##### 









SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549-0001




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FORM 10-Q

(MARK ONE)




|  |                                                                                           
|- | ------------------------------------------------------------------------------------------
|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF 
	 THE SECURITIES EXCHANGE ACT OF 1934

For the three months ended September 30, 2001

OR



|  |                                                                                            
|- | -------------------------------------------------------------------------------------------
|o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF 
	 THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 000-23699



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VISUAL NETWORKS, INC.

(Exact name of registrant as specified in its
charter)


|                                                                          |  |                                                
|------------------------------------------------------------------------- |  | -----------------------------------------------
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|Delaware(State or other jurisdiction of
	incorporation or organization)   |  | 52-1837515(I.R.S. Employer
	Identification No.)
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|                                                                         
|2092 Gaither Road, Rockville, MD(Address of principal executive
	offices) |  | 20850-4013(Zip code)                           

Registrants telephone number, including area code: 
(301) 296-2300



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Indicate by check mark whether the registrant (1) has filed
all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the preceding
12 months (or for such shorter period that the registrant
was required to file such reports), and (2) has been
subject to the filing requirements for the past 90 days.
Yes 
x
     No 
o

The number of outstanding shares of the Registrants Common
Stock, par value $.01 per share, as of November 9,
2001 was 31,868,627 shares.









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##### 



VISUAL NETWORKS, INC.

QUARTERLY REPORT ON FORM 10-Q


FOR THE THREE MONTHS ENDED


SEPTEMBER 30, 2001


TABLE OF CONTENTS

|                              |                                                                                                |                                                                                                  |  |    |   | 
|----------------------------- | ---------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------ |  | -- | - | 
|                              |                                                                                                | Page                                                                                            
|                              |                                                                                                |                                                                                                 
|PART I. FINANCIAL INFORMATION |                                                                                                |                                                                                                  |  |   
|                             
|                             
|                             
|                             
|                              | Item 1. Financial Statements:                                                                  |                                                                                                  |  |    |  
|                             
|                             
|                             
|                             
|                              |                                                                                                | Consolidated Balance Sheets 
	September 30, 2001 and December 31, 2000                          |  |    | 3 | 
|                             
|                             
|                             
|                             
|                              |                                                                                                | Consolidated Statements of Operations 
	Three and nine months ended September 30, 2001 and 2000 |  |    | 4 | 
|                             
|                             
|                             
|                             
|                              |                                                                                                | Consolidated Statements of Cash Flows 
	Nine months ended September 30, 2001 and 2000           |  |    | 5 | 
|                             
|                             
|                             
|                             
|                              |                                                                                                | Notes to Consolidated Financial Statements                                                       |  |    | 6 | 
|                             
|                             
|                             
|                             
|                              | Item 2. Managements Discussion and
	Analysis of Financial Condition and Results of Operations |                                                                                                  |  | 14 |  
|                             
|                             
|                             
|                             
|                              | Item 3. Qualitative and Quantitative
	Disclosure about Market Risk                             |                                                                                                  |  | 22 |  
|PART II. OTHER INFORMATION    |                                                                                                |                                                                                                  |  |   
|                             
|                             
|                             
|                             
|                              | Items 1  6                                                                                    |                                                                                                  |  | 23 |  
|                             
|                             
|                             
|                             
|                              | Signatures                                                                                     |                                                                                                  |  | 26 |  

2



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##### 



PART I:  FINANCIAL INFORMATION

Item  1:  Financial Statements

VISUAL NETWORKS, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited)


(In thousands, except share data)


|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |          |        | 
|-------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | ------------ | ------ |  | ------ | -------- | ------ | 
|                                       |                                                                                                                                                                                     | September 30,                              |       | December 31,
|                                       |                                                                                                                                                                                     | 2001                                       |       | 2000        
|                                       |                                                                                                                                                                                     |                                            |       |             
|                                      
|                                      
|                                      
|                                      
|ASSETS                                
|                                      
|                                      
|                                      
|                                      
|Current assets:                        |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                      
|                                      
|                                      
|                                      
|                                       | Cash and cash equivalents                                                                                                                                                           |                                            | $     | 5,408        |        |  | $      | 17,369   |       
|                                      
|                                      
|                                      
|                                      
|                                       | Short-term investments                                                                                                                                                              |                                            |       | 2,769        |        |  |        | 3,700    |       
|                                      
|                                      
|                                      
|                                      
|                                       | Accounts receivable, net of allowance of $627 and
	$1,103, respectively                                                                                                             |                                            |       | 9,599        |        |  |        | 7,615    |       
|                                      
|                                      
|                                      
|                                      
|                                       | Inventory                                                                                                                                                                           |                                            |       | 6,688        |        |  |        | 13,474   |       
|                                      
|                                      
|                                      
|                                      
|                                       | Other current assets                                                                                                                                                                |                                            |       | 1,999        |        |  |        | 3,089    |       
|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                       |                                                                                                                                                                                     | Total current assets                       |       |              | 26,463 |  |        |          | 45,247 | 
|                                      
|                                      
|                                      
|                                      
|Property and equipment, net            |                                                                                                                                                                                     |                                            | 6,964 |              |        |  | 10,738 |         
|                                      
|                                      
|                                      
|                                      
|Intangible assets, net                 |                                                                                                                                                                                     |                                            | 198   |              |        |  | 8,510  |         
|                                      
|                                      
|                                      
|                                      
|Other assets                           |                                                                                                                                                                                     |                                            | 3,713 |              |        |  | 9,562  |         
|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                       |                                                                                                                                                                                     | Total assets                               |       | $            | 37,338 |  |        | $        | 74,057 | 
|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                      
|                                      
|                                      
|                                      
|LIABILITIES AND STOCKHOLDERS
	EQUITY 
|                                      
|                                      
|                                      
|                                      
|Current liabilities:                   |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                      
|                                      
|                                      
|                                      
|                                       | Accounts payable and accrued expenses                                                                                                                                               |                                            | $     | 18,466       |        |  | $      | 29,354   |       
|                                      
|                                      
|                                      
|                                      
|                                       | Deferred revenue                                                                                                                                                                    |                                            |       | 13,365       |        |  |        | 17,769   |       
|                                      
|                                      
|                                      
|                                      
|                                       | Current portion of long-term debt                                                                                                                                                   |                                            |       | 2,220        |        |  |        | 606      |       
|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                       |                                                                                                                                                                                     | Total current liabilities                  |       |              | 34,051 |  |        |          | 47,729 | 
|                                      
|                                      
|                                      
|                                      
|Long-term debt, net of current portion |                                                                                                                                                                                     |                                            | 263   |              |        |  | 243    |         
|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                       |                                                                                                                                                                                     | Total liabilities                          |       |              | 34,314 |  |        |          | 47,972 | 
|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|Stockholders equity:                  |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                      
|                                      
|                                      
|                                      
|                                       | Common stock, $.01 par value, 50,000,000 shares
	authorized, 31,582,824 and 31,296,383 shares issued and
	outstanding as of September 30, 2001 and December 31,
	2000, respectively |                                            |       | 316          |        |  |        | 313      |       
|                                      
|                                      
|                                      
|                                      
|                                       | Additional paid-in capital                                                                                                                                                          |                                            |       | 472,707      |        |  |        | 473,108  |       
|                                      
|                                      
|                                      
|                                      
|                                       | Deferred compensation                                                                                                                                                               |                                            |       | (87          | )      |  |        | (402     | )     
|                                      
|                                      
|                                      
|                                      
|                                       | Accumulated other comprehensive income                                                                                                                                              |                                            |       | 9            |        |  |        | 11       |       
|                                      
|                                      
|                                      
|                                      
|                                       | Accumulated deficit                                                                                                                                                                 |                                            |       | (469,921     | )      |  |        | (446,945 | )     
|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                       |                                                                                                                                                                                     | Total stockholders equity                 |       |              | 3,024  |  |        |          | 26,085 | 
|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |         
|                                       |                                                                                                                                                                                     | Total liabilities and stockholders equity |       | $            | 37,338 |  |        | $        | 74,057 | 
|                                       |                                                                                                                                                                                     |                                            |       |              |        |  |        |         

See accompanying notes to consolidated financial statements.

3



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##### 



VISUAL NETWORKS, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)


(In thousands, except per share data)


|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |        |         | 
|------------------------------------------------------ | ----------------------------------------------- | ------------------------ | ------ | ------------------- | ------ | ---- | ------- | ------ | ------ | - | ------- | ------ | ------ | - | ------- | ------ | ------- | 
|                                                       |                                                 |                          |        |                    
|                                                       |                                                 | For the three months     |        | For the nine months
|                                                       |                                                 | ended September 30,      |        | ended September 30,
|                                                       |                                                 |                          |        |                    
|                                                       |                                                 | 2001                     |        | 2000                |        | 2001 |         | 2000  
|                                                       |                                                 |                          |        |                     |        |      |         |       
|Revenue                                                |                                                 | $                        | 19,208 |                     |        | $    | 14,607  |        |        | $ | 56,923  |        |        | $ | 73,745  |       
|                                                      
|                                                      
|                                                      
|                                                      
|Cost of revenue                                        |                                                 |                          | 7,099  |                     |        |      | 7,507   |        |        |   | 23,362  |        |        |   | 26,292  |       
|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       
|                                                       | Gross profit                                    |                          |        | 12,109              |        |      |         | 7,100  |        |   |         | 33,561 |        |   |         | 47,453 |        
|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       
|Operating expenses:                                    |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | Research and development                        |                          |        | 4,558               |        |      |         | 8,182  |        |   |         | 15,718 |        |   |         | 19,490 |        
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | Write-off of purchased research and development |                          |        |                    |        |      |         |       |        |   |         |       |        |   |         | 39,000 |        
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | Sales and marketing                             |                          |        | 8,412               |        |      |         | 12,706 |        |   |         | 26,999 |        |   |         | 28,963 |        
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | General and administrative                      |                          |        | 2,115               |        |      |         | 3,382  |        |   |         | 7,133  |        |   |         | 8,009  |        
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | Restructuring and impairment charges            |                          |        |                    |        |      |         |       |        |   |         | 6,276  |        |   |         |       |        
|                                                      
|                                                      
|                                                      
|                                                      
|                                                       | Amortization of acquired intangibles            |                          |        | 13                  |        |      |         | 21,972 |        |   |         | 805    |        |   |         | 30,813 |        
|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       
|                                                       |                                                 | Total operating expenses |        |                     | 15,098 |      |         |        | 46,242 |   |         |        | 56,931 |   |         |        | 126,275 | 
|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       
|Loss from operations                                   |                                                 |                          | (2,989 | )                   |        |      | (39,142 | )      |        |   | (23,370 | )      |        |   | (78,822 | )     
|                                                      
|                                                      
|                                                      
|                                                      
|Interest income, net                                   |                                                 |                          | 10     |                     |        |      | 762     |        |        |   | 394     |        |        |   | 2,132   |       
|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       
|Loss before income taxes                               |                                                 |                          | (2,979 | )                   |        |      | (38,380 | )      |        |   | (22,976 | )      |        |   | (76,690 | )     
|                                                      
|                                                      
|                                                      
|                                                      
|Income taxes                                           |                                                 |                          |       |                     |        |      | 7,671   |        |        |   |        |        |        |   | 9,203   |       
|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       
|Net loss                                               |                                                 | $                        | (2,979 | )                   |        | $    | (30,709 | )      |        | $ | (22,976 | )      |        | $ | (67,487 | )     
|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       
|Basic and diluted loss per share                       |                                                 | $                        | (0.09  | )                   |        | $    | (0.99   | )      |        | $ | (0.73   | )      |        | $ | (2.43   | )     
|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       
|Basic and diluted weighted average shares
	outstanding |                                                 |                          | 31,533 |                     |        |      | 30,967  |        |        |   | 31,501  |        |        |   | 27,801  |       
|                                                       |                                                 |                          |        |                     |        |      |         |        |        |   |         |        |        |   |         |       

See accompanying notes to consolidated financial statements.

