<PAGE>
 
                                                                    EXHIBIT 13.1

COMPANY PROFILE

The flat panel display (FPD) industry has grown significantly in recent years
due to expanding applications made possible by improvements in size, resolution,
and power utilization. Flat panel display manufacturing is a complex, materials
intensive process. Fast, accurate testing of FPDs is a critical step in
successful manufacturing. Early defect detection can eliminate the investment of
further materials and labor, and allows for repair prior to final assembly,
providing a substantial savings in manufacturing costs.

Photon Dynamics is a leading worldwide supplier of test, inspection and repair
systems for the flat panel display industry. Photon Dynamics' products
incorporate technologies that are designed to provide FPD manufacturers with the
ability to obtain information critical to yield improvement and manufacturing
processes insights. Our systems are used to control, monitor and refine the
manufacturing process in order to increase yields, reduce materials loss,
transition new designs from R & D to commercial production, and to assist in the
rapid start-up of new manufacturing facilities.

Photon Dynamics offers a suite of products to inspect virtually all types of
FPDs and to address the key areas of active matrix liquid crystal display
(AMLCD) test, inspection and repair, from research and development through
commercial production. Photon Dynamics' In Process Test Systems (IPT) locate,
count and characterize electrical defects, contamination and other defects at
the active array stage. Flat Panel Inspection Systems (FIS) perform cell and
module inspection to detect and locate optical defects. Review stations with
Integrated Laser Cut and Weld (ILW) repair defects based on precise location
information generated by the IPT and the FIS. Patented technologies, such as
Voltage Imaging and N-Aliasing, work in conjunction with proprietary software
programs to permit low cost, non-contact, full characterization and image
evaluation.

Photon Dynamics has been issued over 21 U.S. patents for flat panel display
test, inspection and repair technologies, and has other U.S. and foreign
applications pending. As the only company with systems addressing all key areas
of AMLCD test, inspection and repair, Photon Dynamics is positioned to provide
an integrated yield and cost management solution for FPD manufacturing.

Customer Commitment

Photon Dynamics' expertise in flat panel test, inspection, and repair comes from
many years of production experience with the worlds leading FPD manufacturers.
Our philosophy is to develop our technologies through close interaction with our
customers in order to provide the most efficient, cost-effective solutions
throughout the world. We are dedicated to maximizing value to our customers, and
cooperating with them to achieve lower costs, higher quality products, and
increased production levels.

Worldwide Presence

Photon Dynamics' main headquarters, located in San Jose, California, is home to
our manufacturing and research and development facilities. In order to meet our
customer' needs throughout the world, Photon Dynamics also maintains offices in
Japan and Korea, and is represented in Taiwan. With systems installed throughout
the world, we are committed to serving our customer base with the highest level
of support possible. Our customer support network 
<PAGE>
 
allows us to meet our customer satisfaction goals, and helps us to stay in close
contact with the issues that impact their success.

Training and Service

The relationships we have with our customers continue long after our systems are
installed at their facilities. Our trained technical support and service staff
is available to maintain the high standard of performance that our customers
expect from our systems. In addition, Photon Dynamics offers a full range of
customer training courses for all of our products, covering maintenance, basic
operation, test design and applications. These courses provide our customers
with the latest theory of operation, methodology, and technological
enhancements. Our service and training teams are dedicated to providing
customized solutions for the specific needs of each of our customers.

SHAREHOLDERS' LETTER

Fiscal 1996 marked an important year of growth for the flat panel display
industry and Photon Dynamics. In the first quarter, we became a publicly traded
company, and reported record revenue and earnings, which earned us a spot as one
of Silicon Valley's 50 fastest growing companies. We have developed new versions
of our test, inspection, and repair systems, added key management and
engineering people, and recently moved into a new 50,000 sq. ft. corporate
office and manufacturing facility in San Jose, Ca. In addition, we have added
several new customers throughout the world, and have seen repeat business from
some of the worlds' largest flat panel display manufacturers that make up our
existing customer base.

Flat panel displays are one of the fastest growing segments of the electronics
industry, with excellent potential for growth throughout the next decade. We are
very excited about the opportunities for flat panel displays, led by the growth
of the notebook computer market. Today, flat panel displays are also being used
for other markets which are potentially much larger than notebook computers.  We
are beginning to see flat panel displays replacing the cathode ray tube (CRT) in
the desktop monitor market, and the technology for a flat television screen that
hangs on the wall is now a reality. Other emerging flat panel display
applications include on-board vehicle navigation, personal information devices,
and projection systems. These visual delivery technologies are key components of
today's multi-media information age.

To be a leader in these industries, companies must be proficient in two key
technologies for the 21st Century:  machine vision and image processing. These
technologies are Photon Dynamics' core competency, and represent the future of
our Company's technological development.

The thrust of our business is to offer integrated, software driven, capital
equipment solutions that apply machine vision technology to flat panel display
manufacturing.

In the future, we plan to broaden our machine vision and image processing
technology to include new applications and new product opportunities.
1997 will present challenges as well as opportunities for Photon Dynamics.

In order to reduce deadline pressures and to help smooth out periods of
fluctuating revenue, as seen in the fourth quarter of fiscal year 1996, we are
committed to building up our backlog to a significant level.  As the flat panel
industry matures and expands, so does the sophistication of the manufacturing
process, which has been gradually gearing up towards mass production to meet
increasing demand. Our challenge is to continue to move the 
<PAGE>
 
use of machine vision systems from a research and development stage to the mass
production lines of all of our strategic customers. To achieve this, we must
improve our throughput to match the high level of performance our systems offer.
We must also continue to raise our level of worldwide service and applications
to meet our customers' requirements, while continuing to develop new
technologies that lead the industry.

