SECURITIES AND EXCHANGE COMMISSION
                                Washington, D.C.

                                   FORM 10-KSB

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

                  For the fiscal year ended: September 30, 1996

                                       OR

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

           For the transition period from ____________ to ___________


                         Commission file number: 0-8632


                             MEDICAL DYNAMICS, INC.
              ----------------------------------------------------
             (Exact name of Registrant as specified in its charter)

          Colorado                                    84-0631765
-------------------------------                 ---------------------
(State or other jurisdiction of                     (IRS Employer
incorporation or organization)                  Identification Number)


         99 Inverness Drive East
           Englewood, Colorado                              80112
---------------------------------------                   ---------
(Address of principal executive offices)                  (Zip Code)


               Registrant's telephone number, including area code:

                                 (303) 790-2990

           Securities registered pursuant to Section 12(b) of the Act:

                                      None

           Securities registered pursuant to Section 12(g) of the Act:

                          Common Stock, $.001 Par Value


     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,  and (2) has been  subject to such filing
requirements for the past 90 days.

                           (1) Yes   X   No _____
                           (2) Yes   X   No _____



<PAGE>



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

     The issuer's revenues for its most recent fiscal year were $667,800.

     The  aggregate  market  value of the voting  stock  held by  non-affiliates
computed by reference  to the price at which the stock was sold,  or the average
bid and asked prices of such stock,  as of December  31, 1996 was  approximately
$23,613,000.

Class                         Outstanding at December 31 , 1996
-----                         ---------------------------------

Common Stock                          7,335,511 shares

                    Documents incorporated by reference: None


                                       -2-


<PAGE>
                             MEDICAL DYNAMICS, INC.

                                   FORM 10-KSB

                                     PART I

Item 1.  Business.

     (a) Business Development

     Medical Dynamics, Inc. is engaged in the design,  development,  manufacture
and  marketing  of medical  and dental  video  cameras  and  related  disposable
products for a variety of professional  specialties.  The Registrant's principal
products are small,  color,  medical and dental video camera  systems for use in
patient  diagnosis and various  surgical  procedures.  The  Registrant  has been
manufacturing such cameras since August of 1981. Medical Dynamics,  Inc. has one
inactive subsidiary, MedPacific Corporation, a Washington state corporation. The
Registrant's principal executive offices and manufacturing  facilities are at 99
Inverness Drive East, Englewood,  Colorado,  80112. Its telephone number at that
address is (303) 790-2990.

     The Registrant was incorporated  under the laws of the State of Colorado on
March  23,  1971,  and began  business  operations  in 1973.  During  1979,  the
Registrant  began its  involvement  with medical video camera  systems.  Initial
operations  relating to such cameras  consisted of the Registrant's  purchase of
completed  cameras  from  their  manufacturer  for  retail  sale to the  medical
community. Exclusive marketing rights to a camera system manufactured by another
company  were  acquired and the  Registrant  served as the  distributor  of that
product until the arrangement was terminated in July of 1981. In August of 1981,
the  Registrant  introduced  its first  medical video camera of which it was the
manufacturer. Subsequently, additional cameras were acquired or developed by the
Registrant.

     During the fiscal year ended  September  30, 1996,  the Regis trant was not
involved in any bankruptcy, receivership or similar proceeding nor did it engage
in any material reclassification,  merger or consolidation.  During that period,
the Registrant did not dispose of any material  amounts of its assets other than
in the ordinary course of its business.

     As  discussed  in  Note 2 to the  financial  statements,  the  Company  has
suffered  recurring losses and negative cash flows from operations.  This raises
substantial  doubt about the Company's  ability to continue as a going  concern.
Management's  plans in regard to these matters are also described in Note 2. The
financial  statements do not include any adjustments  that might result from the
outcome of this uncertainty.

     

                                       -3-


<PAGE>


     During the fiscal  year 1995 the  Registrant  entered  into a  distribution
agreement with Micro-Medical  Devices, Inc. (MMD), of Castle Rock, Colorado. MMD
is a corporation  formed by and 100%  wholly-owned by the Registrants  Chairman.
MMD manufactures and sells minimal quantities of various medical products to the
Registrant.  See  item 12 -  Certain  Relationships  and  Related  Transactions,
"Distribution Agreement."

     (b) Business of the Issuer

     The  Registrant's   principal   business  is  the  design,   de  velopment,
manufacture  and  marketing  of medical  and dental  video  cameras  and related
disposable  products for a variety of professional  specialties.  These products
are  used  in  surgical,  diagnostic,  research  and  teaching  applications  by
physicians, dentists, and other health care professionals.

     A variety of less invasive  diagnostic  and surgical  techniques  have been
developed  which enable  operations to be performed or observation to occur with
minimal  surgical  incisions.  One such surgical  technique is the  arthroscopic
operation used by orthopedic surgeons.  That technique is made possible by means
of a rigid endoscope known as an arthroscope.  The arthroscope is a high quality
optical instrument which is a tube approximately four millimeters in diameter. A
light source is attached to the arthroscope  and it is inserted  through a small
incision made in the patient's  body. The surgeon is then able to observe inside
the  joints  through  the  lenses  of  the  arthroscope  and  special   surgical
instruments  are  used to  perform  corrective  surgery  without  open  surgery.
Arthroscopy  has obtained  widespread  acceptance by orthopedic  surgeons and is
commonly used to remove damaged  cartilage tissue which may result from athletic
and other  injuries.  The use of the  technique is less  destructive  of healthy
tissue and thereby  decreases the time necessary for healing of the damaged area
and reduces the costs of hospitalization and rehabilitation.

     A more common  surgery  involves  the use of a rigid  endoscope  known as a
laparoscope.  The  laparoscope is used in much the same way as the  arthroscope,
but is limited  primarily to use in the abdominal  area. One surgical  technique
involves  the use of the  laparoscope  to remove the gall  bladder,  a procedure
commonly known as laparoscopic cholecystectomy.  The laparoscope also is used to
perform  appendectomies,  kidney  removal  and certain  gynecologic  procedures.
Gynecologic  usage accounts for the majority of all  laparoscopic  procedures at
this time.

     The  Registrant's  camera  systems  are  utilized  in  conjunction  with an
arthroscope,  laparoscope or other endoscope.  They may also be connected with a
microscope for use in microscopic surgery such as hand or eye surgery. The image
which may be seen by the surgeon  through the  endoscope or microscope is viewed
by the camera  and  transmitted  to a  television  monitor.  This use of a video
camera  provides an image  which may be viewed by all  persons in the  operating


                                       -4-


<PAGE>

room,  diagnostic  laboratory or class room.  The ability to observe the surgery
permits the support staff to anticipate  the needs of the surgeon and provides a
mechanism which facilitates instruction of others. Additionally,  the surgeon is
provided with a television  screen used to reduce  intervals of viewing  through
the endoscope,  thereby  attenuating  eye fatigue.  The video camera may also be
attached to peripheral  equipment  which  enables the image to be recorded.  The
procedure and the patient may thereby be studied at a later time.

     The Registrant has recently  applied it's surgical camera  expertise to the
development  of intraoral  dental  cameras for use as a diagnostic  tool for the
dental  profession.  The Registrant  believes that the True Vision(TM) camera it
has created represents the  state-of-the-art  for this camera  technology,  with
high  resolution  surgical camera picture quality coupled with a lower cost than
other competitors' cameras.

     As of  September  30,  1996 and  1995,  the  Registrant  had  approximately
$6,700,000  and $60,400,  respectively,  in purchase  orders for its medical and
dental  products.  The fiscal 1996 backlog is due to demand for the Registrant's
intraoral dental camera from customers. It is expected that it will take between
12 to 18 months to fulfill this order backlog and there can be no assurance that
there will not be  subsequent  modifications  to the  quantities  subject to the
purchase orders. Backlog purchase orders are not recorded in sales revenue until
the order is shipped.  Subsequent to September 30, 1996 the Registrant  received
additional purchase orders for approximately $700,000 in intraoral dental camera
backlog sales.

(b)(1)  Principal Products and Their Markets.

     True  Vision(TM)   Intraoral  Dental  Camera.   The  Registrant   currently
manufactures and markets a dental video camera which is designed for most common
dental applications.  This camera model contains a high performance video sensor
coupled with a 1/4" lens and camera system which  management  believes  provides
superior high resolution  picture quality  compared to other cameras used in the
dental profession.  The camera's  state-of-the-art  technology  consists of easy
angle,  high  resolution  viewing,  a single lens  format,  and the smallest and
lightest hand piece available in the market today.  Production and sales of this
product  began in  September,  1996,  therefore  minimal  sales revenue has been
generated.

     Model  5980  Digital  Surgical  Video  Camera.  The  Registrant   currently
manufactures  and markets a medical  video  camera  which is  designed  for most
endoscopic  applications.  Previously,  differing  light  conditions for varying
procedures required that different camera models be provided. The current camera
model,  the 5980,  contains a high  performance  video sensor  which  provides a
brighter  picture in lower  light  level  environments  than prior  solid  state
 .