4



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##### 



VISUAL NETWORKS, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)


(In thousands)


|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |         |        |         |  
|------------------------------------------------------------------------ | ---------------------------------------------------------------------------- | ----------------------------------------------- | ---------------------------------------------------- | ------- | ------ | ------- | ------- | ------- | ------ | ------- | -
|                                                                         |                                                                              |                                                
|                                                                         |                                                                              | For the nine months                            
|                                                                         |                                                                              | ended September 30,                            
|                                                                         |                                                                              |                                                
|                                                                         |                                                                              | 2001                                            |                                                      | 2000   
|                                                                         |                                                                              |                                                 |                                                      |        
|Cash flows from operating activities:                                    |                                                                              |                                                 |                                                      |         |        |         |         |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Net loss                                                                     |                                                 | $                                                    | (22,976 | )      |         | $       | (67,487 | )     
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Adjustments to reconcile net loss to net cash
	used in operating activities: |                                                 |                                                      |         |        |         |         |         |       
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                              | Depreciation and amortization                   |                                                      |         | 4,584  |         |         |         | 35,263 |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                              | Write-off of purchased research and development |                                                      |         |       |         |         |         | 39,000 |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                              | Non-cash restructuring and impairment charges   |                                                      |         | 4,292  |         |         |         |       |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                              | Deferred taxes                                  |                                                      |         |       |         |         |         | (9,203 | )      
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Changes in assets and liabilities:                                           |                                                 |                                                      |         |        |         |         |         |       
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                              | Accounts receivable                             |                                                      |         | (1,984 | )       |         |         | 2,706  |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                              | Inventory                                       |                                                      |         | 6,786  |         |         |         | (981   | )      
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                              | Other assets                                    |                                                      |         | 1,384  |         |         |         | (232   | )      
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                              | Accounts payable and accrued expenses           |                                                      |         | (9,352 | )       |         |         | 3,191  |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         |                                                                              | Deferred revenue                                |                                                      |         | (2,572 | )       |         |         | (4,650 | )      
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|                                                                         |                                                                              |                                                 | Net cash used in operating activities                |         |        | (19,838 | )       |         |        | (2,393  | )
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|Cash flows from investing activities:                                    |                                                                              |                                                 |                                                      |         |        |         |         |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Net maturities of short-term investments                                     |                                                 |                                                      | 5,931   |        |         |         | 5,555   |       
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Expenditures for property and equipment                                      |                                                 |                                                      | (529    | )      |         |         | (7,245  | )     
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Merger-related transaction costs, net of cash
	acquired                      |                                                 |                                                      |        |        |         |         | (10,085 | )     
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|                                                                         |                                                                              |                                                 | Net cash provided by (used in) investing
	activities |         |        | 5,402   |         |         |        | (11,775 | )
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|Cash flows from financing activities:                                    |                                                                              |                                                 |                                                      |         |        |         |         |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Exercise of stock options and employee stock
	purchase plan                  |                                                 |                                                      | 834     |        |         |         | 3,578   |       
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Net borrowings (repayments) under credit
	agreements                         |                                                 |                                                      | 2,072   |        |         |         | (1,658  | )     
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Principal payments on capital lease obligations                              |                                                 |                                                      | (437    | )      |         |         | (295    | )     
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|                                                                         |                                                                              |                                                 | Net cash provided by financing activities            |         |        | 2,469   |         |         |        | 1,625   |  
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|Effect of exchange rate changes                                          |                                                                              |                                                 | 6                                                    |         |        |         | (8      | )      
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|Net decrease in cash and cash equivalents                                |                                                                              |                                                 | (11,961                                              | )       |        |         | (12,551 | )      
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|Cash and cash equivalents, beginning of period                           |                                                                              |                                                 | 17,369                                               |         |        |         | 54,629  |        
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|Cash and cash equivalents, end of period                                 |                                                                              | $                                               | 5,408                                                |         |        | $       | 42,078  |        
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|Supplemental cash flow information:                                      |                                                                              |                                                 |                                                      |         |        |         |         |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Cash paid for interest                                                       |                                                 | $                                                    | 38      |        |         | $       | 107     |       
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        
|Supplemental disclosure of non-cash investing and
	financing activities: |                                                                              |                                                 |                                                      |         |        |         |         |        
|                                                                        
|                                                                        
|                                                                        
|                                                                        
|                                                                         | Issuance of common stock, options and warrants in
	acquisition               |                                                 | $                                                    | (990    | )      |         | $       | 395,121 |       
|                                                                         |                                                                              |                                                 |                                                      |         |        |         |         |        

See accompanying notes to consolidated financial statements.

5



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##### 



VISUAL NETWORKS, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2001


(Unaudited)


1.  Nature of Operations and Summary of Significant
Accounting Policies:

Visual Networks, Inc. (Visual or the
Company) designs, manufactures, sells and supports
comprehensive service management systems for providers and users
of new world connectivity services and out-sourced Web services.

Risks and Other Important Factors

The Company incurred a net loss of $23.0 million for the
nine months ended September 30, 2001 and a net loss of
$415.5 million for the year ended December 31, 2000. The
net loss for the year ended December 31, 2000 included an
impairment charge of $328.8 million for the write-off of
goodwill and other intangibles related to the Avesta
Technologies, Inc. (Avesta) acquisition. The
deterioration in the operating results that occurred in 2000 was
due, in part, to decreased revenue and increased operating
expenses. In response to the trends, the Company announced a
plan in the fourth quarter of 2000 to realign its product
portfolio, streamline its operations and devote resources to the
markets and products that the Company believes have the greatest
opportunity for growth. In the second quarter of 2001, the
Company announced a second restructuring plan to discontinue
development and sales efforts on the Visual Trinity product. The
Companys revenues have increased from fourth quarter 2000
levels during the nine months ended September 30, 2001. The
Companys operating expenses, excluding non-cash Avesta
related amortization and impairment charges and restructuring
charges, decreased from 2000 levels during the nine months ended
September 30, 2001 as a result of the fourth quarter 2000
and the second quarter 2001 restructurings. In
October 2001, the Company announced a plan to further
reduce operating expenses by reducing its workforce by
approximately 40 employees. The Companys ability to
generate operating income in the future is, in large part,
dependent on its success in achieving revenue goals and reducing
operating expenses. The Company believes that its
October 2001 reduction in force will result in further
reductions in operating expenses that will result in a return to
profitability in the first quarter of 2002. Due to market
conditions, competitive pressures and other factors beyond its
control, there can be no assurances that the Company will be
able to achieve its revenue goals in the future. In the event
that the anticipated cost reductions are not realized or revenue
goals are not met, the Company may be required to further reduce
its cost structure. There can be no assurance that the Company
will become profitable.

The success of the Company is also dependent on its ability to
generate adequate cash for operating and capital needs. The
Company is relying on its existing cash and cash equivalents,
investments and credit facility together with future sales and
the collection of the related accounts receivable to meet its
future cash requirements. If cash provided by these sources is
not sufficient to fund future operations, the Company will be
required to further reduce its expenditures for operations or to
seek additional capital through other means that may include the
sale of assets, the sale of equity securities or additional
borrowings. Although the Company believes that it has the
ability to generate additional cash through such actions, the
results of such actions may be dilutive. There can be no
assurance that additional capital will be available, or
available on terms that are reasonable or acceptable to the
Company. If the Company is unable to generate additional cash,
the business and financial condition would be materially and
adversely affected such that the Company may need to consider
other alternatives for its future.

The Companys operations are subject to certain other risks
and uncertainties, including among others, successful
incorporation of the Companys products into service
provider company infrastructure, long sale cycles, dependence on
significant customers, rapidly changing technology, current and
potential competitors with greater financial, technological,
product and marketing resources, dependence on sole and limited
source suppliers, dependence on key management personnel,
ability to recruit and retain employees, defense against pending
litigation, limited protection of intellectual property and
proprietary rights, uncertainty of future profitability and
possible fluctuation in financial results.

6



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Financial Statement Presentation

The preparation of financial statements in conformity with
generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts
of assets and liabilities, the disclosure of contingent assets
and liabilities at the date of statements and the reported
amounts of revenues and expenses during the reporting periods.
Actual results could differ from those estimates.

These financial statements are unaudited and have been prepared
by the Company pursuant to the rules and regulations of the
Securities and Exchange Commission regarding interim financial
reporting. Accordingly, they do not include all of the
information and footnotes required by generally accepted
accounting principles for complete financial statements, and it
is suggested that these financial statements be read in
conjunction with the financial statements and notes thereto,
included in the Companys Annual Report on Form 10-K
for the year ended December 31, 2000. In the opinion of
management, the comparative financial statements for the periods
presented herein include all adjustments that are normal and
recurring which are necessary for a fair presentation of results
for the interim periods. The results of operations for the nine
months ended September 30, 2001 are not necessarily
indicative of the results for the entire year ending
December 31, 2001.

On May 24, 2000, Visual acquired Avesta in a merger
transaction accounted for using the purchase method of
accounting. Avesta was a provider of fault management and
application performance monitoring software systems to
e-business customers. The results of operations have been
included in the accompanying consolidated statements of
operations from the date of acquisition.

