1996, the fair
      value of each option grant on the date of grant was valued by an
      investment banking firm taking into account as of the grant date the
      exercise price and expected life of the option, the current price of the
      underlying stock and its expected volatility, expected dividends on the
      stock and the risk-free interest rate for the expected term of the option
      as prescribed by SFAS No. 123.

      In connection with their re-election to the Board of Directors in June
      1997, four non-employee directors were each granted a stock option under
      the Director Plan to purchase 10,000 shares of the Company's common stock
      at a price of $4.81 per share. Also, in November 1997, two employee
      directors were each granted options under the Incentive Stock Plan to
      purchase 10,000 shares of the Company's common stock at a price of $7.88
      per share, such options to become vested over a three year period
      contingent upon the continued employment of the directors.

      In December 1997, certain holders of the Company's Amended and Restated J
      Warrants exercised their rights under the Warrants and purchased an
      aggregate of 61,341 shares of the Company's common stock at a price of
      $5.50 per share. In connection with the exercise of these Warrants, the
      Company received cash proceeds of approximately $337,000. Holders of an
      aggregate of 43,600 Warrants elected not to exercise their rights and
      their Warrants expired or were redeemed.

12.   COMMITMENTS AND CONTINGENCIES:

      EMPLOYMENT AND CONSULTING AGREEMENTS

      The Company has entered into various employment and consulting agreements
      with various key personnel, directors and certain shareholders aggregating
      $802,000 which expire at various dates through November 1999. Certain of
      these agreements provide for incentive bonuses and or commissions, as
      defined in the agreements. In connection with the SM acquisition, the
      Company entered into an employment agreement with the seller that provides
      for the issuance of 20,000 shares of the Company's common stock over a
      two-year period if the employee meets certain criteria as specified in the
      agreement. The Company will recognize a charge to operations upon the
      issuance of such shares based on the fair market value of the shares as of
      the issuance date.

      EXCLUSIVE RIGHTS AGREEMENT

      In March 1997, the Company entered into new agreements with CB Svendsen
      a/s ("CBS"), the Danish company with whom the Company has worked on the
      development and marketing of the Microlight 830(TM) since June 1991.
      Pursuant to the new agreements, the Company paid $100,000 to CBS and
      obtained unto perpetuity the sole and exclusive world-wide distribution
      rights to all low level laser devices manufactured by or for CBS. In
      connection with these agreements, the Company is required to pay a 3
      percent royalty on revenue generated by the Company on sales of the
      applicable

                                       35
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      products. Also pursuant to the agreements, the Company obtained unto
      perpetuity the exclusive world-wide manufacturing rights to all low level
      laser devices manufactured by or for CBS subject to the payment to CBS by
      June 15, 1998, of $175,000.

      LEASES

      The Company is obligated under various non-cancelable operating leases
      (including certain related-party leases aggregating approximately $14,150
      per month) for warehouse and office space expiring through June 2001,
      which are subject to increase for real estate taxes and operating expense
      escalation. Rent expense charged to operations under these operating
      leases amounted to approximately $243,000 and $45,000 for the years ended
      December 31, 1997 and 1996, respectively.

      Minimum future rental payments are as follows:

                  FISCAL YEARS
                  ------------
                  1998                    $182,383
                  1999                     174,234
                  2000                     140,009
                  2001                      26,652
                                          --------
                                          $523,278
                                          ========

      LITIGATION AND CLAIMS

      The Company is subject to legal proceedings and claims arising in the
      ordinary course of its business. In the opinion of management, the
      ultimate outcome of all legal actions and claims will not have a material
      adverse effect upon the consolidated financial position and results of
      operations of the Company.

13.   EMPLOYEE BENEFIT PLANS:
      The Company's 401(k) savings plan (the "Plan") adopted in fiscal 1996,
      covers all qualified employees. The Plan permits participants to
      contribute up to 15% of their base compensation (as defined) each year.
      The Company will match at least 25% of the participant's contribution up
      to a maximum of 6% of gross pay. The Company's matching percentage may be
      adjusted as Company profitability dictates. Two officers of the Company
      serve as trustees of the Plan. Matching contributions to the Plan for the
      years ended December 31, 1997 and 1996, amounted to approximately $44,141
      and $25,000, respectively.