                                       -5-


<PAGE>

cameras.  The current Model 5980 utilizes a more advanced  "Digital" base camera
which provides enhanced  visualization of the affected areas of the body without
the aid of an  automatic  light  source.  This model is  submersible  for liquid
sterilization,  and has a detachable cable (facilitating replacement of the most
frequently failing component).  The construction of the Registrant's 5980 camera
is from standard video camera components  purchased from major  manufacturers of
video cameras.  The Registrant  produces variations of the Model 5980 camera for
use with European format video equipment.

     During the years ended September 30, 1996, and 1995 approximately 3 and 15,
respectively,  Model  5980  and  predecessor  model  cameras  were  sold  by the
Registrant at prices ranging from $1,600 to $8,075.

     The Model 5990 Optical  Catheter  System(TM).  In June 1989 the  Registrant
introduced its 5990 Optical Catheter System. The Registrant created this product
from  technology  originally  developed  by the  Chairman  and  licensed  to the
Registrant  in  response  to the demand  for less  invasive  and less  expensive
diagnostic and surgical procedures.  These procedures are now being performed in
physicians'  offices  and  outpatient  clinics.   The  Registrant  is  currently
manufacturing the 5990 Optical Catheter(TM) System in its facility.

     The 5990 Optical Catheter System consists of a modular console containing a
video camera,  light source, and monitor.  A flexible,  small diameter endoscope
utilizing small, flexible and versatile fiber optic image bundles is attached to
the console.  This endoscope  allows  medical  specialists to examine almost any
area in the  body  with a  puncture  as  small  as  that  caused  by a  standard
hypodermic needle.

     The optical  fibers  contained  in the  endoscope  transmit  light from the
console to the lens at the tip, and transmit the image from the lens back to the
camera in the console.  The image is displayed on the video monitor.  Endoscopes
which  can be  used  with  the  console  range  from  .5  millimeters  up to 1.9
millimeters in diameter. Images produced by the 5990 Optical Catheter System can
be preserved by use of recording and printing devices currently  marketed by the
Registrant.

     During the fiscal years ended  September 30, 1996, and 1995, 5 and 10 Model
5990 Optical  Catheter  systems were sold by the  Registrant,  netting  sales of
approximately $49,500, and $87,500 respectively.

     Electronic Video Laparoscope (EVL). The Model 5500 EVL is a rigid endoscope
that  utilizes  the latest in image  processing  without  the need for  multiple
optical  coupling  lenses.  The endoscope  eliminates  the need for coupling and
light source  enhancement  because it  incorporates  these features  within it's
design.  The  Registrant  introduced  this product in October 1992 and commenced
active marketing in April, 1993. 

                                      -6-


<PAGE>


     Unlike a  conventional  surgical  camera  system which  utilizes a separate
camera head and coupler  that never  enters the body,  the EVL  incorporates  an
image sensor chip at the tip of the laparoscope. As a result, the EVL places the
imaging  chip in closer  proximity  to the anatomy  viewed,  thereby  creating a
higher resolution  picture and increased  illumination.  With the elimination of
the ancillary  head and coupler,  the  Registrant  has created a lighter  weight
device that requires only an optional  focusing or  magnification  mechanism and
eliminates the problem of fogging between the coupler and eyepiece. All of these
features result in a safer, more efficient device for use by surgeons.

     In  addition  to the  diagnostic  versions  of the  EVL in 0 and 30  degree
viewing angles, the Registrant received FDA approval in September,  1994 for the
Operative Video  Laparoscope(TM)  in both 3 and 5 millimeter  working  channels.
These  devices  are  believed  to be a  significant  improvement  over  existing
operative  scopes  on the  market  in that  they  allow  the same  bright,  high
resolution  picture as the standard  EVL, with  additional  capability to insert
operative  instruments  or laser  fibers  through  the  working  channels.  Most
competing  operative  scopes lack  illumination and picture quality due to their
less-than-optimal configuration.

     During the fiscal years ended  September 30, 1996 and 1995,  the Registrant
sold 13 and 35 units of the EVL control  module,  to both  domestic  and foreign
markets.  Total gross revenues for all EVL associated  products,  which includes
ancillary scopes,  umbilical cables,  heads and control modules totalled $80,300
and $326,600 for the respective fiscal years.

     Models  6400 and 6600 Light  Sources.  The  Registrant  currently  produces
several light sources used in various  procedures in conjunction  with the model
1001.00  USES,  5980 and 5500 EVL cameras.  The  Registrant  began to market and
produce the model 6600 light source during  fiscal 1993.  The  Registrant  began
production of the model 6400 light source during fiscal 1995.  All model numbers
represent  current  lines used for  Arthroscopy,  Laparoscopy  and various other
endoscopic procedures and vary only in the amount and frequency of light emitted
from each piece of equipment.  The  Registrant  sold 14 and 39, new light source
units during  fiscal 1996 and 1995,  respectively,  netting sales of $51,000 and
$137,100.

     Adair/Veress  Needle(TM).  The Registrant has sold 2,379 and 1,402 units of
this  needle  used  to  perforate  the  abdominal  wall   generating   sales  of
approximately $41,200 and $26,700, during fiscal 1996 and 1995 respectively. The
Medical  Dynamics  5990  catheter  and other  manufacturers  fiber scopes can be
inserted  through the  needle,  facilitating  viewing of  affected  areas of the
abdomen   without  an  incision.   The  Registrant   developed  this  needle  in


                                       -7-


<PAGE>

anticipation  of  its  use  in  emergency  rooms  and  for  certain  established
laparoscopic procedures. The needle has FDA approval and is patented. See (b)(7)
under this Item 1 below.  The majority of sales of this device are  attributable
to Origin Medsystems, a subsidiary of Guidant Corporation.  The Registrant has a
current  purchase order to deliver 1,390 additional units in the future totaling
$22,600.

     Peripherals. The Registrant provides a variety of products designed for use
in connection with its cameras. Because the Registrant's cameras are used with a
variety of endoscopes and microscopes  requiring varying light sources,  optical
couplers must be supplied to enable  connection of the camera,  light source and
endoscope.  These  optical  couplers  are  made  by  an  outside  supplier.  The
Registrant  also  provides  the video  monitors for use in  connection  with its
cameras.  These  monitors are purchased  from major  electronics  manufacturers.
Installation of medical grade cords, plugs,  conductive castors,  opto-isolation
for  control  of  current  leakage  and  remote  footswitching  are a few of the
modifications   provided.   Similarly,   video   cassette   recorders  of  major
manufacturers also are purchased by the Registrant,  modified and resold for use
in connection with its medical cameras.

     Cam-Wrap(TM).  The Registrant markets a sterile camera cover (the Cam-Wrap)
which  permits the head and cable of soakable and  non-soakable  cameras  (which
cameras were previously  manufactured  and sold by the Registrant and others) to
be draped for sterile  requirements of operating rooms. The plastic camera cover
is manufactured  for the Registrant by a non-affiliated  company.  Approximately
19,200 and 21,400  units were sold in fiscal  1996 and 1995,  respectively,  for
total sales of $184,400 and $202,500.


     Lap-Wrap(TM).  In conjunction  with the EVL,  Medical Dynamics also markets
the  Lap-Wrap,  a  disposable  sterile  sheath  and sleeve for the EVL and other
manufacturers' brands of laparoscopes and camera systems. The product is part of
the Registrant's line of higher-margin disposable accessories. The Lap-Wrap is a
low cost  alternative  ($16  list) to  current  sterilization  and  disinfection
techniques.  It reduces  repair  costs on scopes and  camera  systems,  and also
eliminates  the  potential  environmental  and health  hazards  associated  with
exposure to chemical soaking  solutions or ETO (gas)  sterilization.  During the
fiscal years ending  September 30, 1996 and 1995, 264 and 314 cases of Lap- Wrap
were sold resulting in revenues of $38,500 and $49,100,  respectively.  Both the
EVL and Lap-Wrap,  which combine to form a patented  device,  have been licensed
(See Licenses in Part I (b)(7)) to Medical Dynamics by the inventor and Chairman
of the Registrant, Dr. Edwin L. Adair.

     
                                       -8-


<PAGE>

     Universal Sterile  Endoscopy  System(TM)  (USES(TM)).  At the end of fiscal
1995 the Registrant introduced this product group. It consists of a non-soakable
camera system that utilizes a proprietary  "closed system" sterile coupler drape
with each use.  The  advantages  of this system over  competitors  models is the
ability  to have an  absolutely  sterile  camera  for every  surgical  case,  at
approximately  one-third the price of competing  models.  Fiscal 1996 sales were
minimal as the product is still in the introductory stage. See item 12 - Certain
Relationships and Related Transactions, "Distribution Agreement."