Principles of Consolidation

The consolidated financial statements include the accounts of
Visual and its wholly owned subsidiaries. All significant
intercompany account balances and transactions have been
eliminated in consolidation.

Investments

Investments in marketable securities are classified as
available-for-sale and are reported at fair value in accordance
with Statement of Financial Accounting Standards
(SFAS) No. 115, Accounting for Certain
Investments in Debt and Equity Securities. The fair values
are based on quoted market prices. Unrealized gains and losses
on marketable securities are reported as a separate component of
comprehensive income, if significant. As of September 30,
2001, the Company held short-term investments in U.S. Treasury
obligations that mature within one year. The Company also held a
$2.5 million certificate of deposit that matures on
March 31, 2002. As of September 30, 2001, unrealized
gains and losses were not material.

The Company has an investment in an entity, accounted for using
the equity method of accounting, in which the Company has less
than a majority ownership interest but over which the Company
can exercise significant influence. The entity is a distributor
for the Companys products, primarily the Visual Trinity
product. The Company has not had any sales to the entity. As a
result of the Companys announcement to discontinue
development and sales efforts on the Visual Trinity product in
the second quarter 2001, the Company wrote-off the remaining
carrying value of this investment of $656,000 during the three
months ended June 30, 2001. The write-off is included in
the restructuring charge in the accompanying consolidated
statement of operations for the nine months ended
September 30, 2001. The Company also has an investment in
an entity in which the Company exercises no control or
significant influence. Such investment is accounted for under
the cost method and its carrying value of approximately
$3.7 million is included in other assets in the
accompanying balance sheets. The Company periodically reviews
its investments for other than temporary impairments.

7



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Inventory

Inventory is stated at the lower of cost or market. Inventory
consists of the following (unaudited, in thousands):

|                 |       |               |       |              |  |   |       |        | 
|---------------- | ----- | ------------- | ----- | ------------ |  | - | ----- | ------ | 
|                 |       | September 30, |       | December 31,
|                 |       | 2001          |       | 2000        
|                 |       |               |       |             
|Raw materials    |       | $             | 1,989 |              |  | $ | 4,301 |       
|                
|                
|                
|                
|Work-in-progress |       |               | 158   |              |  |   | 151   |       
|                
|                
|                
|                
|Finished goods   |       |               | 4,541 |              |  |   | 9,022 |       
|                 |       |               |       |              |  |   |       |       
|                 | Total |               | $     | 6,688        |  |   | $     | 13,474 | 
|                 |       |               |       |              |  |   |       |       

Intangible Assets

Intangible assets consist of identifiable intangibles related to
the acquisition of Avesta (see Note 3). Intangible assets
consist of the following (unaudited, in thousands) and such
intangibles are amortized using the straight-line method over
the following estimated useful lives:

|                       |       |               |     |              |  |             |       |       |  |  |         |  | 
|---------------------- | ----- | ------------- | --- | ------------ |  | ----------- | ----- | ----- |  |  | ------- |  | 
|                       |       | September 30, |     | December 31, |  |            
|                       |       | 2001          |     | 2000         |  | Useful Life
|                       |       |               |     |              |  |            
|Assembled workforce    |       | $             |    |              |  | $           | 224   |       |  |  | 3 years | 
|                      
|                      
|                      
|                      
|Trademarks/ tradenames |       |               | 50  |              |  |             | 1,064 |       |  |  | 7 years | 
|                      
|                      
|                      
|                      
|Completed technology   |       |               | 148 |              |  |             | 7,222 |       |  |  | 5 years | 
|                       |       |               |     |              |  |             |       |       |  |  |         | 
|                       | Total |               | $   | 198          |  |             | $     | 8,510 |  |  |         |  | 
|                       |       |               |     |              |  |             |       |       |  |  |         | 

Long-Lived Assets

The Company reviews it long-lived assets, including property and
equipment, identifiable intangibles, and goodwill whenever
events or changes in circumstances indicate that the carrying
amount of the assets may not be fully recoverable. To determine
recoverability of its long-lived assets, the Company evaluates
the probability that future estimated undiscounted net cash
flows will be less than the carrying amount of the assets. If
future estimated undiscounted net cash flows are more likely
than not to be less than the carrying amount of the long-lived
asses, then such assets are written down to their fair value.
The Company recorded impairment charges related to its
long-lived assets of $328.8 million in the fourth quarter
of 2000 and $3.1 million in the second quarter of 2001 (see
Notes 3 and 4). The Companys estimates of anticipated
revenues and profits or the remaining estimated lives of
tangible and intangible assets, or both, could be reduced
significantly in the future. As a result, the carrying amount of
long-lived assets, including intangibles, could be further
reduced materially in the future.

Revenue Recognition

The Companys service management products and services
include hardware, software, benchmark services, professional
services and technical support. The Company generally recognizes
revenue from the sale or license of its products upon delivery
and passage of title to the customer. Where agreements provide
for evaluation or customer acceptance, the Company recognizes
revenue upon the completion of the evaluation process and
acceptance of the product by the customer. Revenue from
multiple-element software arrangements is recognized using the
residual method whereby the full fair value of undelivered
customer support and services is deferred and any residual is
allocated to the software license. The fair values of
professional services, technical support and training have been
determined based on the Companys specific objective
evidence of fair value. Maintenance contracts require the
Company to provide technical support and software

8



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

updates to customers. The Company recognizes technical support
revenue, including maintenance revenue that is bundled with
product sales, ratably over the term of the contract period,
which generally ranges from one to five years. Revenue from
services is recognized when the services are performed.
Subscription fees for the Companys benchmark reports are
recognized upon delivery of the reports.

The Company examines the specific facts and circumstances of all
sales arrangements with payment terms extending beyond its
normal payment terms to make a determination of whether the
sales price is fixed and determinable. In the quarter ended
September 30, 2001, the Company recognized software license
revenue of approximately $2.0 million on new arrangements
with previously existing customers that contain payment terms
beyond the normal payment terms. Payments become due under these
arrangements through July 2002.

The Company has agreements with certain resellers that provide
price protection in the event that more favorable prices and
terms are granted by any other customer. Reserves for estimated
price protection credits are established by the Company
concurrently with the recognition of revenue. The Company
monitors the factors that influence the pricing of its products
and reseller inventory levels and makes adjustments to these
reserves when management believes that actual price protection
credits may differ from established estimates.

Credit Risk and Significant Customers

Financial instruments that potentially subject the Company to
significant concentrations of credit risk consist principally of
cash and cash equivalents, investments and accounts receivable.
The Company primarily sells its products to large
telecommunications companies and Internet service providers
primarily in the United States. The Company grants credit terms
without collateral to its customers and has not experienced any
significant credit related losses. Accounts receivable include
allowances to record receivables at their estimated net
realizable value. For the nine months ended September 30,
2001, three customers individually represented 43%, 22% and 15%
of revenue, respectively. For the nine months ended
September 30, 2000, three customers individually
represented 23%, 17% and 12% of revenue, respectively. As of
September 30, 2001, five customers individually represented
20%, 13%, 12%, 11% and 11% of accounts receivable, respectively.

Income Taxes

The Company accounts for income taxes in accordance with SFAS
No. 109, Accounting for Income Taxes. Under
SFAS No. 109, deferred tax assets and liabilities are
computed based on the difference between the financial statement
and income tax bases of assets and liabilities using the enacted
marginal tax rate. SFAS No. 109 requires that the net
deferred tax asset be reduced by a valuation allowance if, based
on the weight of available evidence, it is more likely than not
that some portion or all of the net deferred tax asset will not
be realized.

Foreign Currency and International Operations

The functional currencies of certain of the Companys
subsidiaries are the respective local currencies. The financial
statements of these subsidiaries are translated to U.S. dollars
using period-end rates for assets and liabilities and average
rates during the relevant period for revenues and expenses.
Translation gains and losses are accumulated as a component of
other comprehensive loss in stockholders equity. Such
gains and loses have not been material.

Comprehensive Income (Loss)

The Company reports comprehensive loss in accordance with SFAS
No. 130, Reporting Comprehensive Income. SFAS
No. 130 establishes rules for the reporting and
presentation of comprehensive income (loss) and its
components. SFAS No. 130 requires foreign currency
translation adjustments and the

9



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

unrealized gains and losses on marketable securities, net of
tax, to be included in other comprehensive income (loss).
Because the Company has not had any significant components of
other comprehensive income (loss), the reported net loss does
not differ materially from comprehensive income (loss) for
the three and nine months ended September 30, 2001 and 2000.

Basic and Diluted Earnings (Loss) Per Share

SFAS No. 128, Earnings Per Share, requires dual
presentation of basic and diluted earnings (loss) per
share. Basic earnings (loss) per share includes no dilution
and is computed by dividing net income (loss) available to
common stockholders by the weighted-average number of common
shares outstanding for the period. Diluted earnings
(loss) per share includes the potential dilution that could
occur if securities or other contracts to issue common stock
were exercised or converted into common stock. Options and
warrants to purchase 8,259,120 shares of common stock that were
outstanding at September 30, 2001, were not included in the
computations of diluted loss per share for the three and nine
months ended September 30, 2001 as their effect would be
anti-dilutive. Options to purchase 8,438,707 shares of common
stock that were outstanding at September 30, 2000, were not
included in the computations of diluted loss per share for the
three or nine months ended September 30, 2000 as their
effect would be anti-dilutive.

New Accounting Pronouncements

In June 1998, the Financial Accounting Standards Board (the
FASB) issued SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities, which
establishes accounting and reporting standards requiring every
derivative instrument to be reported on the balance sheet as
either an asset or liability measured at its fair value. It
requires that changes in the derivatives fair value be
recognized currently in earnings unless specific hedge
accounting criteria are met. The Company adopted SFAS
No. 133 for the fiscal year beginning January 1, 2001
and there was no material effect on the Companys financial
position or results of operations.

In June 2001 the FASB issued SFAS No. 141,
Business Combinations, and SFAS No. 142,
Goodwill and Other Intangible Assets. SFAS
No. 141 prospectively prohibits the pooling of interest
method of accounting for business combinations initiated after
June 30, 2001. SFAS No. 142 requires companies to
cease amortizing goodwill that existed at June 30, 2001.
The amortization of existing goodwill will cease on
December 31, 2001. Any goodwill resulting from acquisitions
completed after June 30, 2001 will not be amortized. SFAS
No. 142 also establishes a new method of testing goodwill
for impairment on an annual basis or on an interim basis if an
event occurs or circumstances change that would reduce the fair
value of a reporting unit below is carrying value. The Company
is in the process of evaluating the financial statement impact
of adoption of SFAS No. 142, which will be effective
January 1, 2002.