14.   SUPPLEMENTAL CASH FLOW INFORMATION:
      Non-cash investing and financing transactions during the years ended
      December 31, 1997 and 1996 were as follows:

                                                        1997          1996
                                                     ----------     ---------
      Common shares issued in connection
            with acquisitions                        $2,910,840     $ 750,000
      Common shares issued in connection
            with conversion of bridge notes                -          530,320
      Common shares issued for
            equipment                                      -           12,000
      Common shares issued for employment
            agreement and/non-compete                    53,125       208,000
      Accrued amounts relating to acquisitions             -           92,253
      Compensation related to common stock
            options in legal settlement                 160,000          -

                                       36
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

15.   NON-RECURRING FOURTH QUARTER ADJUSTMENT:

      During the fourth quarter of 1997 the Company revised its estimates of
      collectibility of its accounts receivable, and accordingly, increased its
      reserve for uncollectible accounts by approximately $2,000,000. During the
      3rd quarter of 1997, the Company commenced an extensive analysis of its
      accounts with particular emphasis on its accounts receivable which relate
      to the Company's third-party billing operations. In conjunction with the
      analysis, the Company intensified its collection efforts. The third party
      billing business, by its nature, demands longer-than-average time to bill
      and much longer-than-average time to collect. Upon further scrutiny in the
      fourth quarter and on the basis of the analysis, management revised its
      estimates of collectibility of the Company's accounts receivable for the
      third party billing operations. The Company has also changed certain
      procedures in the collection process in order to improve the future
      collectibility of the accounts receivable.

      The effect of this revision on the Company's results of operation is to
      increase net loss by approximately $2,000,000, the amount of the increase
      in reserve for accounts receivable.

16.   SUBSEQUENT EVENTS - UNAUDITED:

      ACQUISITIONS
      On January 6, 1998, the Company, through a wholly-owned subsidiary,
      acquired all of the outstanding shares of common stock of Garvey Company,
      a Minnesota corporation, as a wholly-owned subsidiary for an estimated
      purchase price of approximately $880,000 plus related acquisition costs of
      approximately $40,000. The purchase price was paid by the issuance of
      120,308 shares of common stock, with a market price of approximately
      $7.315 per share.

      On February 9, 1998, the Company purchased substantially all of the assets
      and assumed certain liabilities associated with AMC Acquisition Corp., a
      Texas corporation, for an estimated purchase price of approximately
      $450,000 plus related acquisition costs of approximately $30,000. The
      purchase price was paid by the issuance of 68,000 shares of common stock,
      with a market price of approximately $6.618 per share.

      On February 12, 1998, the Company entered into an agreement with Maxxim
      whereby it acquired from Maxxim an office/warehouse building located at
      140 Industrial Boulevard, Sugar Land, Texas, for an estimated purchase
      price of approximately $1.2 million. The purchase price was paid in cash
      which the Company obtained pursuant to a second amendment of its Amended
      Loan Agreement (the "Second Amendment") with Comerica. In connection with
      the Second Amendment with Comerica, the Company obtained a Term Note C in
      the principal amount of $1,260,000 with a maturity date of February 12,
      2013. Term Note C bears interest at the Prime Rate plus one-half of one
      percent per annum, is payable in monthly principal installments of $7,000
      plus all accrued interest thereon and subject to the terms and conditions
      of the Amended Loan Agreement with Comerica. All of the borrowings from
      Comerica are secured by substantially all of the assets of the Company.

      EQUITY TRANSACTIONS
      On February 20, 1998 and March 13, 1998, the Company entered into
      agreements with Maxxim pursuant to which Maxxim converted an aggregate of
      $4,000,000 of the Note into an aggregate of 2,000,000 shares of the
      Company's common stock, par value $.01 per share. The conversions were
      based on the current conversion price of $2.00 per share under the Note.
      The agreements also provide that the entire $4 million conversion shall be
      applied to the Company's full redemption obligation due in the year 2003
      and partially to the Company's redemption obligation due in the year 2002
      as provided in the Note. The Company has agreed to file a registration
      statement covering the

                                       37
<PAGE>
                             HENLEY HEALTHCARE, INC.
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

      resale of the shares of Common Stock issued to Maxxim as a result of the
      conversions described above.

      On March 13, 1998, the Company entered into an agreement with some private
      institutional investors pursuant to which the Company issued to the
      investors $1,825,000 of its Series A Convertible Preferred Stock (the
      "Preferred Stock") for cash. The Preferred Stock is convertible into
      Henley's Common Stock at the lesser of (i) 75% of the average closing bid
      price for Henley's Common Stock as reported by Nasdaq for the 5 trading
      days prior to conversion or $6.50. In connection with the agreement, the
      Company also issued to the investors a 5-year warrant to purchase 146,000
      shares of the Company's Common Stock at exercise prices ranging from
      $7.125 to $9.619. The Company has agreed to file a registration statement
      covering the resale of the shares of Common Stock issuable upon the
      conversion of the Preferred Stock and exercise of the warrants sold to the
      investors described above.

      PRO FORMA FINANCIAL INFORMATION
      The following summarized pro forma (unaudited) information assumes these
      acquisition and equity transactions were completed at December 31, 1997:

                    Current assets              $16,126,497
                    Goodwill                      6,458,840
                    Total assets                 27,912,682
                    Line of credit                5,450,868
                    Long-term debt                5,513,816
                    Stockholders' equity        $10,847,064

ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

      On October 20, 1997, the Company informed Goldstein Golub Kessler &
Company, P.C. ("GGK"), its former principal accountants, of the decision of its
Board of Directors to appoint Arthur Andersen LLP as its principal accountants
in place of GGK whom the Board voted to dismiss. The Board's decision in no way
reflects any dissatisfaction with the services of GGK, but is based on the
Company's desire to engage the services of a bigger firm consistent with its
growth strategy.