     Inventory.  The Registrant is required to carry  significant  quantities of
inventory to meet rapid delivery  requirements  of customers or to assure itself
of a continuous allotment of goods from suppliers. The Registrant also carries a
significant  quantity of repair  parts.  At September 30, 1996,  inventories  of
repair  parts valued at $450,000  were  classified  as a long-term  asset in the
Registrant's  balance sheet.  This estimate was  determined by considering  both
historical and projected  levels of sales for goods included in  inventories.  A
substantial  portion of raw  materials is expected to be utilized for repairs of
equipment  sold over the past  several  years  (see  note 3 to the  consolidated
financial statements).  The Registrant has continued to maintain an inventory of
components for its Models 5500,  5940,  5960,  5970, and 5980 cameras,  the 5990
Optical Catheter(TM) System, and various peripherals.  Sufficient  quantities of
the  Registrant's  disposable  product  line such as Lap-Wrap and Cam- Wrap must
also be maintained in anticipation of customer's future needs.

     The  Registrant  typically  sells  product  on a net  30 day  basis  to all
domestic  customers  and a net 60 to 270 day  basis  to  foreign  customers  and
distributors.  With some exceptions,  most foreign  distributors post letters of
credit to insure  payment  on orders.  Inventory  levels  net of  allowance  for
obsolescence  for the  fiscal  years  ended  September  30,  1996 and 1995  were
$714,400 and $948,500 respectively.

     Warranty.  The Registrant's  medical and dental video cameras are warranted
for a one-year  period with  respect to parts and labor  required as a result of
defects in material and  workmanship.  Cables and optical couplers are warranted
to be free of defects  for a period of 180 days.  Defects or mal  functions  are
corrected  by  the  Registrant  at the  Registrant's  cost,  if  the  applicable
conditions to the warranty are satisfied.  In the event warranty  repairs cannot
be effected within five days, the Registrant  generally  provides loaner cameras
for customer use.  Failures normally occur during the early life of the cameras,
and  repair  expenses  usually  occur in the same  year in which  the  camera is
initially placed in service.  The Registrant estimates future warranty costs and
enters the estimated cost into its results of operations  based upon  historical
experience and revenues  currently  reported.  The estimated warranty reserve at
fiscal  year  end   September  30,  1996  and  1995  was  $15,000  and  $25,000,
respectively.

                                       -9-


<PAGE>


(b)(2)   Distribution Methods

     The  Registrant's  medical  video  camera  systems and  disposable  medical
products are sold  principally to physicians and hospitals,  either  directly or
through  one  of  the  Registrant's   independent  sales  representatives.   The
Registrant's  intraoral  dental  camera  is  typically  sold  through  a  select
distribution  network or on an OEM distributor basis. The Registrant has engaged
in marketing and  advertising of all its products at  professional  seminars and
specialty meetings, direct mail promotions,  telemarketing,  and through a sales
representative  network. During the years ended September 30, 1996 and 1995, the
Registrant  spent  $193,700 and  $258,800,  respectively,  on sales  promotions,
conventions and advertising expenses.

     The Registrant engaged approximately 12 organizations with approximately 22
field sales  representatives  to market its medical camera systems in the United
States  during  fiscal year 1996.  Most major  domestic  sales  territories  are
covered by the current sales representative  network. The sales  representatives
enter into a one year  agreement  with the  Registrant  under which they receive
commissions of approximately  15% to 20% on video camera sales revenues,  10% to
15% on camera  accessories and 10% to 20% on disposable  product sales generated
by them in  exclusive  marketing  areas.  All selling  expenses are borne by the
sales  representative.   The  sales  representative   agreements  prohibit  each
representative  from  purchasing  or dealing in products of  competitors  of the
Registrant.  In  addition  to sales made in this  manner,  the  Registrant  also
modifies  some of its products to display the labeling of its  customers.  Those
customers then sell the products directly to end-users.

     As of the fiscal year ended  September  30, 1996,  the Regis trant  engaged
approximately  12 agents to sell  video  cameras  in areas  outside  the  United
States.  The primary foreign  territories  where the Registrant has distributors
are the United Kingdom, Western Europe, Spain, and Latin America.

     During each of the past two fiscal years,  sales of various models of video
camera systems (including ancillary camera equipment)  contributed more than 15%
of the Registrant's total revenue. The percentages of the Registrant's  revenues
contributed  by this product  group during the fiscal years ended  September 30,
1996 and 1995 were 22% and 36%, respectively.


(b)(3)   Status of New Products.

     The  Registrant  has  several  products  which  are in  various  stages  of
development.

                                      -10-


<PAGE>


     3-D  Electronic  Video  Laparoscope(TM).  Medical  Dynamics has developed a
prototype  (not yet FDA  approved),  through its  licensing  agreement  with the
Registrant's  Chairman,  of this new technology,  which combines two EVL systems
within a single  laparoscope to produce a  three-dimensional  view of the target
area.  In  laparoscopic  surgery,  where  surgeons  are  required  to grasp  and
manipulate  organs,  vessels and tissue, the depth of field obtained through 3-D
is superior to the "flat field"  effect of  two-dimensional  camera  systems.  A
commercial  product is expected to be introduced  within two years  provided the
market warrants such an introduction and FDA approval is received.

(b)(4)   Competition.

     With  regard to the  Registrant's  medical  video  cameras,  the  principal
competitive   factors   to  which  it  is  subject   are  price,   technological
configuration, product performance, and product line diversification.  Principal
competitors  in the  United  States  include  Circon/ACMI  Corporation,  Stryker
Corporation, Olympus, Wolf, and Karl Storz, each of which manufactures and sells
some form of medical video system, and there are certain  competitors  overseas.
The principal  reasons why sales volumes  remain  volatile are  fluctuating  OEM
revenue, the limited product line presently offered by the Registrant, a limited
amount of capital available to promote the products through successful marketing
efforts and distribution  channels,  the consolidation of hospitals coupled with
less  influence  over  buying  decisions  by  physicians,   and  the  continuing
uncertainty  surrounding  the effects of a proposed  national  health care plan.
Such  limitations  have  proven  detrimental  to the ongoing  operations  of the
Registrant  to date.  The  industry  has  experienced  a  contraction  of camera
manufacturers  over the past several years but the Registrant  anticipates  that
other  companies  may enter into the  manufacture  and sale of small color video
systems,  thereby causing further  competition in this field. The prices charged
and  warranties  provided  by the  Registrant  and  competing  manufacturers  of
surgical video camera systems are similar.

     The Registrant's 5990 Optical Catheter  System(TM) is protected by a number
of patents licensed to the Registrant by it's Chairman,  and to the Registrant's
knowledge,  no similar  systems  are  presently  being  marketed.  Both the 5990
Optical  Catheter  System and the 5500 EVL are subject to  competition  from the
Registrants   model  5980  camera  and  similar  cameras   manufactured  by  the
Registrant's  competitors,  although  the  Registrant  believes the 5990 is more
suitable for office use than such other cameras.

(b)(5)  Availability of Raw Materials.

     For a number of years, the Registrant had purchased  cameras from Panasonic
Industrial  Company  - Audio  Video  Systems  Group  ("Panasonic")  exclusively.
Although Panasonic is still the primary supplier of cameras,  the Registrant now
procures cameras from additional sources without  sacrificing product or picture
quality.  Management  believes the additional product  resources,  combined with


                                      -11-


<PAGE>

current  purchasing  practices  more  in  line  with  "just-in-time"   inventory
management, are beneficial to the Registrant. The Registrant has entered into an
agreement  with a United States  manufacturer  to supply the head cables used in
its camera  products and has negotiated a similar  agreement with another United
States  manufacturer.  If these sources of head cables were not  available,  the
Registrant believes it would be materially affected,  as other sources for these
camera head cables may not be available to the Registrant.

(b)(6)  Principal Customers.

     The Registrant had one customer who  contributed 10% or more of total gross
revenues  for  both  fiscal  years  1996  and  1995.  Gross  billings  to  Rosot
Enterprises  of Locust  Valley,  New York during fiscal years 1996 and 1995 were
$108,800 and $297,700 or 16% and 25% of Registrant revenues, respectively. Rosot
Enterprises  is an  international  distributing  company which  concentrates  on
Mexico, Central and South America.

(b)(7)   Patents, Trademarks, etc.

     Patents.  Although the Registrant does not own any patents  relating to its
Optical  Catheter  System(TM),  it holds an exclusive  license on three  patents
related  to this  camera  system.  United  States  Patents  No.  4,782,819,  No.
4,736,733,  and No. 4,754,328  expiring November 8, April 12, and June 28, 2005,
respectively,  relating  to the Optical  Catheter(TM)  are owned by Dr. and Mrs.
Adair and are licensed on an exclusive basis to the Registrant. The terms of the
license  agreement are described under  "Licenses"  below. In addition,  Dr. and
Mrs.  Adair have applied for several  more  patents on behalf of the  Registrant
relating to the 5990 Optical Catheter(TM) System, which applications are pending
at the date of this filing.