In June 2001, the FASB issued SFAS No. 143,
Accounting for Asset Retirement Obligations. It
requires an entity to recognize the fair value of a liability
for an asset retirement obligation in the period in which it is
incurred if a reasonable estimate of fair value can be made. If
a reasonable estimate of fair value cannot be made in the period
the asset retirement obligation is incurred, the liability shall
be recognized when a reasonable estimate of fair value can be
made. This new standard is effective in the first quarter of
2003. The Company does not believe that SFAS No. 143 will
have a material effect on the Companys financial position
or results of operations.

In August 2001, the FASB issued SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived
Assets, which supersedes SFAS No. 121,
Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of. SFAS No. 144 is
effective in the first quarter of 2002. The Company does not
believe that the SFAS No. 144 will have a material effect
on the Companys financial position or results of
operations.

10



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Reclassifications

Certain prior period amounts have been reclassified to be
conform to current period presentation.

2.  Credit Agreements:

The Company has a credit facility, as amended, that includes an
asset-based arrangement providing for borrowings up to the
lesser of $10.0 million or 80% of eligible accounts
receivable (as defined in the credit facility and determined by
the bank) with a maximum of $5.0 million available for
issuing standby letters of credit, provided that it either
maintains a minimum of $10.0 million cash on deposit with
the bank, secures with cash any outstanding letters of credit,
or treats any unsecured letters of credit as borrowings. In
December 2000, our bank issued a standby letter of credit,
as amended, that expires on March 31, 2002 in the amount of
$2.5 million. The Company secured the letter of credit with
a pledge of a certificate of deposit in the amount of
$2.5 million. The bank credit facility also includes an
equipment financing facility. The Company borrowed approximately
$451,000 under the equipment financing facility, of which
approximately $412,000 is outstanding as of September 30,
2001. The borrowing is repayable over 36 months beginning
in July 2001. In September 2001, the Company also borrowed
approximately $1.7 million under the accounts
receivable-based arrangement, all of which was outstanding at
September 30, 2001. Borrowings under the equipment
financing facility and the accounts receivable-based arrangement
bear interest at prime plus 2%, which was 8.0% at
September 30, 2001. Subsequent to September 30, 2001,
the Company increased its outstanding borrowings under this
accounts receivable-based arrangement to approximately
$2.2 million. The credit facility matures on
February 28, 2002.

The credit facility contains restrictive financial covenants,
including, but not limited to, requirements related to liquidity
and operating results as well as restrictions related to other
borrowings, acquisitions, dispositions of assets, distributions
and investments. In May 2001, modifications to the credit
facility were completed that revised the financial convenants
and eliminated the Companys ability to make additional
borrowings under the equipment financing arrangement. For the
three months ended September 30, 2001, the Companys
net loss, as defined, exceeded the covenant amount permitted by
the bank. The bank has agreed to amend the facility, thereby
waiving the maximum net loss covenant for the three months ended
September 30, 2001 and reducing the minimum net income
covenant for the three months ended December 31, 2001.

3.  Avesta Acquisition:

The acquisition of Avesta was completed on May 24, 2000 and
has been accounted for as a purchase business combination. At
closing, all of the outstanding preferred and common stock of
Avesta was exchanged for 5,413,530 shares of Visual common
stock. In addition, the outstanding stock options and warrants
of Avesta were converted into options and warrants to purchase
shares of Visual common stock. During the second quarter of
2001, approximately 134,000 shares of the original merger
consideration were returned to the Company in settlement of
certain indemnification claims.

The aggregate purchase price was determined as follows (in
thousands):

|                                   |       |          |         
|---------------------------------- | ----- | -------- | --------
|                                  
|                                  
|                                  
|                                  
|Fair value of common stock         |       | $315,790
|                                  
|                                  
|                                  
|                                  
|Fair value of options and warrants |       | 62,067  
|                                  
|                                  
|                                  
|                                  
|Transaction costs and other        |       | 14,874  
|                                   |       |         
|                                   | Total |          | $392,731
|                                   |       |         

The merger resulted in an allocation of purchase price to the
net tangible and intangible assets of Avesta, as well as a
write-off of the portion of the purchase price allocated to
in-process technology. Visual allocated

11



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

the purchase price based upon the fair values of the assets and
the liabilities acquired as follows (in thousands):

|                       |       |   |         |         | 
|---------------------- | ----- | - | ------- | ------- | 
|                      
|                      
|                      
|                      
|Completed technology   |       | $ | 125,302 |        
|                      
|                      
|                      
|                      
|In-process technology  |       |   | 39,000  |        
|                      
|                      
|                      
|                      
|Assembled workforce    |       |   | 3,885   |        
|                      
|                      
|                      
|                      
|Trademarks/tradenames  |       |   | 18,455  |        
|                      
|                      
|                      
|                      
|Goodwill               |       |   | 238,723 |        
|                      
|                      
|                      
|                      
|Net tangible assets    |       |   | 1,424   |        
|                      
|                      
|                      
|                      
|Deferred tax liability |       |   | (34,058 | )      
|                       |       |   |         |        
|                       | Total |   | $       | 392,731 | 
|                       |       |   |         |        

The pro forma information presented below (unaudited, in
thousands, except per share data) reflects the Avesta
acquisition as if it occurred on January 1, 2000 but
excludes the write-off of purchased research and development of
$39.0 million. These results are not necessarily indicative
of future operating results or what would have occurred had the
acquisition been consummated on that date.

|                                           |  |                    |         |  
|------------------------------------------ |  | ------------------ | ------- | -
|                                           |  | Nine Months       
|                                           |  | Ended             
|                                           |  | September 30, 2000
|                                           |  |                   
|Pro forma net revenues                     |  | $                  | 80,260  |  
|                                          
|                                          
|                                          
|                                          
|Pro forma net loss                         |  | $                  | (69,353 | )
|                                          
|                                          
|                                          
|                                          
|Pro forma basic and diluted loss per share |  | $                  | (2.26   | )

4.  Restructuring and Impairment Charges:

In the fourth quarter of 2000, the Company recorded a
restructuring charge of approximately $7.0 million in
connection with a plan to realign its product portfolio and
streamline operations. In the second quarter of 2001, the
Company reversed approximately $723,000 of this restructuring
charge. The reversal resulted primarily from the lower than
estimated costs related to facility closings.

In the second quarter of 2001, the Company announced a plan to
discontinue development and sales efforts on the Visual Trinity
product. As a result, the Company closed its New York facility
and recorded a $3.9 million restructuring charge that
consists of approximately $1.4 million in employee
termination costs for approximately 50 employees including
severance and other benefits, $1.3 million in leases and
other contractual obligations, and the write-off of $656,000 in
investments (see Note 1) and $487,000 in leasehold
improvements and related assets. As of September 30, 2001,
$1.3 million had been charged against the restructuring
accrual. The remaining accrual is expected to be paid in 2001
and 2002.

In October 2001, the Company announced a plan for a
reduction in force of approximately 40 employees. As a result,
the Company expects to incur approximately $500,000 in related
costs during the three months ended December 31, 2001 for
severance and other benefits.

In the second quarter of 2000, the Company acquired Avesta in a
purchase business combination that resulted in approximately
$386.4 million in goodwill and other intangible assets.
During the third and fourth quarters of 2000, the Companys
results of operations deteriorated. In response to this
deterioration, the Company initiated a restructuring plan in the
fourth quarter of 2000. Due to the significance of these
developments, management performed an evaluation of the
recoverability of its long-lived assets, including those related
to the Avesta acquisition, in accordance with SFAS No. 121.
Based upon this evaluation, the Company concluded that the
remaining values of the goodwill and other intangible assets
related to the Avesta acquisition were impaired. As a result,
the Company recorded an impairment charge of $328.8 million in
the

12



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

fourth quarter of 2000. In May 2001, the Company announced
a decision to discontinue development and sales efforts on the
Visual Trinity product. As a result of this decision, management
performed another evaluation of the recoverability of its
long-lived assets, including those related to the Avesta
acquisition and concluded that the remaining intangibles were
impaired as the Trinity product was the primary product acquired
with Avesta. The Company recorded an impairment charge of
$3.1 million in the second quarter of 2001 related to the
intangibles from the Avesta acquisition. The fair values of the
remaining Avesta long-lived assets were determined based upon
the estimated discounted cash flows to be derived from the
remaining Avesta operations.

5. Revenue by Product:

In May 2001, the Company announced the release of its final
version of the Visual Trinity product. This product was the
primary product acquired with Avesta, and the Company does not
plan to continue development efforts on the Visual Trinity
product. As a result, the Company anticipates that future
revenues for the product will consist primarily of technical
support revenue, a substantial portion of which is currently in
deferred revenue. The Company plans to provide technical support
for the Visual Trinity product through September 2002.

In June 2001, the Company announced the sale of its Visual
Internet Benchmark product. The Company will recognize revenue
from the Visual Internet Benchmark product for existing
contracts, under which the Company is still required to perform
services. The Company will receive royalty payments from the
purchaser on future contracts.

Revenue consists of the following (unaudited, in thousands):

|                            |       |                   |        |               |  |   |        |        | 
|--------------------------- | ----- | ----------------- | ------ | ------------- |  | - | ------ | ------ | 
|                            |       |                  
|                            |       | Nine Months Ended
|                            |       |                  
|                            |       | September 30,     |        | September 30,
|                            |       | 2001              |        | 2000         
|                            |       |                   |        |              
|Visual UpTime               |       | $                 | 41,411 |               |  | $ | 50,361 |       
|                           
|                           
|                           
|                           
|Visual Cell Tracer          |       |                   | 2,065  |               |  |   | 8,022  |       
|                           
|                           
|                           
|                           
|Visual IP Insight           |       |                   | 6,554  |               |  |   | 7,795  |       
|                           
|                           
|                           
|                           
|Visual Internet Benchmark   |       |                   | 3,428  |               |  |   | 3,529  |       
|                           
|                           
|                           
|                           
|Visual Trinity and eWatcher |       |                   | 3,465  |               |  |   | 4,038  |       
|                            |       |                   |        |               |  |   |        |       
|                            | Total |                   | $      | 56,923        |  |   | $      | 73,745 | 
|                            |       |                   |        |               |  |   |        |       

6.  Commitments and Contingencies:

Litigation

In July, August and September 2000, several purported class
action complaints were filed against the Company and certain of
the Companys executives. The complaints allege that
between February 7, 2000 and August 23, 2000, the
defendants made false and misleading statements which had the
effect of inflating the market price of the Companys
stock, in violation of Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934. The complaints do not specify
the amount of damages sought. On October 11, 2001, the
court appointed a lead plaintiff and set a schedule for the next
steps in the litigation. Pursuant to this schedule, the lead
plaintiff filed a consolidated complaint on November 9,
2001. The Companys Motion to Dismiss, which the Company
expects, but is not required to file, must be filed by
December 10, 2001. The Company believes that the
plaintiffs claims are without merit and intends to defend
against these allegations vigorously. The Company expects that a
substantial portion of the legal costs that it might incur
related to this matter will be paid by its directors and
officers insurance policy. The Company cannot presently
determine the ultimate outcome of this action. A negative
outcome could have a material adverse effect on the
Companys financial

13



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

position or results of operations. Failure to prevail in the
litigation could result in, among other things, the payment of
substantial monetary or punitive damages.