      In connection with the audits of the two most recent fiscal years ended
December 31, 1996 and the subsequent interim periods through October 20, 1997,
the Company had no disagreements with GGK on any matter of accounting principles
or practices, financial statement disclosure, or auditing scope or procedure,
which disagreements, if not resolved to the satisfaction of GGK, would have
caused them to make reference to the subject matter of the disagreements in
connection with their opinion.

      The accountant's reports of GGK on the financial statements of the Company
as of and for the fiscal year ended December 31, 1996 did not contain any
adverse opinion or disclaimer of opinion, nor was it qualified or modified as to
uncertainty, audit scope or accounting principles. The accountant's report of
GGK on the financial statements of the Company as of and for the fiscal year
ended December 31, 1995 did not contain any adverse opinion or disclaimer of
opinion, nor was it qualified or modified as to audit scope or accounting
principles, but contained an explanatory paragraph as to uncertainty about the
Company's ability to continue as a going concern relating to substantial
cumulative losses incurred as a development stage company from inception through
that date.

                                       38
<PAGE>
                                    PART III

ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
        WITH SECTION 16(a) OF THE EXCHANGE ACT.

EXECUTIVE OFFICERS AND DIRECTORS

      The following table provides information concerning each executive officer
and director of the Company as of the date hereof:
<TABLE>
<CAPTION>
                              AGE                      TITLE
                              ---                      -----
<S>                           <C>   <C>
Michael M. Barbour            53    President, Chief Executive Officer, Director
Dan D. Sudduth                56    Executive Vice President, Chief Financial Officer, Director
Chike J. Ogboenyiya           46    Vice President -Finance, Secretary
Theron L. Morrow              43    Vice President - Sales and Marketing
Chadwick F. Smith, MD         64    Medical  Director, Director, Chairman of Board
Pedro A. Rubio, MD, Ph.D.     53    Director
Kenneth W. Davidson           50    Director
Ernest J. Henley, Ph.D.       71    Director
</TABLE>
      Michael M. Barbour has been President, Chief Executive Officer and
Director of the Company since May 1991. He has over 13 years experience in the
field of laser products. Prior to forming Lasermedics, he was President of
Medical Training Centers of America (formerly The Houston Laser Institute) from
January 1987 to April 1991, which he founded in order to train and inform
doctors in the medical and surgical use of lasers. From April 1984 to January
1987, he was President of Surgimedics, a Houston, Texas, manufacturer and
distributor of medical products. Mr. Barbour graduated from the University of
Houston in 1967 with a B.B.A. in marketing.

      Dan D. Sudduth joined the Company as Executive Vice President and Chief
Financial Officer in February 1997. He has been a Director of the Company since
January 1996. Mr. Sudduth was Chief Financial Officer for Mezzanine Telecom,
Inc., a Houston-based telecommunications company ("MTI"), from 1994 to January
1997 and currently serves as a Director of MTI. During 1995 and 1996, Mr.
Sudduth was President and Director of AMC Home Healthcare, Inc., a respiratory
therapy company in Houston, Chairman of Mezzanine Financial Relations, Inc., a
merchant banking firm in Houston, and Chief Financial Officer and Director of
Creative Communications International, Inc., a Houston telecommunications
company. From 1992 to 1994, Mr. Sudduth served as Chairman and Chief Executive
Officer of Heart Labs of America, Inc. From 1988 to 1992, he was President and
Chief Financial Officer of American Biomed, Inc. Mr. Sudduth received a B.B.A.
in 1964 from Lamar University.

      Chike J. Ogboenyiya has been Vice President-Finance of the Company since
January 1994 and Secretary since August 1994. He has over 20 years of extensive
industry experience in accounting, corporate finance and business management.
From 1990 to 1993, he was president and owner of a small accounting firm which
offered business consulting and financial services to various clients. Prior to
that time, he was a Director and Chief Financial Officer for Kaulimax
International Corporation, a privately-held exporter of apparel located in
Houston, Texas, from 1984 to 1990. Mr. Ogboenyiya is a Certified Public
Accountant, graduated with an M.S. from the University of Houston in 1979, and
graduated cum laude from Texas Southern University in 1977 with a B.B.A. in
Accounting.

      Theron L. Morrow has been Vice President-Sales and Marketing of the
Company since November 1997. He has over 12 years of experience in the medical
devices industry. From 1991 to 1996, Mr. Morrow

                                       39
<PAGE>
was divisional Vice President of Marketing for Maxxim Medical, Inc. Mr. Morrow
holds a B.S. degree in sports medical sciences from Texas Christian University.