     In addition to the above referenced patents, the following patents are also
licensed to the Registrant from the Chairman:


TITLE                              ISSUE DATE         PATENT NUMBER
-----                              ----------         -------------

"Laser Endoscope"                   5/20/86             4,589,404

"Laser Endoscope" (Divisional)      6/28/88             4,754,328

"Endoscope with Removable           4/12/88             4,736,733
 Eyepiece"

"Gas Insufflation Needle with       9/26/89             4,869,717
 Instrument Port" (Adair Veress
 Needle)


                                      -12-


<PAGE>


TITLE                              ISSUE DATE         PATENT NUMBER
-----                              ----------         -------------


"Rigid Video Endoscope with        11/07/89             4,878,485
 Heat Sterilizable Sheath"
 (EVL and Lap-Wrap)
 Reissue                            3/24/92              RE 33854

"Deformable and Removable
 Sheath for Optical Catheter"       3/30/93             5,197,457

"Deflectable Sheath for             6/30/92             5,125,395
 Optical Catheter"

"Heat Sterilizable Electronic       2/23/93             5,188,094
 Video Endoscope"
 (Autoclavable EVL)

"Steerable Sheath for Use            7/5/94             5,325,845
 With Selected Removable
 Optical Catheter"

"Imaging Tissue or Stone            5/17/94             5,311,858
 Removal Basket"

"Stereoscopic Endoscope"            1/17/95             5,381,784
 (3-D EVL)

"Stereoscopic Endoscope With        2/27/96             5,494,483
 Miniaturized Electronic
 Imaging Chip"

"Miniaturized Electronic            2/27/96             5,495,114
 Imaging Chip"
 (For Reduced Diameter
 Electronic Endoscopes)

     The Bayne Pap Brush(TM) is subject to United States Patents No.  4,762,133,
4,754,764 and 4,873,992  expiring  August 9, 2005 through  October 17, 2006. Dr.
Bayne,  a director of the  Registrant,  assigned these patents to the Registrant
and is  entitled to receive a royalty of two percent of net sales of the product
after  recovery of certain  expenses.  No royalties have been accrued or paid to
Dr. Bayne on this product.

     Trademarks.  The Registrant is also the holder of United States Trademarks,
registration  numbers  1,299,413,  1,299,414,  and 1,719,664 which relate to the
name  "Medical  Dynamics",  the  corporate  logo  of  the  Registrant,  and  the
Adair/Veress  Needle  respectively.  The trademarks are granted for a term of 20
years expiring  October 8, 2004, and if still in use at that time may be renewed
for  successive  20-year  periods by  application.  In addition,  the Registrant
claims rights in numerous  unregistered  trademarks  which it uses in interstate
commerce, and which are subject only to common law protection. Additionally, the
Registrant  holds trademark  registration  number 1,282,319 which relates to the
name "MedPacific Corporation" and its corporate logo. This Trademark was renewed

                                      -13-


<PAGE>

for a 20 year term in June 1990. The Registrant also has trademark  applications
pending on a variety  of  products  including  the EVL,  Lap-Wrap(TM),  and True
Vision(TM) dental camera.

     Licenses.  The  Registrant  entered  into an  exclusive  revocable  license
agreement with Dr. Edwin Adair  effective June 3, 1987, as amended,  relating to
use of certain  technology  invented  and  developed  by Dr.  Adair  relating to
certain malleable endoscopes,  flexible optical catheters,  the Adair/Veress(TM)
needle and  complementary  viewing systems for use in connection with detection,
diagnosis  and  treatment  of  disease  or  injury in humans  and  animals.  The
Registrant used this technology to develop the 5990 Optical Catheter(TM) System,
the Electronic  Video  Laparoscope  (EVL),  and the  Lap-Wrap(TM).  Dr. Adair is
entitled  to receive a royalty  equal to the greater of two percent of net sales
involving the licensed  technology or a minimum annual royalty.  Since inception
and through  September 30, 1996,  $600,000 has been paid to Dr. Adair under this
license  agreement,  and an  additional  $120,000 of expense was  recognized  in
fiscal 1996 for the fair value of stock options issued to Dr. Adair. In December
1995,  120,000 options at a $1.00 exercise price were issued in exchange for the
cash royalty payment for fiscal year 1996. See Notes 4 and 5 to the Consolidated
Financial Statements in Item 7 and Item 12, below for more information regarding
license agreements.

(b)(8) and (9)  Government Regulation.

     The United States Food and Drug Administration (the "FDA"), pursuant to the
Medical Device Amendments of 1976 to the Food, Drug and Cosmetic Act (the "Act")
and regulations  promulgated thereunder,  regulates the testing,  manufacturing,
packaging,  distribution  and marketing of medical devices in the United States,
including the products manufactured by the Registrant.

     The Act requires manufacturers of medical devices to register annually and,
semi-annually,  to list new  devices  being  produced  by the  manufacturer  for
commercial distribution.

     The Act also  classifies  medical  devices  and  requires  compliance  with
specific  manufacturing and quality assurance  standards.  The FDA has published
regulations  defining good manufacturing  practices to provide that each step of
the  manufacturing  process  for  any  device  is  controlled  to  maximize  the
probability   that  the   finished   product   meets  all   quality  and  design
specifications.  The regulations also require that each manufacturer establish a
quality assurance  program by which the manufacturer  monitors the manufacturing
process and maintains records which show compliance with the FDA regulations and
the  manufacturer's  written  specifications  and  procedures  relating  to  the
devices.

         

                                      -14-


<PAGE>

     The Registrant's facilities and records are subject to periodic unannounced
inspections by the FDA for compliance with the applicable FDA  regulations.  The
FDA may issue reports or citations where the  manufacturer  has failed to comply
with all appropriate regulations and procedures. If the FDA finds a manufacturer
not to be in such compliance,  the FDA may prohibit a manufacturer  from selling
the products for which the manufacturer is not in compliance, until such time as
the  manufacturer  complies with the applicable FDA regulations  with respect to
those  products.  Compliance  with  the  provisions  of the Act  and  the  FDA's
regulations is time consuming and expensive due to the extensive  record keeping
required.

     During  October  1996,  The  FDA  performed  a  routine  inspection  of the
Registrant's  premises  and issued a Form  FDA-483  "Inspectional  Observations"
itemizing certain  deviations in the Registrant's  procedures from that required
in the FDA's  regulations.  The registrant has responded with a letter defending
it's practices and to date has received no further response from the FDA. If the
FDA continues to request the proposed  changes after receipt of the Registrant's
response,  the  registrant  will  implement  the requested  changes.  Management
expects  no  negative  product  or  financial  ramifications  from this  action,
although no assurances to that effect can be made.

(b)(10)  Research and Development.

     During the fiscal years ended  September 30, 1996 and 1995,  the Registrant
spent approximately  $206,900 and $228,100,  respectively,  on company-sponsored
research and development  activities.  During those periods,  there were minimal
customer-sponsored  research  activities  relating  to new  products,  services,
techniques or to the improvement of existing products, services or techniques.

(b)(11)  Compliance With Environmental Laws.

     The  Registrant  is not  materially  affected by  federal,  state and local
provisions  which have been  enacted  or adopted  regulating  the  discharge  of
materials into the  environment  or otherwise  relating to the protection of the
environment.

(b)(12)   Employees.

     At September  30, 1996,  the  Registrant  employed 15 persons,  including 3
persons engaged in general administration, and 12 persons engaged in production,
distribution, and customer service of the Registrant's products.

Item 2.  Description of Property.

     The  Registrant  leases 18,358  square feet of space at 99 Inverness  Drive
East, Englewood, Colorado, where its principal executive offices are located and
its business  activities,  including  research,  assembly,  storage and customer


                                      -15-


<PAGE>


service,  are conducted.  The  Registrant has used the bulk of these  facilities
since 1981. A three-year  extension to the lease expired December 31, 1995. This
lease has been renewed for an additional  three-year term,  expiring on December
31, 1998.  The current lease and all  extensions  obligate the Registrant to pay
monthly rentals in the following amounts:

         January 1 - December 31, 1996            $12,315
         January 1 - December 31, 1997            $13,080
         January 1 - December 31, 1998            $13,845

The  Registrant  pays  certain  maintenance,  insurance,  common  area and other
expenses with respect to the property to the extent that the lessor's  costs for
such items exceed a specified amount.  The Registrant also pays any increases in
property taxes due to improvements on the property and pays for utilities.

     The  Registrant  also rents  temporary  storage  space in mini-  warehouses
located near its principal  executive  offices.  During the fiscal year 1996 the
average monthly cost amounted to $380.

Item 3.  Legal Proceedings.

     There are no  material  pending  legal or  regulatory  proceedings  and the
Registrant is not aware of any that are known to be contemplated.

Item 4.  Submission of Matters to a Vote of Security Holders.

     The Registrant  has not submitted any matter to a vote of security  holders
during the fourth quarter of the fiscal year ended September 30, 1996.


                                      -16-


<PAGE>



                                     PART II

Item 5.  Market for Common Equity and Related Stockholder Matters.