In October 1997, a lawsuit was filed against Avesta and one
of its employees alleging infringement of two patents, unfair
competition, breach of contract and interference with
contractual relations resulting in unjust enrichment. Avesta
answered the complaint, denying all allegations, and also
asserted counterclaims against the plaintiff for patent misuse,
unfair competition and interference with business and patent
invalidity. Pursuant to an agreement between the parties, on
June 13, 2001, the court dismissed the action without
prejudice, preserving to the parties the right to refile the
action pending future developments of the Visual Trinity product.

Item 2.  Managements Discussion and
Analysis of Financial Condition and Results of Operations

Overview

From our incorporation in August 1993 through
December 1996, our principal objective was to secure
sufficient equity financing to enable us to accelerate product
development efforts of Visual UpTime for Frame Relay deployment
and to develop our sales and marketing functions and general and
administrative infrastructure. Visual UpTime was first shipped
in mid-1995. We began generating significant revenue from sales
of Visual UpTime during 1996. In August 1996, we entered
into a master reseller agreement with Sprint, resulting in our
products being sold through Sprint to subscribers. In
October 1997, we entered into a similar master reseller
agreement with WorldCom, which also resulted in our shipment of
products through WorldCom to subscribers. In December 1997,
we entered into an agreement with AT&T, which provides for
the sale of our products to AT&T for deployment as part of
AT&Ts infrastructure. During 1998, 1999 and 2000, we
continued to focus on selling Visual UpTime, and added the
following products to our product portfolio as a result of a
series of acquisitions  the Cell Tracer product in
1998; Visual IP Insight and Visual Internet Benchmark, in 1999;
and the Avesta products, Visual Trinity and Visual eWatcher, in
2000. During the second quarter of 2001, the Company announced
the discontinuation of development efforts and the final version
release of the Visual Trinity product and the sale of the Visual
Internet Benchmark product.

We realize revenue from sales of hardware, software, benchmark
services, professional services and technical support. We
generally recognize revenue from the sale or license of our
products upon delivery of the product and passage of title to
the customer. Where the agreements provide for evaluation or
customer acceptance, we recognize revenue upon the completion of
the evaluation process and acceptance of the product by the
customer. Revenue from multiple element software arrangements is
recognized using the residual method whereby the full fair value
of undelivered customer support and services is deferred and any
residual is allocated to the software license. The fair values
of professional services, technical support and training have
been determined based on our specific objective evidence of fair
value. Maintenance contracts require us to provide technical
support and software updates to customers. We recognize
maintenance revenue, including maintenance revenue that is
bundled with product sales, ratably over the lengths of the
maintenance contracts, which currently range from one to five
years. Revenue from services is recognized when the services are
performed. Subscription fees for our benchmark reports are
deferred and recognized upon delivery of the reports. We
currently contract with third party subcontract manufacturers
for most of the assembly, testing and shipping of our products.
We anticipate maintaining a portion of our internal
manufacturing function for the foreseeable future at our
Rockville, Maryland facility.

Our revenues decreased from 1999 to 2000 while our operating
expenses increased resulting in significant losses from
operations. With the acquisition of Avesta in May 2000 we
allowed our business strategy to become less focused, which
increased the complexity of our business and adversely affected
our results of operations. In an attempt to refocus our efforts,
we announced a plan in the fourth quarter of 2000 to realign our
product portfolio, streamline our operations and devote
resources to the markets and products that offer us the greatest
growth opportunities. In May 2001, we decided to
discontinue development and sales efforts on

14



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##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

the Visual Trinity product. This plan includes the closure of
the New York facility and elimination of the related costs. As a
result of these restructurings, our operating results improved
in 2001. Operating expenses, excluding non-cash Avesta related
amortization and impairment charges and restructuring charges,
decreased from $24.0 million in the fourth quarter of 2000
to $17.9 million in the first quarter of 2001 to
$16.9 million in the second quarter of 2001 to
$15.1 million in the third quarter of 2001.

In connection with these plans, we recorded a restructuring
charge of $7.0 million in the fourth quarter of 2000. We
reversed $0.7 million of that charge in the second quarter
of 2001 due primarily to lower than estimated costs related to
facility closures. We recorded a second restructuring charge of
$3.9 million in the second quarter of 2001 as a result of
our decision to discontinue development and sales efforts on the
Visual Trinity product. During the fourth quarter of 2001, we
announced another reduction in force of approximately 40 people
and anticipate that we will incur approximately $500,000 in
related costs during the three months ended December 31,
2001 for severance and other benefits. We believe that this
action will further reduce operating expenses. The failure to
successfully implement our plans would have a material adverse
effect on our business, financial condition and results of
operations. We anticipate that our plans will be fully executed
by the end of 2001.

Results of Operations for the Three Months Ended
September 30, 2001 Compared with the Three Months Ended
September 30, 2000

Revenue. We recognized $19.2 million in
revenue for the three months ended September 30, 2001, a
31.5% increase from revenue of $14.6 million for the three
months ended September 30, 2000. Revenue for the three
months ended September 30, 2001 and 2000 was comprised of
the following (in thousands):

|                            |       |                    |        |               |  |   |       |        | 
|--------------------------- | ----- | ------------------ | ------ | ------------- |  | - | ----- | ------ | 
|                            |       |                   
|                            |       | Three Months Ended
|                            |       |                   
|                            |       | September 30,      |        | September 30,
|                            |       | 2001               |        | 2000         
|                            |       |                    |        |              
|Visual UpTime               |       | $                  | 13,347 |               |  | $ | 9,042 |       
|                           
|                           
|                           
|                           
|Visual Cell Tracer          |       |                    | 736    |               |  |   | 767   |       
|                           
|                           
|                           
|                           
|Visual IP Insight           |       |                    | 3,813  |               |  |   | 1,521 |       
|                           
|                           
|                           
|                           
|Visual Internet Benchmark   |       |                    | 770    |               |  |   | 1,129 |       
|                           
|                           
|                           
|                           
|Visual Trinity and eWatcher |       |                    | 542    |               |  |   | 2,148 |       
|                            |       |                    |        |               |  |   |       |       
|                            | Total |                    | $      | 19,208        |  |   | $     | 14,607 | 
|                            |       |                    |        |               |  |   |       |       

The overall increase in revenue was primarily due to an increase
in Visual Uptime revenue of $4.3 million, primarily from
service providers, an increase in Visual IP Insight revenue of
$2.3 million, offset by a decrease in Visual Internet
Benchmark of $0.4 million and a decrease in Visual Trinity
and eWatcher of $1.6 million. The decrease in sales of
Visual Internet Benchmark and Visual Trinity is due to the
discontinuation of these product lines in the second quarter of
2001. Sales to service providers accounted for approximately 77%
and 70% of revenue for the three months ended September 30,
2001 and 2000, respectively.

In May 2001, we announced the release of our final version
of the Visual Trinity product. This product was the primary
product acquired with Avesta, and we do not plan to continue
development efforts on the Visual Trinity product. As a result,
we anticipate that future revenues for the product will consist
primarily of technical support revenue, a substantial portion of
which is currently in deferred revenue. We plan to provide
technical support for the Visual Trinity product through
September 2002.

15



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##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

In June 2001, we announced the sale of our Visual Internet
Benchmark product. We will recognize revenue from the Visual
Internet Benchmark product for existing contracts, under which
we are still required to perform services. We will receive
royalty payments from the purchaser on future contracts.

Gross Profit. Cost of revenue consists of
subcontracting costs, component parts, direct compensation
costs, communication costs, warranty and other contractual
obligations, royalties, license fees and other overhead expenses
related to our manufacturing operations and to supporting our
software products and benchmark services. Gross profit was
$12.1 million for the three months ended September 30,
2001, as compared to $7.1 million for the three months
ended September 30, 2000, an increase of $5.0 million.
Gross margin was 63.0% of revenue for the three months ended
September 30, 2001, as compared to 48.6% of revenue for the
three months ended September 30, 2000. The increase in
gross margin percentage was due primarily to $1.0 million
in inventory write-downs during the three months ended
September 30, 2000 and, to a lesser extent, an increase in
the higher margin software sales of Visual IP Insight during the
three months ended September 30, 2001. Our future gross
margins may be adversely affected by a number of factors,
including product mix, the proportion of sales to providers,
competitive pricing, manufacturing volumes and an increase in
component part costs.

Research and Development Expense. Research and
development expense consists of compensation for research and
development staff, depreciation of test and development
equipment, certain software development costs and costs of
prototype materials. Research and development expense was
$4.6 million for the three months ended September 30,
2001, as compared to $8.2 million for the three months
ended September 30, 2000, a decrease of $3.6 million.
The decrease in research and development expense was due
primarily to the workforce reductions, facility closures and
other reductions resulting from our fourth quarter 2000 and
second quarter 2001 restructurings. Research and development
expense was 23.7% and 56.0% of revenue for the three months
ended September 30, 2001 and 2000, respectively. We expect
that research and development expenditures may remain at current
levels or continue to decrease in absolute dollars and may
decrease as a percentage of revenue, during the remainder of
2001. The decrease in absolute dollars is primarily expected to
result from our second quarter 2001 and fourth quarter 2001
workforce reductions.

Sales and Marketing Expense. Sales and marketing
expense consists of compensation for the sales and marketing
staff, commissions, pre-sales support, travel and entertainment,
trade shows and other marketing programs. Sales and marketing
expense was $8.4 million for the three months ended
September 30, 2001, as compared to $12.7 million for
the three months ended September 30, 2000, a decrease of
$4.3 million. The decrease in sales and marketing expense
was due primarily to the workforce reductions, facility closures
and other reductions resulting from our fourth quarter 2000 and
second quarter 2001 restructurings. Sales and marketing expense
was 43.8% and 87.0% of revenue for the three months ended
September 30, 2001 and 2000, respectively. We expect that
sales and marketing expenditures may remain at current levels or
continue to decrease in absolute dollars and may decrease as a
percentage of revenue, during the remainder of 2001. The
decrease in absolute dollars is primarily expected to result
from our second quarter 2001 and fourth quarter 2001 workforce
reductions.