      Chadwick F. Smith, MD has been a Director of the Company since May 1991
and Chairman of the Board of Directors since June 1993. He is also a Consultant
to the Company. See "Certain Relationships and Related Transactions." Dr. Smith
is a Clinical Professor of Orthopedic Surgery at the University of Southern
California School of Medicine, a position he has held since 1981. He has also
been a member of the Medical Staff of Orthopedic Hospital, Los Angeles,
California, since 1966. Dr. Smith graduated with a B.A. from Southern Methodist
University in 1954, graduated from the University of Texas medical school in
1958, and has been a diplomate of the American Board of Orthopedic Surgery since
1968.

      Pedro A. Rubio, MD., Ph.D. has been a Director of the Company since
January 1996. He is currently a Clinical Associate Professor of Surgery at the
University of Texas Health Science Center in Houston. He was Director of
Education of the Laser Training Institute of Houston, from November 1993 until
January 1996. He served as World President of the International College of
Surgeons in Chicago in 1995, and was Chairman of the Department of Surgery at
the Columbia/HCA Medical Center Hospital in Houston from 1976 to 1994, when he
became Chairman Emeritus. Dr. Rubio holds the degrees of Bachelor of Science,
Master of Science in Surgical Technology, Doctor of Philosophy in Biomedical
Technology and Doctor of Medicine and Surgery. Dr. Rubio is a Diplomate of the
American Boards of Surgery, Laser Surgery, Abdominal Surgery, Forensic Medicine,
Quality Assurance and Utilization Review, Forensic Examiners and Pain
Management.

      Kenneth W. Davidson has been a Director of the Company since April 1996.
He has also been President, Chief Executive Officer and Chairman of the Board of
Directors of Maxxim Medical, Inc. since November 1986, and a Director since
1982. Prior to that time, Mr. Davidson was the Corporate Director of Business
Development at Intermedics, Inc., which is principally a manufacturer of
implantable devices such as pacemakers. Mr. Davidson is also a Director of
Encore Orthopedics, Inc., a designer and manufacturer of implantable orthopedic
devices.

      Ernest J. Henley, Ph.D., has been a Director of the Company since April
1996, and is also a consultant to the Company. He has been a Director of Maxxim
since 1976. See "Certain Relationships and Related Transactions." Dr. Henley's
principal employment for more than fifteen years has been as a Professor of
Chemical Engineering at the University of Houston.

      All directors hold office until the next annual meeting of stockholders
and until their successors have been duly elected and qualified. All
non-employee directors of the Company are reimbursed for expenses incurred for
attendance at meetings of the Board of Directors and any Board committee and are
eligible to receive stock options pursuant to the 1996 Non-Employee Director
Stock Option Plan. See "Item 10. Executive Compensation."

      Each officer of the Company serves at the discretion of the Board of
Directors, subject to the terms of his employment agreement, if any, and is
eligible to receive stock options pursuant to the 1996 Incentive Stock Plan. See
"Item 10. Executive Compensation" below, for a discussion of the Company's
employment agreement with Mr. Barbour. Each member of management devotes his
full time to the Company's affairs.

COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT

    Section 16(a) of the Exchange Act requires a company's directors and
executive officers, and persons who own more than 10% of the equity securities
of the Company to file initial reports of ownership and reports of changes in
ownership of the Common Stock with the Securities and Exchange Commission.
Officers, directors and greater than 10% shareholders are required to furnish
the Company with copies of all Section 16(a) reports they file.

                                       40
<PAGE>
    Based solely on a review of the forms the Company has received or prepared,
the Company believes that during the year ended December 31, 1997, all filing
requirements applicable to the Company's directors, officers and greater than
10% shareholders were met except Dr. Chadwick F. Smith who failed to file a Form
4 on a timely basis in connection with the shares of Common Stock he pledged as
security for a loan from a financial institution.

SCIENTIFIC ADVISORY BOARD

      The Company established a Scientific Advisory Board of distinguished
physicians and scientists with a wide range of experience in the medical field.
The Board meets formally or by teleconference at the Company's expense every six
months to discuss research data regarding the Company's products.

      By selection, the medical and scientific advisors are geographically
diverse and have varied experience within the laser field, including hospital
work, teaching at universities, and working within different industries or types
of private practice. All of the advisors are in private practice, employed by
hospitals, universities or other organizations, none of which in the future is
expected by the Company to compete with the Company. These advisors are expected
to devote only a small portion of their time to the Company, and they are not
expected to participate actively in the Company's affairs. Certain of the
institutions with which the Scientific Advisors are affiliated may adopt new
regulations or policies that limit the ability of the advisors to consult with
the Company; however, the loss of the services of any of the Scientific Advisors
is unlikely to adversely affect the Company. The Scientific Advisory Board is
comprised of the following individuals:

JACK ANSTANDIG, MD. - Neurologist, Acupuncture and Pain Management Specialist;
Member, American Academy of Neurology, American Academy of Medical Acupuncture
and International Association.

CHADWICK F. SMITH, MD. - Clinical Professor of Orthopedic Surgery, University of
Southern California School of Medicine; Medical Director, International
Children's Program, Orthopedic Hospital, Los Angeles. Dr. Smith is also a
Director of the Company.