We believe that fiscal 1997 will bring more industry growth, more product
development, and more technology advances for Photon Dynamics than any other
period of time in our Company's history. We are focused on the challenges that
face us, and look forward to the tremendous opportunities that lie ahead.

Vincent F. Sollitto Jr.
Chief Executive Officer
 
SELECTED FINANCIAL DATA
 
<TABLE> 
<CAPTION> 
Consolidated Statements of Operations
In thousands except per share data
For the Years Ended September 30,             1996                1995             1994             1993                  1992
<S>                                        <C>                 <C>              <C>              <C>                   <C>
Revenue                                    $24,763             $18,447          $10,587          $10,312               $ 5,721
Gross margin                                11,507               6,756            3,902            3,066                   756
Operating income (loss)                        563                 710           (2,048)          (3,109)               (4,802)
Net income (loss)                          $   854             $   377          $(2,105)         $(3,070)              $(4,607)
 
Net income per share (pro forma for          $0.12               $0.07
 1995)
Shares used in computing net income per      7,387               5,425
 share
</TABLE> 
 
<TABLE> 
<CAPTION> 
Consolidated Balance Sheet Data
In thousands September 30,                    1996                1995             1994             1993                  1992
<S>                                        <C>                 <C>              <C>              <C>                   <C>
Working capital (deficit)                  $17,290             $   709          $   408          $  (857)              $ 2,064
Total assets                                24,958              10,519            6,567            4,948                 5,006
Total shareholders' equity                  19,770               1,857            1,435              132                 3,204
</TABLE> 
<PAGE>
 
<TABLE> 
<CAPTION> 
Unaudited Quarterly Consolidated Financial Data
In thousands

Fiscal Quarters Ended                                December 31, 1995   March 31, 1996    June 30, 1996    September 30, 1996
<S>                                                  <C>                 <C>               <C>              <C>  
Revenue                                                        $ 6,205          $ 6,308          $ 7,709               $ 4,541
Gross margin                                                     2,804            2,975            3,599                 2,129
Net income (loss)1                                                 563              751              825                (1,285)
 
<CAPTION> 
Fiscal Quarters Ended                                December 31, 1994   March 31, 1995    June 30, 1995    September 30, 1995
1995
<S>                                                  <C>                 <C>               <C>              <C>  
Revenue                                                        $ 2,963          $ 4,448          $ 4,857               $ 6,179
Gross margin                                                     1,192            1,453            1,778                 2,333
Net income                                                          25               32              110                   210
</TABLE>

1. Net loss for the fourth quarter of fiscal 1996 includes a $844,000 charge for
the write down of assets related to a product line disposal, see Note 3 to the
consolidated financial statements.

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

The following table sets forth certain operating data as a percentage of total
revenue:

<TABLE>
<CAPTION>
Years Ended September 30,                   1996            1995 
<S>                                        <C>             <C>   
Revenue:                                                         
Product sales                               94.4%           75.4%
Development contracts                        5.6            24.6 
                                           100.0           100.0 
Cost of revenue:                                                 
Product sales                               49.6            38.6 
Development contracts                        3.9            24.8 
                                            53.5            63.4 
Gross margin                                46.5            36.6 
Operating expenses:                                              
Research and development                    16.1             9.1 
Selling, general and administrative         24.7            23.7 
Asset write-off related to product line      3.4               - 
 disposal                                                        
Total operating expenses                    44.2            32.8 
Operating income                             2.3             3.8 
Other income (expense), net                  1.3            (1.7)
Income before provision for income taxes     3.6             2.1 
Provision for income taxes                   0.2             0.1 
Net income                                   3.4%            2.0% 
</TABLE>
<PAGE>
 
To the extent that this annual report discusses financial projections,
information or expectations about products or markets of Photon Dynamics Inc.
(the Company), all such forward looking statements are based on information
available to the Company on the date hereof, and the Company assumes no
obligation to update any such forward looking statements. It is important to
note that the Company's actual results could differ materially y from those in
such forward looking statements. The Company's results will be affected,
particularly when measured on a quarterly basis, by the volume, composition and
timing of orders for capital equipment by Flat Panel Display (FPD)
manufacturers.

Other uncertainties include, acceptance of new products, timing of orders
received, costs associated with new product introductions and managing growth.
For a further discussion of the Company's business, please refer t= o the
Company's 1996 Annual Report on Form 10-KSB.

Overview

Photon Dynamics develops, manufactures and markets on a worldwide basis a suite
of products to inspect virtually all types of FPDs and to address all key areas
of AMLCD test, inspection and repair throughout all major stages of the
manufacturing life cycle, from research and development to commercial
production. The Company's revenue is derived primarily from the sale of products
and, to a lesser extent, from revenue under development contracts. In fiscal
1996 and 1995, revenue under development contracts accounted for 6% and 25% of
total revenue, respectively.

The Company expects revenue under development contracts to decline on an
absolute dollar basis in 1997. The Company does not expect that service revenue
for continuing maintenance of its products will be a significant part of its
revenue in the near term.

Results of Operations

Revenue

Revenue increased 34% from $18.4 million in fiscal 1995 to $24.8 million in
fiscal 1996. Revenue from product sales increased 68% from $13.9 million to
$23.4 million over the same period. The increase in product sales was primarily
attributable to the introduction of the In-Process Test Mass Production System
(IPT-MPS) in late fiscal 1995, which sold into both new and existing customer
plants, and the continued penetration of the Japanese and Korean markets.
International sales accounted for $21.6 million and $11.6 million of revenue in
fiscal 1996 and 1995, respectively. Sales to Japan increased to $9.3 million in
fiscal 1996 from $5.2 million in fiscal 1995, and sales to Korea increased to
$10.6 million in fiscal 1996 from $4.5 million in fiscal 1995.