     (a) Market Information

     The  Registrant's  $.001 par value  common  stock (the  "Common  Stock") is
traded in the  over-the-counter  market and price quo tations for the two fiscal
years  shown below were  reported  on the  National  Association  of  Securities
Dealers Automated Quotation SmallCap Market System ("NASDAQ"),  under the symbol
"MEDY".  The quotations shown below were compiled by the Registrant from Monthly
Statistical  Reports  supplied by the NASD.  All quotes  represent  inter-dealer
quotations,   without  retail  markup,   markdown  or  commission  and  may  not
necessarily represent actual transactions in the Common Stock:


                                     High bid            Low bid
                                     --------            -------
      Fiscal Year ended
      September 30, 1996
      ------------------
      First quarter                    $1.38              $0.50
      Second quarter                    2.31               1.03
      Third quarter                     4.06               1.44
      Fourth quarter                    5.19               2.13

      Fiscal Year ended
      September 30, 1995
      ------------------
      First quarter                    $2.83              $1.00
      Second quarter                    1.69               1.00
      Third quarter                     2.19               1.00
      Fourth quarter                    1.69               0.94


     (b) Holders

     The number of record holders of the Common Stock, as of September 30, 1996,
was 13,227 not including an unknown number of beneficial holders in street name.

     (c) Dividends

     (c)(1) Payment of Dividends.

     The  Registrant  has never paid a dividend with respect to its Common Stock
and does not intend to pay such a dividend in the foreseeable future.


                                      -17-


<PAGE>



     (c)(2) Restrictions on the payment of dividends.

     There are no contractual  restrictions  on the Company's  present or future
ability to pay dividends.

Item 6.   Management's Discussion and Analysis of Financial Condition and
          Results of Operations.

     As  discussed  in  Note 2 to the  financial  statements,  the  Company  has
suffered  recurring losses and negative cash flows from operations.  This raises
substantial  doubt about the Company's  ability to continue as a going  concern.
Management's  plans in regard to these matters are also described in Note 2. The
financial  statements do not include any adjustments  that might result from the
outcome of this uncertainty.

     Liquidity  and  Capital  Resources.  (September  30,  1996 as  compared  to
September  30,  1995)  During the fiscal  year ended  September  30,  1996,  the
Registrant's  current ratio  declined to 4.7 as compared to 7.2 at September 30,
1995. Net working capital  decreased  approximately  $1,054,400 due primarily to
the  use  of  cash  in  operations,   the  resulting   operating   loss,  and  a
reclassification  of  $450,000  of  inventory  to  a  non-current  asset.  These
inventories,  consisting of significant quantities of repair parts for equipment
sold over the last several years,  were  classified as a long-term  asset in the
Registrant's  balance sheet.  This estimate was  determined by considering  both
historical and projected  levels of sales for goods included in  inventories.  A
substantial  portion of raw  materials is expected to be utilized for repairs of
equipment  sold over the past  several  years  (see  note 3 to the  consolidated
financial  statements).  Cash  has  been  used  primarily  to fund  the  general
operations of the Registrant including research and development,  and to promote
the sales and marketing of products.

     Principal  changes in the components of net working  capital for the fiscal
year ended  September  30, 1996  consist of a decrease in  outstanding  accounts
receivable by $210,000, a collection of the Micro-Medical  Devices, Inc. related
party receivable of $110,000, a decrease in reported current inventory levels by
$684,100  ($450,000  of which was  reclassified  to other long term  assets),  a
reduction  in prepaid  expenses  and other of $15,700,  and a reduction in total
current liabilities by $43,900 to the current level of $310,400.

     During the fiscal year ended September 30, 1996, the Registrant experienced
negative  cash flow from  operating  activities  of  approximately  $789,200  as
compared  to  negative  cash flow from  operating  activities  of  approximately
$1,102,200  during the comparable period of the prior fiscal year. The aggregate
decrease in cash used in operating  activities  during fiscal 1996 versus fiscal
1995 was a result of the following factors:

                                      -18-


<PAGE>



Inventory   levels   decreasing   in   fiscal   1996   due  to   writeoffs   and
reclassifications,  with no cash used in purchases  other than for sales,  where
during fiscal 1995 the Company increased inventory by purchases in the amount of
$79,900.  Accounts payable and accrued expenses  increased during fiscal 1996 by
$56,100 over fiscal 1995  balances.  Aggregate  trade accounts  receivable  cash
collections  reduced  outstanding  balances due by $170,000  during  fiscal 1996
versus a reduction of $66,200 during fiscal 1995.

     Certain  consulting  services  received  by the  Registrant  were  paid for
through the  issuance of common stock  options  during the year in lieu of cash.
Although the services required no cash outlay, the options granted, issued at an
exercise price higher than market,  still required the  recognition of estimated
expense per the accounting  rules  prescribed in FAS 123  "Accounting  for Stock
Based  Compensation".  This  statement  requires  that the  fair  value of stock
options  issued to  non-employees  of the  company be  computed  under an option
pricing model and be recorded in the Registrant's  accounts. A total of $133,600
of  non-cash  consulting  expense  has  been  recognized  to  comply  with  this
accounting  rule.  The  Registrant has elected to continue to use APB 25 for the
computation  of employee  stock  option  expense.  Total  non-cash  compensation
expense  recognized for employee stock options was $271,400  during fiscal 1996.
See Note 5 to The Consolidated Financial Statements for additional information.

     To  curtail  operating  losses,  negative  cash  flow from  operations  and
liquidity  erosion  further,  management  is  continually  reviewing all expense
accounts to determine if any additional reductions in expenditures are possible.
Purchasing  procedures have also been  implemented to minimize  product cost and
avoid excess inventory levels.

     During fiscal 1996 the Registrant maintained workforce levels approximately
the same as the levels of fiscal year 1995.  In addition,  the  Registrant  paid
royalties  due to Dr.  Adair for fiscal year 1996 by issuing an option to him in
lieu of cash.  Although  there was no cash  outlay  required  for the payment of
royalties incurred during fiscal 1996, proper accounting treatment under FAS 123
required  that an  expense  recognition  for the  fair  value of the  option  be
recorded in the  Registrant's  books.  The Registrant  has recorded  $120,000 of
non-cash expense under this rule.

     Without significant sales increases,  the Registrant  anticipates  negative
cash flow from operating activities for fiscal 1997 and beyond. The Registrant's
future  viability  depends on its ability to generate  cash  through  profitable
operations.  During  fiscal 1996 cash flow  deficits  were  funded by  employee,
officer,  and consultant  stock option  exercises  (raising  $611,700 during the
fiscal year), equity placements during fiscal 1994, and in previous fiscal years
through loans from the Registrant's Chairman. However, the Registrant's ability

                                      -19-


<PAGE>

to fund its operations  will be dependant upon  achieving  profitability  and in
generating positive cash flow from operations.  Unless the Registrant is able to
increase sales revenues and maintain profitability, the Registrant may be facing
significant  working capital shortages beginning in fiscal 1998. There can be no
assurance  that the  Registrant  will be able to achieve  this goal.  Should the
Registrant be unable to meet future minimum royalty payments to the Registrant's
Chairman  beginning  October  1,  1996,  then  under the terms of the  licensing
agreement the majority of patent rights under the agreement could revert back to
the Registrant's  Chairman,  unless further compensatory  arrangements are made.
Possible  compensation  arrangements  could  include  stock  options  in lieu of
royalties or deferral of royalty  payments,  among others.  No assurances can be
given that these  arrangements  will be made.  The majority of the  Registrant's
medical  products  use  patents  licensed to the  Company by the  Chairman.  The
Registrant's  new dental  camera is not made under license  agreements  from the
Company Chairman.  See item 12 - Certain Relationships and Related Transactions,
"Distribution Agreement."

     The Registrant  believes that its existing capital resources are sufficient
for the 1997 fiscal year, and the Registrant has planned no significant  capital
expenditures. The Registrant is not seeking additional debt or equity capital at
this time. If, however,  the Registrant does obtain additional capital (of which
there  can be no  assurance),  the  Registrant  will be able  to  allocate  more
resources  to  sales  and  marketing   efforts   (including   negotiations  with
prospective OEM relationships), and research and development.

     Results of  Operations.  (Fiscal 1996 as compared to Fiscal 1995) As an aid
to  understanding  the  Registrant's  operating  results,  the  following  table
indicates the percentage relationships of principal revenue and expense items to
total net sales  included in the  consolidated  statements of operations for the
years ended  September 30, 1996,  and 1995 and the  percentage  changes in those
items for the same years.