C. THOMAS VANGSNESS, MD. - Assistant Professor, Orthopedic Surgery and Chief of
Sports Medicine, University of Southern California. Dr. Vangsness owns 22,833
shares of the Company's common stock.

PEDRO A. RUBIO, MD., PH.D. - Past World President of the International College
of Surgeons (Chicago); Clinical Associate Professor of Surgery, University of
Texas Health Science Center, Houston; Diplomate, American Boards of Surgery,
Laser Surgery, Forensic Medicine, Quality Assurance and Pain Management. Dr.
Rubio is also a Director of the Company.

ITEM 10. EXECUTIVE COMPENSATION

      SUMMARY OF COMPENSATION. The following table provides information
concerning compensation paid or accrued during the fiscal years ended December
31, 1997, 1996 and 1995 to the Company's President and Chief Executive Officer,
Michael M. Barbour and Chief Financial Officer, Dan D. Sudduth. During 1997,
1996 and 1995, no other executive officers received compensation which exceeded
$100,000:
<TABLE>
<CAPTION>
                                                                          LONG TERM COMPENSATION
                                                                 --------------------------------------
                                                                           AWARDS               PAYOUTS
                                                                 ----------------------------   -------
                                   ANNUAL COMPENSATION                             SECURITIES
                        --------------------------------------                     UNDERLYING                 ALL
                                                  OTHER ANNUAL    RESTRICTED        OPTIONS/      LTIP       OTHER
   NAME AND POSITION    YEAR     SALARY    BONUS  COMPENSATION   STOCK AWARDS       SARS (#)     PAYOUTS  COMPENSATION
   -----------------    ----     ------    -----  ------------   ------------       --------     -------  ------------
<S>                     <C>     <C>         <C>      <C>             <C>             <C>           <C>         <C>
                        1997    $160,000  40,000       --            --              3,333         --          --
   Michael M. Barbour   1996    $171,657    --         --            --               --           --          --
   CEO                  1995    $110,000    --       $9,000          --               --           --          --
</TABLE>
                                       41
<PAGE>
<TABLE>
<CAPTION>
                                                                          LONG TERM COMPENSATION
                                                                 --------------------------------------
                                                                           AWARDS               PAYOUTS
                                                                 ----------------------------   -------
                                   ANNUAL COMPENSATION                             SECURITIES
                        --------------------------------------                     UNDERLYING                 ALL
                                                  OTHER ANNUAL    RESTRICTED        OPTIONS/      LTIP       OTHER
   NAME AND POSITION    YEAR     SALARY    BONUS  COMPENSATION   STOCK AWARDS       SARS (#)     PAYOUTS  COMPENSATION
   -----------------    ----     ------    -----  ------------   ------------       --------     -------  ------------
<S>                     <C>     <C>         <C>      <C>             <C>             <C>           <C>         <C>
                        1997    $134,811    --         --            --              3,333         --          --
   Dan D. Sudduth  (1)  1996        --      --         --            --               --           --          --
   CFO                  1995        --      --         --            --               --           --          --
</TABLE>
------------
(1) Mr. Sudduth was a consultant to the Company prior to February 1997 when he
    became an employee.

    OPTION/SAR GRANTS. The following table provides certain information with
respect to common stock options granted during the fiscal year ended December
31, 1997 by the Company's Chief Executive Officer and Chief
Financial Officer:

                    NUMBER OF
                    SECURITIES   PERCENT OF
                    UNDERLYING   TOTAL OPTIONS    EXERCISE
NAME AND            OPTION/SARS  /SARS GRANTED    PRICE            EXPIRATION
POSITION            GRANTED      TO EMPLOYEES     ($/SHARE)        DATE
--------            -----------  ------------     ---------        ----------
Michael M. Barbour  10,000       50%               $7.88/share     11/07/00
CEO

Dan D. Sudduth      10,000       50%               $7.88/share     11/07/00
CFO

    AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR AND FISCAL YEAR ENDED OPTION
VALUES. The following table provides certain information with respect to option
exercises during the fiscal year ended December 31, 1997 by the Company's Chief
Executive Officer and Chief Financial Officer:
<TABLE>
<CAPTION>
                                                                         NUMBER OF                              VALUE OF
                                                                    SECURITIES UNDERLYING                     UNEXERCISED
                                                                         UNEXERCISED                         IN-THE-MONEY
                            SHARES                                       OPTIONS/SARS                       OPTIONS/SARS AT
                          ACQUIRED ON          VALUE               AT FISCAL YEAR END (#)               FISCAL YEAR END ($) (1)
    NAME                   EXERCISE          REALIZED                DECEMBER 31, 1997                          REALIZED
    ----                   --------          --------          ------------------------------        ------------------------------
                                                               EXERCISABLE      UNEXERCISABLE        EXERCISABLE      UNEXERCISABLE
                                                               -----------      -------------        -----------      -------------
<S>                          <C>                <C>              <C>                 <C>              <C>
   Michael M. Barbour        --                 --               225,000             3,333            $ 712,500            --

   Dan D. Sudduth            --                 --                  --               3,333                 --              --
</TABLE>
(1)   Calculated by multiplying the number of shares underlying outstanding
      in-the-money options by the difference between the last sales price of the
      Common Stock on December 31, 1997 ($7.00 per share) and the exercise
      prices, which range between $3.00 and $4.50 per share. Options are
      in-the-money if the fair market value of the underlying Common Stock
      exceeds the exercise price of the option.