Gross Margin

Gross margin as a percent of revenue increased to 46.5% in fiscal 1996 from
36.6% in 1995. This increase in gross margins was due to the relative decrease
in development contract revenue, with associated lower gross margins, as a
percentage of total revenue. The gross margin for product sales decreased to
47.4% in fiscal 1996 from 48.8% in fiscal 1995. The decrease was the result of
lower foreign exchange rates on Yen denominated sales and a less favorable
product mix year to year. Overall product gross margins will fluctuate on a
quarterly basis as the Company's product mix fluctuates. The Company expects to
add to its infrastructure by hiring additional personnel and increasing its
<PAGE>
 
capital expenditures for new facilities and equipment which is expected to
modestly reduce gross margins at the start of 1997.

The increase in gross margin attributable to development contracts was primarily
due to the ending of two lower margin contracts with government agencies.

Research and Development

The Company increased its research and development expenses on an absolute
dollar basis to $4.0 million in fiscal 1996, or 16% of revenue, from $1.7
million in fiscal 1995, or 9% of revenue. In addition to these research and
development expenses incurred for product development, the Company spent $1.0
million in fiscal 1996 and $4.6 million in fiscal 1995 in performance of its
obligations under third party development contracts. The combination of research
and development expenses and costs incurred on development contracts was $4.9
million, or 20% of revenue, in fiscal 1996 and $6.3 million, or 34% of revenue,
in fiscal 1995. The Company expects that these combined product development
expenses will increase in absolute dollar amounts in fiscal 1997 with continued
emphasis on Company spending and lower spending under third party development
contracts.

Selling, General and Administrative

Selling, general and administrative expenses increased to $6.1 million, or 25%
of revenue, in fiscal 1996 from $4.4 million, or 24% of revenue, in fiscal 1995.
The increase reflects an overall increase in revenue and the associated
incremental selling costs as well the administration costs associated with being
a public company. Selling, general and administrative expenses may increase in
absolute dollar amounts in fiscal 1997 and in future periods depending on
factors including the level of the Company's revenue and other operations.
Selling expenses may also fluctuate based on the Company's product and territory
sales mix, which have different sales channels and associated cost structures.

In September, 1996, the Company ceased operations of its Defect Monitoring Tool
(DMT) product line. The DMT product group had been working exclusively on a
single customer project not in the flat panel display market. As a result of the
cancellation of this project, the associated inventory and assets of this
product line which can not be transferred to other products will be disposed of.
The Company recorded a $844,000 charge to write down the inventory and assets
associated with the product line.

Interest income/expense

Interest income in fiscal 1996 increased to $646,000 from the fiscal 1995 level
of $16,000 as a result of interest received on the proceeds from the Company's
Initial Public Offering (IPO) in November 1995. Interest expense was $263,000
and $194,000 in fiscal 1996 and 1995 respectively, because of increases in
borrowings under the Company's revolving bank line s of credit which were repaid
in the first quarter of fiscal 1996, as well as borrowing under a term loan
which was repaid in late fiscal 1996.

Provision for Income Taxes

Provisions for income taxes in fiscal 1995 and 1996 were minimal due to
utilization of loss carryforwards. As of September 30, 1996 the Company had
available federal and state net operating loss carryforwards of approximately
$12.5 million and $3.0 million, respectively. The Company also had federal and
state research and development tax credit carryforwards of approximately
<PAGE>
 
$698,000 and $341,000, respectively. The net operating loss and credit
carryforwards will expire at various times beginning in 1998 through 2011 if not
utilized. As of September 30, 1996, the Company had deferred tax assets of
approximately $7.8 million, for which no benefit has been recorded on the
Company's financial statements, and which consist primarily y of net operating
loss carryforwards. This deferred tax asset will be recognized in future periods
as taxable income is realized and consistent profits are reported.

Under certain provisions of the Internal Revenue Code of 1986, as amended, the
availability of the Company's operating loss and credit carryforwards may be
subjected to limitation if it should be determined that there has been a change
of ownership of more than 50% of the value of the Company's stock within any
three year period. See Note 7 to Consolidated Financial Statements.

Liquidity and Capital Resources

Working capital increased from $709,000 as of September 30, 1995 to $17.3
million at September 30, 1996, of which $5.1 million was cash or cash
equivalents. In November 1995, the Company completed its IPO of 2,932,500 shares
of Common Stock, of which 2,127,661 shares were issued and sold by the Company
and 804,839 shares were sold by stockholders. The IPO raised approximately $17.8
million before deducting offering expenses.

Cash used by operating activities was $3.8 million for the year. Working capital
items that significantly impacted cash balances were accounts receivable and
inventory. The Company's accounts receivable balance increased $3.4 million to
$8.7 million. The factors affecting the accounts receivable balance include, the
Company's credit terms to customers which typically have a small portion of the
payment extended for a period of months after shipment resulting in a larger
accounts receivable balance, especially when combined with the growth in product
sales in fiscal 1996 compared fiscal 1995 as well as the near quarter end timing
of such product shipments. Inventory levels increased $1.1 million reflecting
the increased production levels in fiscal 1996.