General and Administrative Expense. General and
administrative expense consists of finance, administration and
general management activities. General and administrative
expense was $2.1 million for the three months ended
September 30, 2001, as compared to $3.4 million for
the three months ended September 30, 2000, a decrease of
$1.3 million. The decrease in general and administrative
expense was due to the workforce reductions, facility closures
and other reductions resulting from our fourth quarter 2000 and
second quarter 2001 restructurings. General and administrative
expense was 11.0% and 23.2% of revenue for the three months
ended September 30, 2001 and 2000, respectively. We expect
that general and administrative expenditures may remain at
current levels or decrease in absolute dollars and may decrease
as a percentage of revenue,

16



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##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

during the remainder of 2001. This decrease in absolute dollars
is primarily expected to result from our second quarter 2001 and
fourth quarter 2001 workforce reductions.

Amortization of Acquired Intangibles. The Company
recorded $13,000 in amortization of intangibles during the three
months ended September 30, 2001.

Interest Income, Net. Interest income, net, for
the three months ended September 30, 2001, was
approximately $10,000 as compared to $0.8 million for the
three months ended September 30, 2000, a decrease of
$0.8 million. The decrease was primarily due to decreased
cash and investment balances.

Income Taxes. There was no income tax benefit for
the three months ended September 30, 2001 due to increases
in the valuation allowance. The benefit for income taxes for the
three months ended September 30, 2000, was
$7.7 million.

Net Loss. Net loss for the three months ended
September 30, 2001, was $3.0 million as compared to
$30.7 million for the three months ended September 30,
2000, a decrease of $27.7 million. This decrease was due
primarily to the increase in gross profit of $5.0 million,
the decrease in operating expense of $9.2 million, the
decrease in goodwill and other intangible asset amortization of
$22.0 million, offset by the decrease in interest income of
$0.8 million and the decrease in tax benefit of
$7.7 million.

Results of Operations for the Nine Months Ended
September 30, 2001 Compared with the Nine Months Ended
September 30, 2000

Revenue. We recognized $56.9 million in
revenue for the nine months ended September 30, 2001, a
22.8% decrease from revenue of $73.7 million for the nine
months ended September 30, 2000. Revenue for the nine
months ended September 30, 2001 and 2000 was comprised of the
following (in thousands):

|                            |       |                   |        |               |  |   |        |        | 
|--------------------------- | ----- | ----------------- | ------ | ------------- |  | - | ------ | ------ | 
|                            |       |                  
|                            |       | Nine Months Ended
|                            |       |                  
|                            |       | September 30,     |        | September 30,
|                            |       | 2001              |        | 2000         
|                            |       |                   |        |              
|Visual UpTime               |       | $                 | 41,411 |               |  | $ | 50,361 |       
|                           
|                           
|                           
|                           
|Visual Cell Tracer          |       |                   | 2,065  |               |  |   | 8,022  |       
|                           
|                           
|                           
|                           
|Visual IP Insight           |       |                   | 6,554  |               |  |   | 7,795  |       
|                           
|                           
|                           
|                           
|Visual Internet Benchmark   |       |                   | 3,428  |               |  |   | 3,529  |       
|                           
|                           
|                           
|                           
|Visual Trinity and eWatcher |       |                   | 3,465  |               |  |   | 4,038  |       
|                            |       |                   |        |               |  |   |        |       
|                            | Total |                   | $      | 56,923        |  |   | $      | 73,745 | 
|                            |       |                   |        |               |  |   |        |       

The overall decrease in revenue was primarily due to a decrease
in Visual Uptime revenue of $9.0 million, primarily from
service providers, a decrease in Visual Cell Tracer of
$6.0 million from one customer, a decrease in Visual IP
Insight revenue of $1.2 million and a decrease in Visual
Trinity of $0.6 million. The decrease in sales of Visual
Uptime and Visual Cell Tracer was primarily attributable to a
change in purchasing behavior of our major customers. The
decrease in Visual Trinity and eWatcher is due to our decision
to discontinue sales of Visual Trinity. Sales to service
providers accounted for approximately 80% and 76% of revenue for
the nine months ended September 30, 2001 and 2000, respectively.

Gross Profit. Gross profit was $33.6 million
for the nine months ended September 30, 2001, as compared
to $47.5 million for the nine months ended
September 30, 2000, a decrease of $13.9 million. Gross
margin was 59.0% of revenue for the nine months ended
September 30, 2001, as compared to 64.3% of revenue for the
nine months ended September 30, 2000. The decrease in gross
margin percentage was due primarily to higher fixed product
support and manufacturing costs supporting a lower revenue base,
the decrease in the higher margin software sales of Visual IP
Insight and Visual Trinity and an increase in inventory
write-downs of approximately $900,000, offset in part by the
Avesta acquisition in 2000.

17



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##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Research and Development Expense. Research and
development expense was $15.7 million for the nine months
ended September 30, 2001, as compared to $19.5 million
for the nine months ended September 30, 2000, a decrease of
$3.8 million. The decrease in research and development
expense was due primarily to the workforce reductions, facility
closures and other reductions resulting from our fourth quarter
2000 and second quarter 2001 restructurings, offset in part by
the Avesta acquisition in 2000. Research and development expense
was 27.6% and 26.4% of revenue for the nine months ended
September 30, 2001 and 2000, respectively.

Write-off of Purchased Research and Development. A
write-off of purchased research and development costs of
$39.0 million was recorded in the three months ended
September 30, 2000. We recorded this expense in connection
with the acquisition of Avesta. At the date of acquisition,
Avesta had in-process technology which represented research and
development projects of Avesta that had not reached
technological feasibility and that had no alternative future use
in research and development activities or otherwise. Amounts
assigned to in-process research and development meeting the
above criteria must be charged to expense at the date of
consummation of the purchase business combination.

Sales and Marketing Expense. Sales and marketing
expense was $27.0 million for the nine months ended
September 30, 2001, as compared to $29.0 million for the
nine months ended September 30, 2000, a decrease of $2.0
million. The decrease in sales and marketing expense was due
primarily to the decreases resulting from workforce reductions,
facility closures and other reductions resulting from our fourth
quarter 2000 and second quarter 2001 restructurings, offset in
part by the Avesta acquisition in 2000. Sales and marketing
expense was 47.4% and 39.3% of revenue for the nine months ended
September 30, 2001 and 2000, respectively.

General and Administrative Expense. General and
administrative expense was $7.1 million for the nine months
ended September 30, 2001, as compared to $8.0 million
for the nine months ended September 30, 2000, a decrease of
$0.9 million. The decrease in general and administrative
expense was due primarily to the decreases resulting from
workforce reductions, facility closures and other reductions
resulting from our revised strategic focus initiated in the
fourth quarter of 2000 and our second quarter 2001
restructuring, offset in part by the Avesta acquisition in 2000.
General and administrative expense was 12.5% and 10.9% of
revenue for the nine months ended September 30, 2001 and
2000, respectively.

Restructuring and Impairment Charges. We reversed
approximately $0.7 million of the fourth quarter 2000
restructuring charge in the nine months ended September 30,
2001. The reversal resulted primarily from the lower than
estimated costs related to facility closings. We recorded a
restructuring charge in the nine months ended September 30,
2001 in the amount of $3.9 million related primarily to a
workforce reduction of approximately 50 employees and the
closure of the New York facility as a result of our plans to
discontinue development and sales efforts on the Visual Trinity
product. We recorded an impairment charge of $3.1 million
in the nine months ended September 30, 2001 for the
write-off of intangible assets related to the Avesta acquisition
(see Notes 3 and 4 of Notes to Consolidated Financial
Statements).

Amortization of Acquired Intangibles. The Company
recorded approximately $0.8 million in amortization of
intangibles related to the acquisition of Avesta during the nine
months ended September 30, 2001.

Interest Income, Net. Interest income, net, for
the nine months ended September 30, 2001, was approximately
$0.4 million as compared to $2.1 million for the nine
months ended September 30, 2000, a decrease of
$1.7 million. The decrease was primarily due to decreased
cash and investment balances.

Income Taxes. There was no income tax benefit for
the nine months ended September 30, 2001 due to increases
in the valuation allowance. The benefit for income taxes for the
nine months ended September 30, 2000, was $9.2 million.

18



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##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Net Loss. Net loss for the nine months ended
September 30, 2001, was $23.0 million as compared to
$67.5 million for the nine months ended September 30, 2000,
a decrease of $44.5 million. This decrease was due
primarily to the $39.0 million write-off of purchased
research and development, the decrease in operating expenses of
$6.6 million and the decrease in goodwill and other
intangible asset amortization of $30.0 million, offset by a
decrease in gross profit of $13.9 million and restructuring
and impairment charges of $6.3 million.

Liquidity and Capital Resources

At September 30, 2001, our combined balance of cash and
cash equivalents was $5.4 million as compared to
$17.4 million as of December 31, 2000, a decrease of
$12.0 million. This decrease is primarily attributable to
cash used in operations, including the payment of a portion of
the restructuring charges recorded in the prior year. Net cash
used in operating activities for the nine months ended
September 30, 2001 was $19.8 million. During this
period, we also used cash of $529,000 to purchase equipment and
other fixed assets, and we made principal payments on capital
lease obligations of $437,000. Cash was provided from the
maturities of short-term investments of $5.9 million, the
sale of common stock pursuant to the exercise of employee stock
options and our employee stock purchase plan of $834,000, and
borrowings from our bank of $2.1 million.

We require substantial working capital to fund our core
business, particularly to finance inventories, accounts
receivable, research and development activities and capital
expenditures. We currently anticipate that capital expenditures
for 2001 will not exceed $1.0 million. To date, we have
financed our operations and capital expenditures primarily with
the proceeds from our initial public offering completed in
February 1998 and from our operating income generated
through the first quarter of 2000. In 2001, as discussed above,
we have become dependent on cash that has been provided by our
bank under our credit facility.