COMPENSATION OF DIRECTORS

      Effective January 15, 1996, the Board of Directors of the Company (the
"BOD") adopted the following plans which were approved by the Company's
shareholders in July 1996: (i) a 1996 Incentive Stock Plan under which the
Company can issue up to 1.2 million shares of the Company's common stock to
eligible officers, employees, and consultants of the Company and (ii) a 1996
Non-Employee Directors Stock Option Plan (the "Outside Director Plan") under
which the Company can issue up 250,000 shares of common stock to its outside
directors. On February 17, 1998, the Company filed a registration statement on
Form S-8 covering all of the shares issuable under both plans with the
Securities and Exchange Commission.

      In connection  with their  re-election to the BOD in June 1997,  Drs.
Rubio,  Smith, and Henley and Mr. Davidson were each granted a stock option
under the Outside Director Plan to purchase 10,000 shares of the

                                       42
<PAGE>
Company's common stock at a price of $4.81 per share. Also, in connection with
their membership in the BOD in 1997, each of Messrs. Sudduth and Barbour was
granted an option under the 1996 Incentive Stock Plan to purchase 10,000 shares
of the Company's common stock at a price of $7.88 per share. The options granted
to Messrs. Barbour and Sudduth vest over a three-year period.

      The Outside Director Plan also provides that at the discretion of the BOD,
the Company may pay a cash fee to non-employee directors from time to time for
serving on and for attendance at meetings of, the BOD or any committee thereof
(as such fees are set by the BOD from time to time.) During the year ended
December 31, 1997, the Company paid the non-employee directors $500 per person
for attendance at each meeting of the Board of Directors.

EMPLOYMENT CONTRACTS

       In November 1996, the Company entered into an agreement with Michael M.
Barbour, effective as of May 1, 1996, employing him as its Chief Executive
Officer at a base annual salary of $160,000. The agreement also provides for an
annual bonus amount payable to Mr. Barbour based on specific formula as provided
in the agreement. The agreement terminates on December 31, 1998.

ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

        The following table sets forth certain information regarding the number
and percentage of shares of Common Stock beneficially owned as of March 16,
1998, by any person (including any group of affiliated persons) known by the
Company to own 5% or more of the outstanding shares of the Company's Common
Stock, each named executive officer and director, and all executive officers and
directors of the Company as a group. Unless otherwise indicated, the Company has
been advised that all holders listed have the power to vote and dispose of the
number of shares set forth as beneficially owned by them.

                                          AMOUNT AND NATURE OF
      NAME AND ADDRESS                         BENEFICIAL         PERCENT OF
      OF BENEFICIAL OWNER (1)                 OWNERSHIP (2)         CLASS
      -----------------------                 -------------         -----
      Ernest J. Henley, Ph.D. ........        3,545,000(3)          51.17%

      Kenneth W. Davidson.............        3,520,000(3)          50.99%
          10300 49th Street North
          Clearwater, FL 33762

      Maxxim Medical, Inc. ...........        3,500,000(4)          50.85%
          10300 49th Street North
          Clearwater, FL 33762

      Chadwick F. Smith, MD. .........          430,666(5)           7.67%
          1127 Wilshire Blvd.
          Los Angeles, California 90017

      Michael M. Barbour..............          421,748(6)           7.52%

      Pedro A. Rubio, MD, Ph.D. ......          129,128(7)           2.36%

      Dan D. Sudduth..................           70,000(8)           1.28%

      All Executive Officers and
      Directors as a Group (8 persons)        4,667,042(9)          61.38%
------------
(1)   Unless otherwise specified, the address of each beneficial owner is c/o
      Henley Healthcare, Inc. 120 Industrial Boulevard, Sugar Land, Texas 77478.

                                       43
<PAGE>
(2)   Except as otherwise indicated, all shares are beneficially owned, and the
      sole investment and voting power is held, by the person named. This table
      is based on information supplied by the officers, directors and principal
      shareholders and reporting forms, if any, filed with the Securities and
      Exchange Commission on behalf of such persons. A person is deemed to
      beneficially own shares of common stock underlying options, warrants or
      other convertible securities if the stock can be acquired by such person
      within sixty days of the date hereof.

(3)   Includes 1,500,000 shares issuable upon the conversion of the Company's
      convertible subordinated promissory note, as amended, in the principal
      amount of $3 million issued to Maxxim (the "Maxxim Note"), and 2,000,000
      shares currently owned by Maxxim, as to which Dr. Henley and Mr. Davidson,
      who are directors of both the Company and Maxxim, may be deemed the
      beneficial owners by virtue of their affiliation with Maxxim. See "Certain
      Relationships and Related Transactions." The additional 45,000 and 20,000
      shares listed for each of Dr. Henley and Mr. Davidson, respectively,
      consist entirely of warrants and/or options exercisable as of the date
      hereof.