Capital expenditures in fiscal 1996 and fiscal 1995 were $1.2 million and
$1.0 million, respectively. The increase is the result of the capitalization of
engineering and demonstration equipment related to the Company's latest
products. In the first quarter of fiscal 1997 the Company relocated to a new
facility and expects to spend approximately $700,000 in leasehold improvements
and related costs.

The Company believes that cash and cash equivalents, income from operations and
the proceeds from the Offering will be sufficient to satisfy working capital
requirements and capital equipment needs for the next 12 months. As of September
30, 1996, the Company had no material outstanding commitments to purchase or
lease capital equipment.

The Company believes that success in its industry requires substantial capital
in order to maintain the flexibility to take advantage of opportunities as they
may arise. The Company may, from time to time, invest in or acquire
complementary businesses, products or technologies. The Company may effect
additional equity or debt financing to fund such activities. The sale of
additional equity or convertible debt could result in additional dilution to the
Company's shareholders.

Other Factors Affecting Company Results

The Company has experienced, (see unaudited quarterly consolidated financial
data, page 5), and expects to continue to experience significant fluctuations
<PAGE>
 
in its quarterly results of operations. The Company derives substantially all of
its revenue from the sale of a relatively small number of systems, which
typically range in price from $400,000 to $1,500,000. As a result, the timing of
the sale of a single system could have a significant impact on the Company's
quarterly revenue and results of operations. The failure to receive anticipated
orders or delays in shipments in a particular quarter, due, for example, to
unanticipated shipment reschedulings or cancellations by customers or unexpected
manufacturing difficulties, may cause revenue for that quarter to fall
significantly below the Company's expectations, which would have a material
adverse effect on the Company's results of operations for such quarter.

The Company's backlog at the beginning of each quarter is not necessarily
indicative of actual sales for any succeeding period. All orders are subject to
delay or cancellation with limited or no penalty. The Company's sales will often
reflect orders shipped in the same quarter that they are received.

Other factors which may have an influence on the Company's results of operations
in a particular quarter include the volume, mix and timing of the receipt of
orders from major customers, competitive pricing pressures, costs of components
and subsystems, the Company's ability to design, manufacture and introduce new
products on a cost effective and timely basis, the delay between incurrence of
expenses to further develop marketing and service capabilities and realization
of benefits from such improved capabilities, fluctuations in foreign exchange
rates, the timing of recognition of revenue under development contracts, the
introduction and announcement of new products by the Company's competitors and
changing conditions in the FPD market worldwide. In particular, due to
substantial differences in gross margin for the Company's products, changes in
the mix of products sold could result in substantial fluctuations in the
Company's gross margin. Accordingly, the Company's results of operations are
subject to significant variability from quarter to quarter.

<TABLE>
<CAPTION>
CONSOLIDATED BALANCE SHEETS
 
In thousands, except share amounts
Years Ended September 30,                                                  1996                 1995
<S>                                                                     <C>                   <C> 
Assets                                                                                     
Current assets:                                                                            
Cash and cash equivalents                                               $ 5,108              $   298
Short term investments                                                    4,066                    -
Accounts receivable, net of allowance for doubtful                        8,652                5,280
 accounts of $629 ($224 in 1995); including $1,220                                          
 receivable from related parties ($1,907 in 1995)                                           
Inventories                                                               4,125                2,986
Prepaid expenses and other current assets                                   518                  219
Total current assets                                                     22,469                8,783
                                                                                            
Property, equipment, and leasehold improvements, net                      1,849                1,418
</TABLE> 
<PAGE>
 
<TABLE> 
<S>                                                                     <C>                   <C> 
Other assets                                                                 640                 318
Total assets                                                            $ 24,958             $10,519
 
Liabilities and shareholders' equity
Current liabilities:
Accounts payable                                                        $  2,743            $  1,684
Accrued expenses and other liabilities                                     2,067               2,368
Customer deposits and deferred revenue                                       353               1,251
Line of credit and other short-term debt                                       -               2,407
Current portion of long-term debt                                             16                 364
Total current liabilities                                                  5,179               8,074
                                                                        
Noncurrent portion of long-term debt                                           9                 588 
Commitments and contingencies                                           
                                                                        
Shareholders' equity:                                                   
Preferred stock, no par value, issuable in series:                             -              17,935
 13,000,000 authorized, convertible shares issued and                   
 outstanding - 9,822,826 in 1995                                        
Preferred Stock, no par value, 5,000,000 authorized,                           -                   -
 none issued and outstanding                                            
Common stock, no par value, 20,000,000 authorized,                        38,064               3,008
 shares issued and outstanding - 6,888,032 and                          
 1,155,782 in 1996 and 1995                                             
Accumulated deficit                                                      (18,201)            (19,055)
Foreign currency translation adjustment and other                             (7)                104
Notes receivable from shareholders                                           (86)               (135)
Total shareholders' equity                                                19,770               1,857
Total liabilities and shareholders' equity                              $ 24,958            $ 10,519
</TABLE> 
 
See accompanying notes to consolidated financial statements.
<PAGE>
 
CONSOLIDATED STATEMENTS OF OPERATIONS

<TABLE>   
<CAPTION>   
In thousands, except share amounts
Years Ended September 30,                                                   1996                1995
<S>                                                                     <C>                 <C> 
Revenue                                                                                     
Product sales                                                           $ 23,381            $ 13,906
Development contracts                                                      1,382               4,541   
                                                                          24,763              18,447   
Cost of revenue:                                                                                       
Product sales                                                             12,294               7,114   
Development contracts                                                        962               4,577   
                                                                          13,256              11,691   
Gross margin                                                              11,507               6,756   
                                                                                                       
Operating expenses                                                                                     
Research and development                                                   3,982               1,676   
Selling, general, and administrative                                       6,118               4,370    
Asset write-off related to product line disposal                             844                   -
Total operating expenses                                                  10,944               6,046
Operating income                                                             563                 710
                                                                                            
Interest income                                                              646                  16
Interest expense                                                            (263)               (194)
Foreign exchange loss                                                        (53)               (142)
Income before provision for income taxes                                     893                 390
                                                                                            
Provision for income taxes                                                    39                  13
                                                                                            
Net income                                                              $    854            $    377
                                                                                            
Net income per share (pro forma for 1995)                               $   0.12            $   0.07
Shares used in computing net income per share                              7,387               5,425
</TABLE> 
           
See accompanying notes to consolidated financial statements.