<TABLE>
<CAPTION>

      As a percent of total                                                     
      revenue for the years                                               Percentage               
       ended September 30,                                                change from
       1996        1995                 Revenue/Expense Items         FYE 1995 to FYE 1996
       ----        ----                 ---------------------        ---------------------

     <S>          <C>                  <C>                                <C>  
     100.0%      100.0%                 Net sales                          (44.1%)
      97.7%       84.7%                 Cost of goods sold                 (35.6%)
       2.3%       15.2%                 Gross profit                       (91.5%)
      15.4%        7.1%                 Other operating revenue             21.4%
     131.5%       91.7%                 Selling general and                (19.8%)
                                          administrative
      60.7%        0.0%                 Fair value of common                 n/a
                                          stock options

                                               -20-



<PAGE>

     As a percent of total
      revenue for the years                                               Percentage
       ended September 30,                                               change from
       1996        1995                 Revenue/Expense Items         FYE 1995 to FYE 1996
       ----        ----                 ---------------------        ---------------------

      31.0%       19.1%                 Research and Dev.                 (9.3%)

      31.0%       22.5%                 Depreciation                      22.7%
      18.0%       10.0%                 Royalties                          0.0%
      13.0%        8.4%                 Obsolete Inventory                12.7%
       0.0%        6.1%                 Patent Loss                        n/a
    (267.6%)    (135.4%)                Operating loss                   (10.4%)
       6.7%       11.2%                 Other income/(expense)           (66.4%)
    (260.8%)    (124.2%)                Net income (loss)                (17.4%)
</TABLE>

     Additionally,  as an  aid  to  understanding  trends  and  factors  of  the
Registrant,  the following  ratios describe  historical  summaries of liquidity,
activity and  profitability  ratios for the years ended  September  30, 1996 and
1995.

                                                  1996             1995
                                                  ----             ----

         Liquidity
         Current ratio                            4.67             7.22
         Current ratio less inventory             3.85             4.54

         Activity
         Trade receivables turnover               3.68             2.81
         Inventory turnover                        .94             1.15

         Profitability
         Return on assets                        (77.9%)        (40.9%)
         Return on equity                        (86.8%)        (45.4%)
         Return on sales                        (260.8%)       (124.2%)

     Revenue.  Revenue decreased  $527,400,  or 44.1% primarily as a result of a
decrease in sales in substantially all product groups,  including the following:
catheters & accessories by $39,300,  general accessories by $245,900, a decrease
in combined Cam Wrap and Lap Wrap sales by $28,200, a decrease in EVL model 5500
sales by $184,200, and a decrease in the model 5990 sales by $38,000. This sales
decrease was due primarily to a lack of market  acceptance for the  Registrant's
medical products, a decrease in capital budget expenditures in hospitals coupled
with less influence over purchasing  decisions by physicians,  reduced marketing
efforts by the Registrant, and increased competition from other manufacturers of
surgical  cameras.  The Registrant is taking steps to introduce  products in the
fiscal 1997 time frame that  address the combined  issues of cost and  sterility
that plague the cost driven  hospital  market,  although  no  assurances  of the
success of that strategy can be given.

     OEM sales  decreased  during  fiscal 1996 to $46,800 from  $132,900  during
fiscal year end 1995.  This decrease was due primarily to a continued  reduction
and final termination of shipments to Endosurgical Development Company (EDC).
         

                                      -21-


<PAGE>


     Foreign  market  sales  revenues  totaled  $235,400  for fiscal  1996.  The
Registrant has experienced a slowdown in the foreign marketplace,  primarily due
to reduced shipments to Central and South America through Rosot Enterprises, but
still remains optimistic regarding expansion of the foreign distribution network
in fiscal 1997 along with an increase in revenues from this source,  although no
assurances can be given as to the success of those efforts.

     Cost of Goods Sold.  Cost of Goods Sold for the fiscal years ended 1996 and
1995 were $652,300 and  $1,012,400  respectively,  for a decrease of $360,100 or
35.6%.  Cost of goods sold as a percent of revenue increased to 97.7% for fiscal
1996 from 84.7% in Fiscal 1995. The principal reason for the decrease in overall
cost of goods sold is lower sales  volumes,  while the increase in cost of sales
as a  percentage  of  gross  revenue  in  fiscal  1996 is  attributed  to  lower
production volumes and charging excess  manufacturing  capacity to cost of goods
sold. Underabsorbed overhead variances will continue to adversely affect cost of
goods sold as a percentage  of revenues  during fiscal 1997 until such time that
increases in sales and production volumes materialize.

     Selling,  General & Administrative Expenses (S,G&A). S,G&A expenses for the
fiscal years 1996 and 1995 were  $878,300 and  $1,095,800,  respectively,  for a
decrease of $217,500 or 19.8%.  The decrease is primarily  due to the  continued
effectiveness  during  fiscal  1996  of  cost  cutting  measures  instituted  by
management,  precipitated by lower sales and production volumes.  The Registrant
continues to reduce or eliminate expenses in all areas when practical  including
executive compensation, employee benefits, and travel & promotions.

     Research and Development  Costs (R&D). R&D costs for the fiscal years ended
1996 and 1995 were  $206,900  and  $228,100,  respectively,  for a  decrease  of
$21,200 or 9.3%.  The  decrease  is  primarily  attributable  to the  Registrant
focusing it's R&D efforts on the intraoral dental camera and reduced allocations
of R&D funds to other projects  throughout the fiscal year. The Registrant  will
continue to fund R&D as it deems  appropriate  to maintain or gain a competitive
advantage.

Recent Accounting Standards

     In March,  1995,  the  Financial  Accounting  Standards  Board issued a new
statement  entitled  "Accounting for Impairment of Long-Lived  Assets." This new
standard is  effective  for years  beginning  after  December  15, 1995 and will
change the Company's  method of  determining  impairment  of long-lived  assets.
Although the Company has not performed a detailed analysis of the impact of this
new standard on the Company's financial statements, the Company does not believe
that adoption of the new standard  will have a material  effect on the financial
statements.

                                      -22-


<PAGE>

     In October,  1995, the Financial  Accounting  Standards  Board issued a new
statement titled  "Accounting for Stock-Based  Compensation"  (FAS 123). FAS 123
encourages,  but does not require,  companies to recognize  compensation expense
for grants of stock,  stock options,  and other equity  instruments to employees
based on fair value. Companies that do not adopt the fair value accounting rules
must  disclose  the  impact  of  adopting  the new  method  in the  notes to the
financial  statements.  The  Company  does not  intend to adopt  the fair  value
accounting  prescribed  by FAS  123,  and  will  be  subject  to the  disclosure
requirements  prescribed  by FAS 123  beginning  with  the  fiscal  year  ending
September 30, 1997.

Effect of Changing Prices and Inflation

     Generally,  inflation has not been a significant factor on the Registrant's
operations.


                                      -23-


<PAGE>




Item 7.  Financial Statements.

     The following consolidated financial statements are filed as a part of this
Form 10-KSB and are included immediately following the signature page.

        Reports of Independent Certified Public Accountants

        Consolidated Balance Sheets - September 30, 1996 and 1995

        Consolidated Statements of Operations - Years ended September
        30, 1996 and 1995

        Consolidated Statements of Stockholders' Equity - Years ended
        September 30, 1996 and 1995

        Consolidated Statements of Cash Flows - Years ended
        September 30, 1996 and 1995

        Notes to Consolidated Financial Statements


                                      -24-


<PAGE>



Item 8.  Changes in and Disagreements With Accountants on  Accounting and
         Financial Disclosure.


     On September 5, 1996 the board of directors of Medical Dynamics,  Inc. (the
"Registrant")  approved the  engagement  of Hein +  Associates,  LLP, of Denver,
Colorado,  to audit and report on the Registrant's  financial statements for the
year ended September 30, 1996.

     On such  date,  the board of  directors  also  approved  the  dismissal  of
McGladrey & Pullen, LLP, of Denver, Colorado as the Company's previous auditors.

     The  reports  of  McGladrey  &  Pullen,  LLP  on  the  Company's  financial
statements  as of September 30, 1995,  and for the year then ended  contained an
explanatory paragraph as to the ability of the Registrant to continue as a going
concern.  Such reports for the last two years contained no other adverse opinion
or disclaimer of an opinion.  None of such reports were qualified or modified as
to uncertainty, audit scope, or accounting principles.

     During the Registrant's two most recent fiscal years and subsequent interim
periods through the date of dismissal of McGladrey & Pullen,  LLP, there were no
disagreements  with  McGladrey  &  Pullen,  LLP  on  any  matter  of  accounting
principles or practices,  financial statement  disclosure,  or auditing scope or
procedure, which disagreement,  if not resolved to the satisfaction of McGladrey
and Pullen, LLP, would have caused it to make reference to the subject matter of
the disagreement in connection with its report.

     The Registrant has provided the former accountant, McGladrey & Pullen, LLP,
with a copy of the foregoing disclosures. A letter, addressed to the Commission,
by the former accountants  stating that it agrees with the above statements made
by the Registrant is attached hereto as an exhibit.