(4)   In addition to holding 2,000,000 shares of common stock, Maxxim is the
      holder of the Maxxim Note, which is convertible into 1,500,000 shares of
      Common Stock. See "Certain Relationships and Related Transactions."

(5)   Includes 235,000 shares issuable upon exercise of currently exercisable
      options.

(6)   Includes 228,333 shares issuable upon exercise of currently exercisable
      options.

(7)   Includes 78,333 shares issuable upon exercise of currently exercisable
      options.

(8)   Includes 63,333 shares issuable upon exercise of currently exercisable
      options or warrants.

(9)   In addition to the 1,500,000 shares issuable upon conversion of the Maxxim
      Note and the currently exercisable options and warrants listed above, this
      amount includes (i) 500 shares and 50,000 currently exercisable options
      owned by Chike J. Ogboenyiya, the Company's Vice President-Finance and
      Secretary.

ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

    Effective May 1996, the Company entered into a consulting agreement with
Chadwick F. Smith, MD, one of its Directors. The agreement includes an annual
compensation of $90,000 and terminates on December 31, 1998.

    In May 1996, the Company entered into an agreement with Mezzanine Financial
Relations, Inc., a financial relations company ("Mezzanine"), pursuant to which
Mezzanine agreed to provide financial consulting services with regard to
potential mergers and acquisitions in consideration for a monthly fee of
$10,000. Mr. Sudduth, Executive Vice President, Chief Financial Officer and a
Director of the Company, is a shareholder of Mezzanine and its Chairman of the
Board. The agreement terminated on January 31, 1997.

    On April 30, 1996, the Company entered into an agreement with Maxxim,
whereby the Company purchased certain assets (and assumed certain liabilities)
associated with for an estimated purchase price of approximately $13.5 million.
The purchase price was paid by the issuance of the Company's convertible
subordinated promissory note in the principal amount of $7 million, with the
balance of the purchase price paid in cash provided through a financing with a
bank. Mr. Davidson and Dr. Henley are currently employed by Maxxim, with Mr.
Davidson serving in the capacities of Chairman of the Board, Chief Executive
Officer and President and Dr. Henley serving as a Director and consultant. Dr.
Henley's consulting agreement, which was entered into between Dr. Henley and
Maxxim in 1987, was acquired in the transaction with Maxxim. The agreement
included a monthly consulting fee in the amount of $5,833 and terminated on
October 31, 1997. The Company currently uses Dr. Henley's services on as-needed
basis for a monthly consulting fee of $1,750.

                                       44
<PAGE>
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K

      EXHIBITS

      See "Index of Exhibits" below which lists the documents filed as exhibits
herewith.

      REPORTS ON FORM 8-K

      On October 15, 1997, the Company filed a Current Report on Form 8-K in
which it reported its agreement with Cybex pursuant to which it purchased
certain assets of (and assumed certain liabilities associated with) the
isokinetic rehabilitation product line of Cybex.

      On October 20, 1997, the Company filed a Current Report on Form 8-K in
which it reported the dismissal of Goldstein Golub Kessler & Company, P.C.
("GGK"), the Company's former principal accountants, and the engagement of
Arthur Andersen LLP as its principal accountants to replace GGK.

                                       45
<PAGE>
                                   SIGNATURES

      IN ACCORDANCE WITH SECTION 13 OR 15(d) OF THE EXCHANGE ACT, THE REGISTRANT
CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE UNDERSIGNED, THEREUNTO DULY
AUTHORIZED, ON THE 30TH DAY OF MARCH, 1998.

                                          HENLEY HEALTHCARE, INC.
                                               (Registrant)

                                          By:  MICHAEL M. BARBOUR
                                          -----------------------------
                                               Michael M. Barbour
                                         (President and Chief Executive Officer)

        IN ACCORDANCE WITH THE EXCHANGE ACT, THIS REPORT HAS BEEN SIGNED BY THE
FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND IN THE CAPACITIES AND ON THE
DATES INDICATED.
<TABLE>
<CAPTION>
SIGNATURE                                 TITLE                             DATE
---------                                 -----                             ----
<S>                           <C>                                        <C>
MICHAEL M.  BARBOUR           President and Chief Executive Officer      March 30, 1998
--------------------          and Director (Principal Executive Officer)
(Michael M. Barbour)


DAN D. SUDDUTH                Executive Vice President and Director      March 30, 1998
--------------------          (Principal Financial Officer)
(Dan D. Sudduth)


CHIKE J. OGBOENYIYA           Vice President-Finance & Secretary         March 30, 1998
--------------------          (Principal Accounting Officer)
(Chike J. Ogboenyiya)


CHADWICK F. SMITH, MD.        Chairman and Director                      March 30, 1998
--------------------
(Chadwick F. Smith, MD.)