CONSOLIDATED STATEMENTS OF CASH FLOWS

<TABLE> 
<CAPTION> 
In thousands                                                                                
Years Ended September 30,                                       1996               1995
<S>                                                         <C>                 <C> 
Operating activities                                                            
Net income                                                  $    854            $    377
Adjustments to reconcile net                                                    
 income to net cash used in                                                     
 operating activities:                                                                               
Depreciation and amortization                                    723                 451
</TABLE> 
<PAGE>
 
<TABLE> 
<S>                                                                     <C>                 <C> 
Changes in operating assets and liabilities:                                                                           
Accounts receivable                                                       (3,372)             (2,615)
Inventories                                                               (1,139)             (1,433)
Prepaid expenses and other current assets                                   (299)               (167)
Other assets                                                                (418)               (173)
Accounts payable                                                           1,044                (109)
Accrued expenses and other liabilities                                      (301)                117
Customer deposits and deferred revenue                                      (898)                293
Net cash used in operating activities                                     (3,806)             (3,259)
                                                                                            
Investing activities                                                                        
Acquisition of property and equipment                                     (1,154)               (975)
Acquisition of short term investments                                    (10,554)                  -
Maturities of short term investments                                       6,488                   -
Net cash used in investing activities                                     (5,220)               (975)
                                                                                            
Financing activities                                                                        
Borrowings under lines of credit                                               -               2,325
Proceeds from issuance of note payable                                         -               1,000
Proceeds from issuance of short term debt                                      -                  41
Repayment of lines of credit                                              (2,325)                  -
Principal payments under capital leases                                      (30)                (50)
Issuance of common stock                                                     226                  83
Proceeds from initial public offering, net                                16,895                   -
Repayment of notes receivable from shareholders                               49                   -
Payment of notes payable                                                    (979)               (103)
Net cash provided by financing activities                                 13,836               3,296
 
Net increase (decrease) in cash and cash equivalents                       4,810                (938)
Cash and cash equivalents at beginning of period                             298               1,236
Cash and cash equivalents at end of period                              $  5,108            $    298 
</TABLE> 

See accompanying notes to consolidated financial statements.
<PAGE>
 
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
 

<TABLE> 
<CAPTION> 
                                              Convertible                    Common Stock        
                                               Preferred                                        
                                                 Stock                                          
                                          Shares       Amount             Shares           Amount
In thousands                                                                                    
<S>                                       <C>          <C>                <C>             <C>    
Balance at September 30, 1994              9,823       $ 17,935              860          $ 2,790
Issuance of common stock                       -              -               98               83
Issuance of common stock for                   -              -              198              135
 notes receivable                                                                                
Foreign currency translation                   -              -                -                -
 adjustment                                                                                      
Net Income                                     -              -                -                -
Balance at September 30, 1995              9,823       $ 17,935            1,156          $ 3,008
Issuance of common stock                       -              -              122              226
Conversion of preferred                   (9,823)       (17,935)           3,482           17,935
 stock to common stock                                                                           
Initial public offering, net                   -              -            2,128           16,895
 of offering costs                                                                               
Foreign currency translation                   -              -                -                -
 adjustment                                                                                      
Repayment of notes receivable                  -              -                -                -
Net Income                                     -              -                -                -
Balance at September 30, 1996                  -              -            6,888          $38,064

<CAPTION> 
                                     Accumulated        Foreign          Notes           Total     
                                       Deficit         Currency        Receivable     Shareholders'
                                                      Translation        From            Equity     
                                                       Adjustment     Shareholders'              
                                                       and other                                 
In thousands 
<S>                                     <C>               <C>             <C>             <C>   
Balance at September 30, 1994           $(19,432)         $ 142           $    -          $ 1,435
Issuance of common stock                       -              -                -               83
Issuance of common stock for                   -              -             (135)               -
 notes receivable                                                                                
Foreign currency translation                   -            (38)               -              (38)
 adjustment                                                                                      
Net Income                                   377              -                -              377
Balance at September 30, 1995           $(19,055)         $ 104             (135)         $ 1,857
Issuance of common stock                       -              -                -              226
Conversion of preferred                        -              -                -                -
 stock to common stock                                                                           
Initial public offering, net                   -              -                -           16,895
 of offering costs                                                                               
Foreign currency translation                   -           (111)               -             (111)
 adjustment                                                                                      
Repayment of notes receivable                  -              -               49               49
Net Income                                   854              -                -              854
Balance at September 30, 1996           $(18,201)         $  (7)            $(86)         $19,770 
</TABLE>
<PAGE>
 
See accompanying notes to consolidated financial statements.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE I  Summary of Significant
Accounting Policies

Basis of Presentation

The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries after elimination of all material intercompany
balances and transactions. Photon Dynamics, Inc. is a manufacturer of test
inspection and repair systems for the flat panel display industry.