The credit facility, as amended, includes an asset-based
arrangement providing for borrowings up to the lesser of
$10.0 million or 80% of eligible accounts receivable (as
defined in the credit facility and determined by the bank) with
a maximum of $5.0 million available for issuing standby
letters of credit, provided that we either maintain a minimum of
$10.0 million cash on deposit with the bank, secure with
cash any outstanding letters of credit, or treat any unsecured
letters of credit as borrowings. In December 2000, our bank
issued a standby letter of credit, as amended, that expires on
March 31, 2002 in the amount of $2.5 million. We
secured the letter of credit with a pledge of a certificate of
deposit in the amount of $2.5 million. Our bank credit
facility also includes an equipment financing facility. We
borrowed approximately $451,000 under the equipment financing
facility, of which approximately $412,000 is outstanding as of
September 30, 2001. The borrowing is repayable over
36 months beginning in July 2001. In September 2001,
we also borrowed approximately $1.7 million under the
accounts receivable-based arrangement, all of which was
outstanding at September 30, 2001. Borrowings under the
equipment financing facility and the accounts receivable-based
arrangement bear interest at prime plus 2%, which was 8.0% at
September 30, 2001. Subsequent to September 30, 2001,
we increased our outstanding borrowings under this accounts
receivable-based arrangement to approximately $2.2 million.
The credit facility matures on February 28, 2002. At
September 30, 2001, we believe that we would have had the
ability to borrow an additional $1.6 million under the
credit facility.

The credit facility contains restrictive financial covenants,
including, but not limited to, requirements related to liquidity
and operating results as well as restrictions related to other
borrowings, acquisitions, dispositions of assets, distributions
and investments. In May 2001, modifications to the credit
facility were completed that revised the financial covenants and
eliminated our ability to make additional borrowings under the
equipment financing arrangement. For the three months ended
September 30, 2001, our net loss, as defined, exceeded the
covenant amount permitted by the bank. The bank has agreed to
amend the facility, thereby waiving the maximum net loss
covenant for the three months ended September 30, 2001 and
reducing the minimum net income covenant for the three months
ended December 31, 2001. Based on our current

19



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

expectations of operating results and cash availability, we
believe that we will comply with the revised financial covenants
of the credit facility for the remainder of the facilitys
term.

The deterioration of our operating results in 2000, excluding
the effects of the non-cash Avesta-related charges and the
restructuring charge, was due primarily to decreased revenue and
increased operating expenses. In response to the trends, we
initiated a restructuring plan in the fourth quarter of 2000 to
realign our product portfolio, streamline our operations and
devote resources to the markets and products that we believe
have the greatest opportunity for growth. In the second quarter
of 2001, we announced a plan to discontinue development and
sales efforts on the Visual Trinity product and eliminate the
related costs. As a result of the plans, operating expenses,
excluding the non-cash Avesta-related amortization and
impairment charges and restructuring charges, decreased from
$24.0 million in the fourth quarter of 2000 to $17.9
million in the first quarter of 2001 to $16.9 million in
the second quarter of 2001 to $15.1 million in the third
quarter of 2001. In the fourth quarter of 2001, we announced a
plan to further reduce our workforce by approximately
40 employees. Our ability to generate operating income in
the future is, in large part, dependent upon our success in
achieving our revenue goals and reducing operating expenses.
There can be no assurances that we will be able to meet our
revenue goals in the future due to market conditions,
competitive pressures and other factors beyond our control. We
believe that our fourth quarter 2001 reduction in force will
result in a further reduction in operating expenses that, when
combined with the anticipated revenue goals, will result in a
return to profitability in the first quarter of 2002. In the
event that the anticipated cost reductions are not realized or
revenue goals are not met, we may be required to further reduce
our cost structure. There can be no assurance that we will
become profitable.

Our success is also dependent on our ability to generate
adequate cash for operating and capital needs. We are relying on
our existing cash and cash equivalents, investments and credit
facility together with future sales and the collection of the
related accounts receivable to meet our future cash
requirements. If cash provided by these sources is not
sufficient to fund future operations, we will be required to
further reduce our expenditures for operations or to seek
additional capital through other means that may include the sale
of assets, the sale of equity securities or additional
borrowings. Although we believe that we have the ability to
generate additional cash through such actions, the results of
such actions may be dilutive. There can be no assurance that
additional capital will be available, or available on terms that
are reasonable or acceptable to us. If we are unable to generate
additional cash, our business and financial condition would be
materially and adversely affected such that we may need to
consider other alternatives for our future.

Factors That May Affect Future Results

The Company incurred a net loss of $23.0 million for the
nine months ended September 30, 2001 and a net loss of
$415.5 million for the year ended December 31, 2000. The
net loss for the year ended December 31, 2000 included an
impairment charge of $328.8 million for the write-off of
goodwill and other intangibles related to the Avesta
Technologies, Inc. acquisition. The deterioration of our
operating results in 2000, excluding the effects of the non-cash
Avesta-related charges and the restructuring charge, was due
primarily to decreased revenue and increased operating expenses.
In response to these trends, we initiated a restructuring plan
in the fourth quarter of 2000 to realign our product portfolio,
streamline our operations and devote resources to the markets
and products that we believe have the greatest opportunity for
growth. In the second quarter of 2001, we announced a plan to
discontinue development and sales efforts on the Visual Trinity
product and eliminate the related costs. As a result of the
plans, operating expenses, excluding the non-cash Avesta-related
amortization and impairment charges and restructuring charges,
decreased from $24.0 million in the fourth quarter of 2000
to $17.9 million in the first quarter of 2001 to
$16.9 million in the second quarter of 2001 to
$15.1 million in the third quarter of 2001. In the fourth
quarter of 2001, we implemented a plan to further reduce our
workforce by approximately 40 employees. Our ability to generate
operating income in the future is, in large part, dependent upon
our success in achieving revenue goals and reducing operating
expenses. There can be no assurances that we will be able to
achieve our revenue goals in

20



---



##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

the future due to market conditions, competitive pressures and
other factors beyond our control. We believe that our fourth
quarter 2001 reduction in force will result in a further
reduction in operating expenses that, when combined with the
anticipated revenue goals, will result in a return to
profitability in the first quarter of 2002. In the event that
the anticipated cost reductions are not realized or revenue
goals are not met, we may be required to further reduce our cost
structure. There can be no assurance that we will become
profitable.

Our revenue in any period depends primarily on the volume and
timing of orders received during the period, which are difficult
to predict. Our expense levels are based, in part, on the
expectation of future revenue. Results of operations may be
affected disproportionately by a reduction in revenue because a
large portion of our expenses are fixed and cannot be easily
reduced without adversely affecting our business. If revenue
levels, particularly in the fourth quarter, are below
expectations due to delays associated with customers
decision-making processes or for any other reason, operating
results and our cash balances may be adversely affected.

We have outsourced the major portion of our manufacturing to a
single subcontract-manufacturing firm that builds products based
on our purchase orders and other forecasts of future business.
The credit and inventory exposure incurred by this firm is
reduced by the $2.5 million irrevocable letter of credit
discussed above that has been issued on its behalf. However, our
ability to obtain products is dependent on the subcontract
manufacturers grant of credit to us over and above the
amount of the letter of credit. Should we become unable to make
timely payments to the subcontract manufacturer, we may have our
credit reduced or eliminated. If shipments are suspended, we may
be forced to obtain products from alternative sources if they
are available, which could impair our ability to deliver our
products to our customers in a timely and cost-effective manner.
This could have an adverse effect on our business, financial
condition and results of operations and could jeopardize our
relationships with those customers.

The market for our products is growing rapidly and our business
environment is characterized by rapid technological changes,
changes in customer requirements and new emerging market
segments. Consequently, to compete effectively, we must make
frequent new product introductions and enhancements and deploy
sales and marketing resources to take advantage of new business
opportunities. Our operations are also subject to certain other
risks and uncertainties including, among other things,
successful implementation of new strategic business initiatives,
failure of broadband access services to achieve market
penetration, lack of profitability, inability to sustain
historical revenue trends, successful incorporation of products
into service provider company infrastructure, long sales cycles,
dependence on significant customers, rapidly changing
technology, current and potential competitors with greater
financial, technological, production, and marketing resources,
dependence on sole and limited source suppliers, dependence on
key management personnel, inability to recruit and retain
employees, limited protection of intellectual property and
proprietary rights, uncertainty of future profitability and
possible fluctuations in financial results. Failure to meet any
of these challenges could adversely affect future operating
results.

Although a significant majority of our sales to date have been
made to customers in the United States, we intend to continue
our sales efforts in other international markets. We plan to
sell our products to international customers at prices
denominated in U.S. dollars. However, if we experience material
levels of sales at prices not denominated in U.S. dollars, we
intend to adopt a strategy to hedge against currency
fluctuations.

The preparation of financial statements in conformity with
generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts
of assets and

21



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##### 



VISUAL NETWORKS, INC.


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

liabilities and disclosure of contingent assets and liabilities
at the date of the financial statements and the reported amounts
of revenues and expenses during the reporting periods. Actual
results could differ from those estimates.

The foregoing discussion contains forward-looking information
within the meaning of Section 27A of the Securities Act of
1933 and Section 21E of the Securities Exchange Act of
1934, and is subject to the safe harbor created by those
sections. Our future results may be impacted by various
important factors including, but not limited to, successful
implementation of new business strategic initiatives, failure of
broadband access services to achieve market penetration, lack of
profitability, inability to sustain historical revenue trends,
successful incorporation of products into service provider
company infrastructure, long sales cycles, dependence on
significant customers, rapidly changing technology, current and
potential competitors with greater financial, technological,
production, and marketing resources, dependence on sole and
limited source suppliers, dependence on key management
personnel, ability to recruit and retain employees, limited
protection of intellectual property and proprietary rights,
integration of acquisitions, uncertainty of future profitability
and possible fluctuations in financial results, and other risk
factors set forth in our Annual Report on Form 10-K for the
year ended December 31, 2000.

Item 3.  Qualitative and Quantitative
Disclosure About Market Risk

We have existing obligations relating to our bank credit
facility outstanding. This financial instrument exposes us to
interest rate risk. As disclosed in Note 2 of our
consolidated financial statements, which are included as part of
this report, we had $2.1 million in variable rate debt
under our equipment financing facility and our accounts
receivable-based arrangement as of September 30, 2001. The
significant terms of our instruments are fully disclosed in
Note 2 to the consolidated financial statements. We are not
currently engaged in the use of off-balance sheet derivative
financial instruments to hedge or partially hedge interest rate
exposure arising from changes in interest rates.