     During the two most recent fiscal years and the  subsequent  interim period
preceding McGladrey & Pullen, LLP's dismissal, the Registrant was not advised by
McGladrey & Pullen,  LLP that internal controls  necessary for the Registrant to
develop reliable financial statements do not exist nor that information has come
to its  attention  that  led it to no  longer  be able  to rely on  management's
representations  or that  has  made  it  unwilling  to be  associated  with  the
financial statements prepared by management. The Registrant has not been advised
by McGladrey & Pullen, LLP of the need to expand  significantly the scope of the
Registrant's audit, nor has the Registrant been advised that during the two most
recent fiscal years and the subsequent  interim periods preceding its dismissal,
information  has  come to the  attention  of  McGladrey  &  Pullen,  LLP that if


                                      -25-


<PAGE>

investigated  may (i) materially  impact the fairness or reliability of either a
previously issued audit report or the underlying  financial  statements,  or the
financial  statements  issued  or to  be  issued  covering  the  fiscal  periods
subsequent  to the date of the most recent  financial  statements  covered by an
audit report  (September 30, 1995), or (ii) cause McGladrey & Pullen,  LLP to be
unwilling to rely on  management's  representations  or be  associated  with the
Registrant's financial statements.

     The  Registrant  has not been  advised  by  McGladrey  &  Pullen,  LLP that
information has come to its attention that it has concluded  materially  impacts
the fairness or  reliability  of either (i) a previously  issued audit report or
the underlying  financial  statements or (ii) the financial statements issued or
to be issued covering the fiscal periods subsequent to September 30, 1995.

     No consultations occurred between the Registrant and Hein + Associates, LLP
during the two most recent fiscal years and any subsequent periods prior to Hein
+  Associates,  LLP's  appointment,  regarding  the  application  of  accounting
principles,  the type of audit opinion,  or other information  considered by the
Registrant in reaching a decision as to any accounting,  auditing,  or financial
reporting issue.


                                      -26-


<PAGE>
                                    PART III

Item 9.  Directors, Executive Officers, Promoters and Control Persons of the
         Company; Compliance With Section 16(a) of the Exchange Act.

     (a) Identification of Directors and Executive Officers.

     The following table sets forth certain information  regarding the directors
and executive officers of the Registrant:

Name                             Age        Position
----                             ---        --------

Edwin L. Adair, M.D. (1)         66         Chairman of the Board and Treasurer

Van A. Horsley                   44         Director, President, Chief Financial
                                            Officer and Chief Executive Officer

Pat Horsley Adair (1)            68         Director and Secretary

I. Dean Bayne, M.D.              69         Director and Assistant Secretary

Leroy Bilanich                   46         Director

Jo Brehm                         60         Vice President

--------------
(1)  Members of the Compensation Committee.

     No  arrangement  exists  between any of the above  officers  and  directors
pursuant  to which  any one of those  persons  was  elected  to such  office  or
position.

     Directors  hold office until the next meeting of  shareholders  and until a
successor  is elected  and  qualified,  or until  their  resignation.  Executive
officers  are elected at annual  meetings of the Board of  Directors.  Each such
officer holds office for one year or until a successor has been duly elected and
qualified or until death, resignation or removal.

     Edwin L. Adair,  M.D. has been a director of the Registrant  since June 30,
1971,  Chairman of the Board since  September 8, 1981 and Treasurer  since March
27, 1973.  From  February 6, 1986 until July 13, 1990,  Dr. Adair also served as
Chief  Executive  Officer of the  Registrant.  Dr. Adair  received B.S. and M.D.
degrees from the University of Colorado in 1951 and 1955, respectively.  He prac
ticed  medicine  from 1956 until  1983 and is a  board-certified  urologist  who
discontinued  the  practice of medicine due to a physical  disability  resulting
from an accident.  Dr. Adair has published  articles in medical journals and has
taught at the University of Colorado  School of Medicine.  Dr. Adair is a member
of the American  Medical  Association,  American Board of Urology,  the American
Urological  Society  and  the  American  College  of  Surgeons.  The  Registrant
currently carries a $100,000 key man life insurance policy on Dr. Adair, reduced
from $1,100,000 as a cost savings measure during fiscal 1996.

     Van A. Horsley has been a director,  President and Chief Executive  Officer
of the Registrant  since July 13, 1990.  From March 1, 1990 until July 13, 1990,
Mr.  Horsley  served as Chief  Financial  Officer.  Mr. Horsley holds a B.S.B.A.
degree in finance from the  University of Denver and a graduate  degree from the
School of Banking at the  University of Colorado.  From 1974 to February,  1990,
Mr.  Horsley was employed in various  capacities by Affiliated  Denver  National
Bank in  Denver,  Colorado  and from  1985  through  February,  1990  served  as
executive vice president - head of lending.

     Pat Horsley Adair has been a director and Secretary of the Registrant since
September 8, 1981.  Mrs.  Adair  attended  McMurray  College in Abilene,  Texas,
taking courses in English and business which did not lead to a degree. From June
1974 to July 1983,  Mrs. Adair was employed by the Registrant as office manager.
Since that time, Mrs. Adair has served as Corporate Secretary to the Registrant.
From 1964 to 1975,  Mrs.  Adair  served as  executive  director of the  Arapahoe
County Medical Society and from 1976 to 1980 she served as executive director of
the Metro Denver  Founda tion for Medical  Care,  an  organization  which serves
Arapahoe, Denver, Boulder, Jefferson and Adams counties, Colorado.

     I. Dean Bayne,  M.D. has been a director of the Registrant  since July 1987
and Assistant  Secretary  since October 1988.  Dr. Bayne  received B.S. and M.D.
degrees from Louisiana State University in 1949 and 1953, respectively,  and has
been engaged in private medical practice since 1958. Dr. Bayne was a resident in
obstetrics  at Herman  Kiefer  Hospital,  Detroit,  Michigan,  and a resident in
gynecology at Detroit Receiving Hospital,  Detroit,  Michigan. He is a member of
the Board of Obstetrics and  Gynecology  and the American  College of Obstetrics
and Gynecology.

     Leroy Bilanich, Ed.D. has been a director of the Registrant since September
13,  1990.  Dr.  Bilanich  has  a  B.S.  in  journalism  and  broadcasting  from
Pennsylvania  State University,  an M.A. in communication from the University of
Colorado and has an Ed.D. in  organizational  behavior from Harvard  University.
Dr. Bilanich  currently works as a consultant to large  corporations in the area
of organizational  development and in the past has held various positions in the
Human Resource  Departments  at Pfizer,  Inc. from 1983 to March of 1988 and the
Olin Corporation.

                                      -27-


<PAGE>

     Jo Brehm is Vice President - Sales and  Administration  of the  Registrant.
She has been an employee of the  Registrant  since 1973.  From  December 1984 to
September  1988,  Mrs.  Brehm served as Vice President of the  Registrant.  From
September  1988  until  July  1990,  Mrs.  Brehm  served  as  President  of  the
Registrant.  In each position, Mrs. Brehm has performed various duties including
management of customer service and order  processing,  as well as administration
of the  Registrant's  office affairs,  personnel  relations and medical standard
compliance  activities.  She  also  handles  all  OEM  and  foreign  distributor
relationships.  In her present  position,  Mrs. Brehm  continues to direct these
activities as well as supervising the  Registrant's  general and  administrative
activities.

     No  director  of the  Company  is a  director  of  another  company  having
securities registered under Section 12 of the Securities Exchange Act of 1934 or
a company registered under the Investment Company Act of 1940.

     (b) Identification of Certain Significant Employees.

     There are no significant  employees who are not also directors or executive
officers, described above.

     (c) Family relationships.

     Dr. Edwin L. Adair and Pat Horsley Adair are married. Van A. Horsley is the
son of Pat Horsley  Adair.  There are no other  family  relationships  among the
officers or directors.

     (d) Involvement in Certain Legal Proceedings.

     During the past five years, no director or officer of the Company has:

          (1) Filed or has had filed  against  him a petition  under the federal
bankruptcy laws or any state insolvency law, nor has a receiver, fiscal agent or
similar  officer been  appointed by a court for the business or property of such
person, or any partnership in which he was a general partner, or any corporation
or business  association  of which he was an executive  officer at or within two
years before such filings;

          (2) Been convicted in a criminal proceeding or is a named subject of a
pending  criminal  proceeding  (excluding  traffic  violations  and other  minor
offenses);

          (3)  Been  the  subject  of  any  order,   judgment,  or  decree,  not
subsequently  reversed,   suspended  or  vacated,  of  any  court  of  competent
jurisdiction,   permanently  or  temporarily  enjoining  such  person  from,  or
otherwise  limiting  his  involvement  in any type of  business,  securities  or
banking activities.

                                      -28-


<PAGE>

          (4) Been found by a court of competent jurisdiction in a civil action,
the  Securities  and  Exchange  Commission  or  the  Commodity  Futures  Trading
Commission to have violated any federal or state  securities or commodities law,
which judgment has not been reversed, suspended, or vacated.

Compliance with Section 16(a) of the Exchange Act

     Section 16(a) of the Securities  Exchange Act of 1934 (the "Exchange  Act")
requires the Company's  directors and officers and persons who own more than ten
percent of the  Company's  equity  securities,  to file reports of ownership and
changes in ownership with the Securities  and Exchange  Commission  (the "SEC").
Directors,  officers and greater than  ten-percent  shareholders are required by
SEC  regulation  to furnish the Company with copies of all Section 16(a) reports
filed.