Use of Estimates

The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts in the financial statements and accompanying notes. Actual
results could differ from those estimates.

Initial Public Offering

In November 1995, the Company completed an initial public offering (IPO) 
of 2,932,500 share of Common Stock, of which 2,127,661 shares were issued and
sold by the Company and 804,439 shares were sold by stockholders. The
IPO raised approximately $17.8 million before deducting offering expenses.

Reverse Stock Split

In November 1995, the Company effected a one-for-three reverse stock split of
the Company's common stock. All references in the accompanying financial l
statements to numbers of common shares and per share amounts have been
retroactively restated to reflect the reverse stock split.

Cash and Cash Equivalents

The Company considers all highly liquid investments purchased with a maturity of
three months or less on the date of purchase to be cash equivalents.

Short Term Investments

Effective October 1, 1994, the Company adopted Statement of Financial Accounting
Standards No. 115 Accounting for Investments in Certain Debt and Equity
securities (FAS 115), which requires investment securities to be classified as
either held to maturity, trading or available for sale.

The Company has classified its investment portfolio as available for sale. Under
FAS 115, investments classified as available for sale are required to be
recorded at fair value and any temporary difference between an investment's cost
and its fair value is recorded as a separate component o= f shareholders'
equity.

At September 30, 1996, short term investments consisted of commercial paper and
fixed rate notes. The cost of these securities approximated the fair value and
the amount of unrealized gains or losses was not significant. These securities
mature through May 1997.

Inventories

Inventories are stated at the lower of cost or market, with cost being
determined on a first-in, first-out basis.
<PAGE>
 
<TABLE>
<CAPTION>
September 30,                               1996     1995
Inventories comprise
(in thousands):
<S>                                        <C>      <C>
Raw materials                              $1,970   $1,322
Work-in-progress                            1,247      461
Finished goods                                908    1,203
                                           $4,125   $2,986
</TABLE>

Property, Equipment and Leasehold Improvements

Property and equipment are recorded at cost. Depreciation is computed using the
straight-line method based upon the estimated useful lives of the assets,
generally three to five years.

Equipment recorded under capital leases is amortized using the straight-line
method over the lesser of the lease terms or the lives of the related assets.

<TABLE>
<CAPTION>
September 30,                                1996       1995
<S>                                        <C>        <C>
Property and equipment comprise
(in thousands):
Equipment                                  $ 3,553    $ 2,390
Office furniture and fixtures                  265        268
Leasehold improvements                         459        458
                                             4,277      3,116
Less accumulated depreciation and           (2,428)    (1,698)
 amortization
                                           $ 1,849    $ 1,418
</TABLE>

Foreign Currency Translation

Assets and liabilities of the Company's foreign subsidiary are translated into
U.S. dollars at year-end exchange rates and revenues and expenses are translated
at average rates prevailing during the year. Translation adjustments are
included in a separate component of shareholders' equity.

Foreign currency transaction gains and losses are included in results of
operations.

Revenue Recognition

The Company generally recognizes revenue from product sales at the time of
shipment. The Company also sells one-year service contracts, for which revenue
is recognized ratably over the contract period. Revenue under cost reimbursement
type development contracts is recorded as costs are incurred.

Applicable estimated profits are included in revenue in the same proportion that
incurred costs bear to total estimated costs. Certain fixed-price contracts that
require substantial performance over a long period of time before deliveries
begin are accounted for under the percentage-of-completion method. Under all
other contracts, sales are recorded at delivery or on completion of specified
tasks, as applicable, and estimated contract profits are taken into earnings in
proportion to recorded sales.

Concentrations of Credit Risk

The Company markets its products primarily to a limited number of customers in
the Far East. The Company has development contracts primarily with the U.S.
government and companies in the Far East.

The Company is subject to economic conditions affecting its customers and the
countries in which it operates. The Company believes its credit evaluation and
<PAGE>
 
monitoring process mitigates this credit risk. In 1996, sales to two
unaffiliated and one affiliated customer accounted for 30%,14% and 19%
respectively. In 1995, sales to two unaffiliated and one affiliated customer
represented 25%, 24%, and 24% of total revenue. International sales accounted
for 88% and 63% of total revenue in 1996 and 1995, respectively.

Warranty and Installation

The Company generally warrants its systems for a period of 12 months from
installation for material and labor to repair and service the system. A
provision for the estimated cost of installation and warranty is recorded upon
shipment.

Net Income Per Share

Except as noted below, net income per share is computed using the weighted
average number of shares of common stock and dilutive common stock equivalents
from stock options and warrants (using the treasury stock method). Pursuant to
Securities and Exchange Commission Staff Accounting Bulletins, common and common
stock equivalent shares issued by the Company at prices below the initial
offering price during the 12-month period prior to the offering in 1995 have
been included in the calculation as if they were outstanding for all periods
presented regardless of whether they are dilutive (using the treasury stock
method and the initial public offering price).

The net income per share for the year ended September 30, 1995 is pro forma and
is computed using the same method described above and also gives effect to
common equivalent shares from convertible preferred stock using the if-converted
method.

Impact of Recently Issued Accounting Standards

In March 1995, the FASB issued Statement of Financial Accounting Standards
No. 121, Accounting for the Impairment of Long-Lived Assets and for Long Lived
Assets to be Disposed Of (FAS 121), effective for fiscal years beginning after
December 15, 1995. The Company will adopt FAS 121 in the first quarter of fiscal
1997 and, based on current circumstances, does not believe the effect of
adoption will be material. In October 1995, the FASB issued Statement of
Financial Accounting Standards No. 123, Accounting for Stock Based compensation
(FAS 123), effective for fiscal years beginning after December 15, 1995. The
Company will adopt the FAS 123 disclosure method of reporting in its fiscal 1997
financial statements.