22



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##### 



PART II  OTHER INFORMATION

Item  1.  Legal Proceedings

In July, August and September 2000, several purported class
action complaints were filed against the Company and certain of
the Companys executives. The complaints alleges that
between February 7, 2000 and August 23, 2000, the
defendants made false and misleading statements which had the
effect of inflating the market price of the Companys
stock, in violation of Sections 10(b) and 20 (a) of
the Securities Exchange Act of 1934. The complaints do not
specify the amount of damages sought. On October 11, 2001,
the court appointed a lead plaintiff and set a schedule for the
next steps in the litigation. Pursuant to this schedule, the
lead plaintiff filed a consolidated complaint on
November 9, 2001. The Companys Motion to Dismiss,
which the Company expects, but is not required to file, must be
filed by December 10, 2001. The Company believes that the
plaintiffs claims are without merit and intends to defend
against these allegations vigorously. The Company expects that a
substantial portion of the legal costs that it might incur
related to this matter will be paid by its directors and
officers insurance policy. The Company cannot presently
determine the ultimate outcome of this action. A negative
outcome could have a material adverse effect on the
Companys financial position or results of operations.
Failure to prevail in the litigation could result in, among
other things, the payment of substantial monetary or punitive
damages.

In October 1997, a lawsuit was filed against Avesta and one
of its employees alleging infringement of two patents, unfair
competition, breach of contract and interference with
contractual relations resulting in unjust enrichment. Avesta
answered the complaint, denying all allegations, and also
asserted counterclaims against the plaintiff for patent misuse,
unfair competition and interference with business and patent
invalidity. Pursuant to an agreement between the parties, on
June 13, 2001, the court dismissed the action without
prejudice, preserving to the parties the right to refile the
action pending future developments of the Visual Trinity product.

Item  2.  Changes in Securities and Use of
Proceeds

None.

Item  3.  Defaults Upon Senior
Securities

None.

Item  4.  Submission of Matters to Vote of
Security Holders

None.

Item  5.  Other Information

None.

23



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##### 



Item  6.  (a) Exhibits

|        |  |                     |  |                                                                                                                                                                                                                            
|------- |  | ------------------- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|        |  |                    
|Exhibit |  |                    
|Number  |  | Exhibit Description
|        |  |                    
|3.1     |  | $                   |  | Amended and Restated Certificate of Incorporation
        of the Company.                                                                                                                                                  
|3.1.1   |  | @                   |  | Certificate of Amendment to Amended and Restated
        Certificate of Incorporation.                                                                                                                                     
|3.2     |  | *                   |  | Restated By-Laws of the Company.                                                                                                                                                                                           
|10.1    |  | *                   |  | 1994 Stock Option Plan.                                                                                                                                                                                                    
|10.2    |  | *                   |  | 1997 Omnibus Stock Plan, as amended.                                                                                                                                                                                       
|10.3    |  | *                   |  | Amended and Restated 1997 Directors Stock
        Option Plan.                                                                                                                                                            
|10.4    |  | !!                  |  | 2000 Stock Incentive Plan, as amended.                                                                                                                                                                                     
|10.5    |  | *                  |  | Reseller/ Integration Agreement, dated
        August 29, 1997, by and between the Company and MCI
        Telecommunications Corporation.                                                                                 
|10.5.1  |  | $$$               |  | Second Amendment, dated November 4, 1998, to
        the Reseller/ Integration Agreement between the Company and MCI
        Telecommunications Corporation (relating to Exhibit 10.5).                                    
|10.6    |  | ****              |  | Master Purchase of Equipment and Services
        Agreement, dated as of May 22, 2000, between Sprint/ United
        Management Company and the Company.                                                                  
|10.7    |  | *                  |  | General Agreement for the Procurement of
        Equipment, Services and Supplies, dated November 26, 1997,
        between the Company and AT&T Corp.                                                                     
|10.8    |  | *                   |  | Lease Agreement, dated December 12, 1996, by
        and between the Company and The Equitable Life Assurance Society
        of the United States.                                                                        
|10.8.1  |  | *                   |  | Lease Amendment, dated September 2, 1997, by
        and between the Company and The Equitable Life Assurance Society
        of The United States (related to Exhibit 10.8).                                              
|10.8.2  |  | $$$                 |  | Second Lease Amendment, dated February 8,
        1999, by and between the Company and TA/ Western, LLC, successor
        to The Equitable Life Assurance Society of The United States
        (relating to Exhibit 10.8).
|10.8.3  |  | ***                 |  | Third Lease Amendment, dated January 10,
        2000, by and between the Company and TA/ Western, LLC (relating
        to Exhibit 10.8).                                                                                 
|10.8.4  |  | !!                  |  | Fourth Lease Amendment, dated May 17, 2000,
        by and between the Company and TA/ Western, LLC (relating to
        Exhibit  10.8).                                                                                   
|10.10   |  | *                   |  | Employment Agreement, dated December 15,
        1994, by and between the Company and Scott E. Stouffer, as
        amended.                                                                                               
|10.11   |  | !!                  |  | Lease Agreement, dated April 7, 2000, by and
        between Visual Networks, Inc. and TA/ Western, LLC.                                                                                                                   
|10.12   |  | *                   |  | Terms of Employment, dated June 11, 1997, by
        and between the Company and Peter J. Minihane, as amended.                                                                                                            
|10.17   |  | **                  |  | Net2Net 1994 Stock Option Plan.                                                                                                                                                                                            
|10.20   |  | $$                  |  | 1999 Employee Stock Purchase Plan, as amended
        April 11, 2001.                                                                                                                                                      
|10.22   |  | %%                  |  | Inverse Network Technology 1996 Stock Option Plan.                                                                                                                                                                         
|10.23   |  | @                   |  | Merger Agreement, dated February 7, 2000, by
        and among Visual Networks, Inc., Visual Acquisitions Three, Inc.
        and Avesta Technologies, Inc.                                                                
|10.23.1 |  | !!                  |  | Avesta Technologies 1996 Stock Option Plan.                                                                                                                                                                                
|10.24   |  | ****                |  | Loan and Security Agreement, dated
        February 28, 2001, by and between Silicon Valley Bank and
        the Company.                                                                                                  
|10.24.1 |  | !!!                 |  | First Loan Modification to the Loan and Security
        Agreement, dated May 24, 2001 (related to
        Exhibit 10.24).                                                                                                 
|10.25   |  | ****                |  | Accounts Receivable Financing Agreement dated
        February 28, 2001, by and between Silicon Valley Bank and
        the Company.                                                                                       
|10.25.1 |  | !!!                 |  | First Loan Modification to the Accounts
        Receivable Financing Agreement, dated May 24, 2001 (related
        to Exhibit 10.25).                                                                                     
|10.26   |  | ****                |  | Intellectual Property Security Agreement dated
        February 28, 2001, by and between Silicon Valley Bank and
        the Company.                                                                                      

24



---



##### 



|        |  |                     |  |                                                                                                                 
|------- |  | ------------------- |  | ----------------------------------------------------------------------------------------------------------------
|        |  |                    
|Exhibit |  |                    
|Number  |  | Exhibit Description
|        |  |                    
|10.28   |  | !!!                 |  | Employment Agreement, dated May 3, 2001, by
        and between the Company and Elton King.                     
|10.29   |  | !!!                 |  | Nonstatutory Stock Option Grant Agreement, dated
        May 3, 2001, by and between the Company and Elton King.
|10.30   |  | !!!                 |  | Terms of Employment, dated July 27, 2000, by
        and between the Company and Steve Hindman.                 
|16.2    |  | @                   |  | Letter regarding change in certified accountants.                                                               
|21.1    |  | ****                |  | List of subsidiaries of the Company.                                                                            




|     |  |                                                                                                                                                                                                                                                                                                                                    
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|*    |  | Incorporated herein by reference to the
        Companys Registration Statement on Form S-1,
        No. 333-41517.                                                                                                                                                                                                               
|**   |  | Incorporated herein by reference to
        Exhibit 10.1 to the Companys Registration Statement
        on Form S-8, No.  333-53153.                                                                                                                                                                                              
|***  |  | Incorporated herein by reference to the
        Companys Annual Report on Form 10-K for the year
        ended December 31, 1999.                                                                                                                                                                                                 
|**** |  | Incorporated herein by reference to the
        Companys Annual Report on Form 10-K for the year
        ended December 31, 2000.                                                                                                                                                                                                 
|%    |  | Incorporated herein by reference to the
        Companys Registration Statement on Form S-3,
        No. 333-90105.                                                                                                                                                                                                               
|%%   |  | Incorporated herein by reference to
        Exhibit 10.1 to the Companys Registration Statement
        on Form S-8, No.  333-88719.                                                                                                                                                                                              
|@    |  | Incorporated herein by reference to the
        Companys Registration Statement on Form S-4,
        No. 333-33946.                                                                                                                                                                                                               
|$    |  | Incorporated herein by reference to
        Exhibit 3.1 to the Companys Quarterly Report on
        Form 10-Q for the three months ended June 30, 1999.                                                                                                                                                                           
|$$   |  | Incorporated herein by reference to the
        Companys Definitive Proxy Statement on Schedule 14A
        filed April 30, 2001.                                                                                                                                                                                                 
|$$$  |  | Incorporated herein by reference to the
        Companys Annual Report on Form 10-K for the year
        ended December 31, 1998.                                                                                                                                                                                                 
|    |  | Portions of this Exhibit were omitted and have
        been filed separately with the Secretary of the Commission
        pursuant to the Companys Application Requesting
        Confidential Treatment under Rule 406 of the Securities
        Act, filed on December  22, 1997, January 28, 1998 and
        February 4, 1998.
|   |  | Portions of this Exhibit were omitted and
        have been filed separately with the Secretary of the Commission
        pursuant to the Companys Application Requesting
        Confidential Treatment under Rule 24b-2 of the Securities
        Exchange Act.                                                                
|!!   |  | Incorporated herein by reference to the
        Companys Quarterly Report on Form 10-Q for the three
        months ended June 30, 2000.                                                                                                                                                                                          
|!!!  |  | Incorporated herein by reference to the
        Companys Quarterly Report on Form 10-Q for the three
        months ended June 30, 2001.                                                                                                                                                                                          

(b)  Reports on Form 8-K

None.

25



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##### 



SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of
1934, the Company has duly caused this report to be signed on
its behalf by the undersigned thereunto duly authorized.



|    |                                                   
|--- | --------------------------------------------------
|    | VISUAL NETWORKS, INC.                             
|   
|By: | /s/ PETER J. MINIHANE                             
|    |                                                   
|    | Peter J. Minihane                                 
|    | Executive Vice President, Chief Financial Officer,
|    | Treasurer and Director (principal financial and   
|    | accounting officer)                               

November 14, 2001

26