PEDRO A. RUBIO,  MD, Ph.D.    Director                                   March 30, 1998
--------------------
(Pedro A. Rubio, MD, Ph.D.)


ERNEST J. HENLEY, Ph.D.       Director                                   March 30, 1998
--------------------
(Ernest J. Henley, Ph.D.)


KENNETH W. DAVIDSON           Director                                   March 30, 1998
--------------------
(Kenneth W. Davidson)
</TABLE>
                                       46
<PAGE>
                             HENLEY HEALTHCARE, INC.
                             EXHIBITS TO FORM 10-KSB
                      FOR THE YEAR ENDED DECEMBER 31, 1997

                                INDEX OF EXHIBITS

      Exhibits incorporated by reference to a prior filing are designated by an
asterisk (*); all exhibits not so designated are documents filed herewith:

EXHIBIT
  NO.                              DESCRIPTION
-------                            -----------

3.1*  Amended and Restated Articles of Incorporation (Exhibit 3.1 to the
      Company's Periodic Report on Form 10-QSB for the quarter ended June 30,
      1997 (File No. 0-28556)).

3.2   Amended and Restated By-Laws

3.3   Statement of Designation of Series A Preferred Stock

4.1*  Specimen Stock Certificate. (This exhibit to the Company's
      Registration Statement on Form S-18 (No. 33-49972) dated July 22,
      1992).

4.2*  Specimen Form of Warrant Certificate. (Exhibit 4.2 to the Company's Annual
      Report on Form 10-KSB for the year ended December 31, 1995 (File No.
      0-28566)).

4.3*  Form of Underwriter's Warrant. (Exhibit 4C to the Company's Registration
      Statement on Form S-18 (No. 33-49972) dated July 22, 1992).

10.1* 1996 Amended and Restated Non-Employee Director Stock Option Plan.
      (Exhibit C to the Company's Proxy Statement on Schedule 14A dated June 24,
      1996 (File No. 0-28566)).

10.2* 1996 Incentive Stock Plan. (Exhibit B to the Company's Proxy Statement on
      Schedule 14A dated June 24, 1996 (File No. 0-28566)).

10.3* Employment Agreement with Michael Barbour dated November 22, 1996.
      (Exhibit 10.4 to the Company's Annual Report on Form 10-KSB for the year
      ended December 31, 1996 (File No. 0-28566)).

10.4* Consulting Agreement with Chadwick F. Smith, MD dated November 22, 1996.
      (Exhibit 10.5 to the Company's Annual Report on Form 10-KSB for the year
      ended December 31, 1996 (File No. 0-28566)).

10.5* Asset Purchase Agreement dated November 12, 1996 with MJH Medical
      Equipment and Michael J. Houska. (Exhibit 10.6 to the Company's Annual
      Report on Form 10-KSB for the year ended December 31, 1996 (File No.
      0-28566)).

10.6* Employment Agreement with Michael J. Houska dated November 12, 1996.
      (Exhibit 10.7 to the Company's Annual Report on Form 10-KSB for the year
      ended December 31, 1996 (File No. 0-28566)).

10.7* Plan and Agreement of Merger with Health Career Learning Systems, Inc.
      dated November 27, 1996. (Exhibit 10.8 to the Company's Annual Report on
      Form 10-KSB for the year ended December 31, 1996 (File No. 0-28566)).

                                       47
<PAGE>
                          INDEX OF EXHIBITS, CONTINUED

EXHIBIT
  NO.                             DESCRIPTION
-------                           -----------
10.8* Stock Purchase Agreement with Paula L. Buhr dated January 24, 1996.
      (Exhibit 10.9 to the Company's Annual Report on Form 10-KSB for the year
      ended December 31, 1996 (File No. 0-28566)).

10.9* Asset Purchase Agreement with Gatti Medical Supply dated January 24, 1996.
      (Exhibit 10.10 to the Company's Annual Report on Form 10-KSB for the year
      ended December 31, 1996 (File No. 0-28566)).

10.10*Master Agreement and Manufacturing Agreement with CB Svendsen, a/s dated
      March 12, 1997. (Exhibit 10.11 to the Company's Annual Report on Form
      10-KSB for the year ended December 31, 1996 (File No. 0-28566)).

10.11 Asset Purchase Agreement with Cybex International, Inc. dated September
      30, 1997.

10.12 Plan and Agreement of Merger with Garvey Company dated January 9, 1998.

10.13 Asset Purchase Agreement with AMC Acquisition Corp., Dan D. Sudduth,
      Britton D. Sudduth and Roger W. Dartt dated February 12, 1998.

10.14 Asset Purchase Agreement with August Schild d/b/a Summer Medical dated
      October 6, 1997.

21.1  Subsidiaries of Registrant

23.1  Consent of Arthur Andersen LLP

23.2  Consent of Goldstein Golub Kessler & Company, P.C.

27.1  Financial Data Schedule

                                       48