NOTE 2 =F1 Related Parties

During 1996 and 1995 the Company sold approximately $4,651,000 and
$4,482,000 of its systems to LG. Electronics, Inc. LG. Electronics owns
approximately 8% of the Company's common stock, and warrants to purchase
28,333 shares of Common Stock at an exercise price of $0.60 per share. The
Company believes its sales to LG. Electronics were made on terms no less
favorable than would have been obtained from unaffiliated parties.

NOTE 3 =F1 Asset Write-off Related to Product line Disposal

In September, 1996, the Company ceased operations of its Defect Monitoring Tool
(DMT) product line. The DMT product group had been working exclusively on a
single customer project not in the flat panel display market. As a result of the
cancellation of this project, the associated inventory and assets of this
<PAGE>
 
product line which can not be transferred to other products will be disposed of.
The Company recorded a $844,000 charge to write down the inventory and assets
associated with the product line.

NOTE 4 =F1 Lease Obligations and Commitments

The Company leases certain equipment under capital leases. Total capitalized
costs and related accumulated amortization for equipment under capital leases
was $215,000 and $175,000, respectively, as of September 30, 1996 and $215,000
and $150,000, respectively, as of September 30, 1995.

The Company leases its main facility under a noncancelable operating lease
agreement that expires in fiscal 1997. In late fiscal 1996 the Company entered
into a new noncancelable operating lease on a facility which commences in
November 1996 and expires in fiscal 2002.

Total future minimum lease obligations are as follows:

<TABLE>
<CAPTION>
In thousands                               Operating Leases
<S>                                              <C>
1997                                             $512
1998                                              574
1999                                              591
2000                                              609
2001                                              627
2002                                               52
</TABLE>

Rental expense for the years ended September 30, 1996 and 1995 was $352,000 and
$404,000, respectively.

NOTE 5 =F1 Shareholders' Equity Preferred Stock

At September 30, 1995 the Company had 9,822,826 shares of Convertible
Preferred Stock outstanding which automatically converted into Common Stock upon
the closing of the Company's initial public offering in November 1995=
=2E

Additionally, in November 1995, the Board of Directors approved an amendment of
the Company's Articles of Incorporation to authorize 5,000,00=
0 shares of preferred stock, no par value, none of which are outstanding.

In 1995, the Company issued two sets of warrants to purchase 177,777 shares of
Series E preferred stock, which are currently exercisable in exchange for 59,259
shares of common stock at $5.50 per share. The warrants expire from 2000 to
2002.

Warrants to Purchase Common Stock

In connection with bridge financing in 1994, the Company issued warrants to
purchase a total of 160,856 shares of common stock at $0.60 per share.
These warrants expire in 1999.

Stock Reserved for Future Issuance

As of September 30, 1996, the Company has reserved 1,732,506 shares of common
stock for future issuance.

Stock Option and Purchase Plans

Under the Company's stock option plans, the Board of Directors may, at its
discretion, grant incentive or nonqualified stock options to employees and
directors. Options may be granted for a period not to exceed ten years from the
date of grant, at prices at least equal to the fair market value of common 
<PAGE>
 
stock at the grant date, and become exercisable generally over a period of four
years.

The following table summarizes activity under the Plans:

<TABLE>
<CAPTION>
                               Shares Under Option    Exercise Price
<S>                                <C>                <C>
Balance at Sept. 30, 1994             615,956      
Granted                               616,678         $0.60 - $ 7.20
Exercised                            (293,383)        $0.60 - $ 7.20
Canceled                             (119,671)        $0.60 - $ 1.20
Balance at Sept. 30, 1995             819,580      
Granted                               591,900         $6.75 - $11.00
Exercised                             (91,905)        $0.60 - $ 7.20
Canceled                             (217,056)        $0.60 - $11.00
Balance at Sept. 30, 1996           1,102,519      
</TABLE>

Options to purchase 409,872 shares of common stock are available for grant as of
September 30, 1996. Options to purchase 67,328 shares of common stock have been
granted subject to shareholder approval by the Board of Directors. Compensation
related to such options will not be measured until approved. Options for 354,119
shares are currently exercisable (options for 223,872 shares at September 30,
1995).

The Company has reserved 100,000 shares of common stock to be issued under the
1995 Employee Stock Purchase Plan. The plan permits eligible employees to
purchase common stock, through payroll deductions, at 85% of the lower of the
fair market value of the common stock on the date at the beginning of the two-
year offering period or the last day of the purchase period.

Substantially all employees are eligible to participate in the plan. At
September 30, 1996 81,884 shares were available for issuance under the plan.

NOTE 6 =F1 Notes Receivable From Shareholders

The notes receivable from shareholders arose from certain employees exercising
their stock options. The notes bear interest at 6.83% per annum, and are secured
by the shares of common stock.

NOTE 7 =F1 Income Taxes

The provision for income taxes for the year ended September 30, 1996 consists of
the following:

<TABLE>
<CAPTION>
In thousands
Year Ended September 30,                    1996     1995
<S>                                        <C>     <C>  
Federal - current                          $  29   $  10
State - current                               10       3
Total                                      $  39   $  13 
</TABLE>

The provisions for taxes on income differed from the provisions calculated by
applying the federal statutory rate to income before taxes as follows:

<TABLE>
<CAPTION>
In thousands
Years ended September 30,                   1996     1995
<S>                                        <C>      <C>
Expected provision (benefit) at            $ 313    $ 137
 statutory rate
Alternative minimum taxes                     39       13
Benefit of operating loss carryforwards     (313)    (137)
                                           $  39    $  13
</TABLE>
<PAGE>
 
As of September 30, 1996, the Company has federal and state net operating loss
carryforwards of approximately $12,500,000 and $3,000,000, respectively. The
Company also has federal and state research and development tax credit
carryforwards of approximately $698,000 and $341,000, respectively. The net
operating loss and credit carryforwards will expire at various times beginning
in 1998 through 2011, if not utilized.

Under certain provisions of the Internal Revenue Code of 1986, as amended, the
availability of the Company's net operating loss and tax credit carryforwards
may be subject to limitation if it should be determined that there has been a
change in ownership of more than 50% of the value of the Company's stock. Such
determination could limit the utilization of net operating loss and tax credit
carryforwards. Deferred tax assets reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes, net operating
loss and credit carryforwards.

Significant components of the Company's deferred tax assets are as follows:

<TABLE>
<CAPTION>
In thousands
Years Ended September 30,                     1996         1995
<S>                                        <C>          <C>
Deferred tax assets:
Net operating loss carryforwards           $ 4,712      $ 4,955
Research credit carryforwards                  920          794
Capitalized research costs                     335          338
Inventory valuation                            771          584
Deferred revenue                               103          534
Other individually immaterial items            960          755
Total deferred tax assets                    7,801        7,960
Valuation allowance                         (7,801)      (7,960)1
Net deferred tax assets                    $     -      $     -
</TABLE> 
1The valuation allowance increased by $201,000 in 1995.
 
NOTE 8 - Statements of Cash Flows Data

<TABLE> 
<CAPTION> 
In thousands                                  1996         1995
Supplemental disclosure of cash flow information
<S>                                        <C>          <C> 
Interest paid                              $   272      $   124
Income taxes paid                          $   110      $    13
</TABLE> 

Supplemental disclosure of noncash investing and financing activities

<TABLE> 
<S>                                        <C>          <C> 
Equipment purchased under capital leases   $     -      $    16                                           
Common stock issued for notes              $     -      $   135
Conversion of Preferred Stock to Common    $17,935      $     -
 Stock
</TABLE>
<PAGE>
 
REPORT OF INDEPENDENT AUDITORS

The Board of Directors
Photon Dynamics, Inc.

We have audited the accompanying consolidated balance sheets of Photon Dynamics,
Inc. as of September 30, 1996 and 1995, and the related consolidated statements
of operations, shareholders' equity, and cash flow s for the years then ended.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits 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 audits provide a reasonable basis for our opinion. In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Photon
Dynamics, Inc. as of September 30, 1996 and 1995, and the consolidated results
of its operations and its cash flows for the years then ended in conformity with
generally accepted accounting principles.

San Jose California
October 25, 1996

CORPORATE OFFICERS AND DIRECTORS

Directors
E. Floyd Kvamme - Chairman
Partner
Kleiner Perkins Caufield & Byers

Barry Cox
Private Investor

Michael Kim
Executive Director - New Business Development
LG Electronics, Inc.

Dr. Malcolm J. Thompson
Chief Executive Officer dpiX

Francois Henley
Chief Technical Officer
Photon Dynamics, Inc.
<PAGE>
 
Steve Krausz
General Partner
U.S. Venture Partners

Vincent F. Sollitto Jr.
Chief Executive Officer
Photon Dynamics, Inc.

Officers
Vincent F. Sollitto Jr.
Chief Executive Officer

Francois Henley
Chief Technical Officer

Howard Bailey
Chief Financial Officer

Jeff Hawthorne
Vice President - Development

Alan Nolet
Senior Vice President - Sales

Donald Jerome
Vice President - Operations

C.J. Meurell
Vice President - Marketing and Technology

Dr. William Pratt
Chief Technical Officer - Software

CORPORATE INFORMATION

Independent Auditors
Ernst and Young LLP
San Jose, CA
Legal Counsel
Morrison and Foerster LLP
San Francisco, CA
Registrar and Transfer Agent
Bank of Boston
Boston, MA

Investor Information

Additional Copies of this report, as well as copies of SEC Form 10-KSB, for the
year ended September 30, 1996, may be obtained from the Company without charge
by contacting Investor Relations at Photon Dynamics Corporate Office.

The Company's common stock is traded on the Nasdaq National Market under the
symbol PHTN.
<PAGE>
 
<TABLE> 
<CAPTION> 
   FISCAL 1996
                      High                  Low
<S>                                         <C> 
1st Quarter          12 1/4                 6 7/8
2nd Quarter          10 1/2                 6 3/4
3rd Quarter          13 1/2                 7
4th Quarter          10 1/4                 5
</TABLE>

The preceding table sets forth the high and low sales prices as reported on the
Nasdaq National Market since the IPO in November 1995.

Corporate Office
Photon Dynamics, Inc.
6325 San Ignacio Avenue
San Jose, CA 95119-1202 telephone: (408) 226-9900 facsimile: (408) 226-9910

Subsidiaries
K.K. Photon Dynamics
No. 2 SVAX Hamamatsucho Building
Minato-ku, Tokyo 105
Japan telephone: (03) 5472-6147 facsimile: (03) 5472-6138

Photon Dynamics, Korea
7th Floor Taejin Building
14-2 Yangjae-Dong
Soecho-Ku, Seoul, Korea telephone: (02) 575-3443 facsimile: (02) 575-3446