     Based  solely on its review of the copies of the reports it  received  from
persons  required  to file,  the  Company  believes  that during the period from
October 1, 1995 through January 14, 1997 all filing  requirements  applicable to
its officers,  directors and greater than ten-percent shareholders were complied
with except as follows:

     Dr. and Mrs. Adair, chairman and secretary of the Registrant,  filed a form
4 reporting an event which occurred in October, 1996 late. This report was filed
on November 12, 1996.

     I.  Dean  Bayne,  director  of the  Registrant,  filed  two form 4's  late,
reporting an event which  occurred in each of the months July and August,  1996,
in October, 1996.

                                      -29-


<PAGE>

Item 10.  Executive Compensation.

(a)  Summary Compensation Table

     The following table sets forth information  regarding  compensation paid to
the  chief  executive  officer  of the  Registrant  for the  five  years  ending
September 30, 1996. No other person who is currently an executive officer of the
Registrant earned salary and bonus compensation exceeding $100,000 during any of
those years.

<TABLE>
<CAPTION>

                               Annual Compensation ($$)      Long Term Compensation
                                                               Awards        Payouts
       (a)             (b)   (c)        (d)        (e)     (f)      (g)        (h)         (i)
                                                          Restricted
     Name and                                             Stock   Options    LTIP         Other
     Position         Year  Salary     Bonus      Other   Awards  & SARs     Payouts   Compensation
     --------         ----  ------     -----      -----   ------  ------     -------   ------------
                             ($$)       ($$)      ($$)     ($$)     (##)       ($$)       ($$)

<S>                   <C>   <C>          <C>      <C>       <C>    <C>          <C>       <C>
Van A. Horsley        1996  105,000     -0-       925      -0-     37,174*     -0-        260
President and         1995  105,000     -0-       925      -0-     40,900      -0-        559
Chief Executive       1994  105,000     -0-       925      -0-     50,000      -0-        559
Officer
</TABLE>

*    Does not include  options to acquire  150,000 shares  exercisable at prices
     ranging  from  $2.75 to $3.75 per  share  which  vest  based  upon  defined
     performance goals.

     401(k) Plan. On January 1, 1990, the Registrant adopted an employee benefit
plan under  Internal  Revenue Code Section  401(k).  The 401(k) plan is a profit
sharing  plan under which both  employees  and the  Registrant  are entitled (at
their own  discretion)  to con tribute a portion of  compensation  and earnings,
respectively, to investment funds to supplement employee retirement benefits. At
September 30, 1996, the Registrant's matching  contributions to the plan for the
accounts  of Van  Horsley  and Jo  Brehm  totalled  approximately  $438  and the
matching  contribution under the plan for the accounts of all executive officers
as a group  totalled  $438.  These  amounts  are  included  in column (i) of the
Summary Compensation Table.

     (b) Stock Option Plans.

     Options and Option Plans. Until April 10, 1988 the Registrant had two plans
pursuant to which stock  options could be granted to its directors and officers.
These  plans  were  the  1981  Non-  Qualified  Consultants'  Plan  and the 1981
Incentive  Stock Option Plan (the "Old Plans").  On April 10, 1988, the Board of
Directors canceled the Old Plans to the extent that shares reserved for issuance
thereunder were not then under option, and adopted and authorized the 1988 Stock
Option Plan (the "1988 Plan") and directed that management prepare the documents
formally  defining the plan. At that time the Board also authorized the issuance
of certain  options under the 1988 Plan.  The Board  formally  approved the 1988
Plan on July 14, 1988 and the  shareholders  approved the 1988 Plan on September
28, 1988.

                                      -30-


<PAGE>

     Allocations of options under the  Registrant's  stock option plans are made
by the Compensation  Committee based on the duties,  contributions  and value of
the services of the  respective  optionee.  The  Committee  has the authority to
determine  to whom options were  granted,  the number of shares  covered by each
option, when each option was to be granted, date of initial ability to exercise,
exercise  price and certain other terms and to prescribe,  interpret,  amend and
rescind rules and regulations relating to each plan. Any options canceled or not
exercised  within the option period  became  available for grants of new options
under the plans. The Board also has the power to select committees consisting of
not less than two members to  administer  each plan.  The 1988 Plan contains the
same provisions for administration as were contained in the Old Plans.

     Under the 1988 Plan,  the  Registrant  reserved an  aggregate  of 1,000,000
shares of its common  stock for  issuance  to  employees  (including  officers),
consultants and directors of the Registrant or any subsidiary. The plan contains
restrictions  on the  number of  options  granted  to  officers  and  directors,
exercise  price,  maximum  term  and  transferability.  On  May  14,  1991,  the
Registrant  filed a registration  statement  under the Securities Act of 1933 on
Form S-8 which registered the shares of common stock underlying  options granted
under the 1988 Plan. As such, shares issued upon exercise of outstanding options
can be traded on the open market with limited restriction.

     All of the  options  granted  under  the Old Plans and the 1988 Plan may be
exercised  through payment of the exercise price with shares of the Registrant's
Common  Stock  or  cash,  or both.  The  ability  to  exercise  options  through
surrendering  shares of Common Stock enables  holders of options to exercise the
entire  amount of an  option  by first  exercising  a small  number of  options,
followed by successively  larger option  exercises which the optionee is able to
effect by surrendering  the increasing  number of shares obtained  thereby.  For
little or no initial cash payment, repeated exercises of options by surrendering
stock having a market price in excess of the option  exercise  price,  enable an
optionee to provide  sufficient  consideration to the Registrant to exercise his
entire stock option. The exercise of options might otherwise require substantial
cash consideration. This procedure is often referred to as pyramiding.

     The following table sets forth certain information  regarding stock options
granted by the Registrant to the Chief Executive  Officer and no other executive
officers  received  total annual  salary and bonus in excess of $100,000  during
1996. No stock appreciation rights were granted.


                                      -31-


<PAGE>
<TABLE>
<CAPTION>


Option Grants in Fiscal 1996

(a)                                (b)                    (c)                     (d)                 (e)
                                                        % of Total
                                                      Options Granted           Exercise or
                                 Options          to Empl. / Cons. in         Base Price          Expiration
Name                           Granted (#)            Fiscal Year               ($/sh)              Date
----                           -----------            -----------             -------------     --------------

<S>                              <C>                    <C>                  <C>                <C> 
Van A. Horsley                   37,174                   3.0%                  $1.375          Apr. 18, 2001
Van A. Horsley*                  50,000                   4.0%                  $2.00           Sep. 05, 2001
</TABLE>

*    Does not include  options to acquire  150,000 shares  exercisable at prices
     ranging  from  $2.75 to $3.75 per  share  which  vest  based  upon  defined
     performance goals.


Aggregated  Option  Exercises  in Last  Fiscal  Year and Fiscal  Year End Option
Values.

     The  Following  table  sets  forth  information   regarding  stock  options
exercised by the chief executive officer and certain other officers or directors
during the 1996 fiscal year as well as the year-end  value of options being held
by such persons on September  30, 1996: No Stock  Appreciation  Rights have been
granted, or are held by, any such person:

<TABLE>
<CAPTION>

(a)                         (b)               (c)                   (d)                   (e)
                                                                Number of              Value of
                                                                Unexercised          In-the-Money
                          Shares                                Options at            Options at
                         Acquired                                 FY End                FY End
                            on               Value             (Exercisable/         (Exercisable/
Name                     Exercise          Realized           Unexercisable)        Unexercisable)
----                     --------          --------           --------------        --------------

<S>                        <C>              <C>                <C>                  <C>  
Van A. Horsley               -0-           $      0            224,638 / 0           $553,037 / 0
Edwin L. Adair           104,000           $160,225            360,000 / 0           $450,000 / 0
Pat H. Adair              23,600           $ 61,950                  0 / 0           $      0 / 0
I. Dean Bayne             20,000           $ 40,000             20,000 / 0           $  5,000 / 0
Leroy Bilanich            20,000           $ 67,880             20,000 / 0           $ 55,000 / 0
Jo Brehm                  14,800           $ 34,040             50,000 / 0           $156,000 / 0
</TABLE>

     (c) The Registrant has no long term incentive compensation plans.

     (d) Other Compensation

     There are no plans to pay bonuses or deferred  compensation to employees of
the Company.

     The Company  has adopted a medical  insurance  plan for its  employees  and
provides  life,  disability,  and other  insurance  plans for the benefit of its
employees.

     (e) Compensation of Directors

     General. The Registrant's directors are authorized to receive $200 for each
directors'  meeting  attended by them. To date,  the directors have waived their
right to receive  directors  fees. In September  1990,  certain  directors  were
granted  options  under the 1988 Stock Option Plan.  Dr. Bayne owns an incentive
stock  option to  acquire  20,000  shares of  common  stock at $4.00 per  share,
expiring June 11, 2003. Leroy Bilanich owns an incentive stock option to acquire
20,000 shares of common stock at $1.50 per share, expiring June 11, 2003.


                                      -32-


<PAGE>

     The following options were granted during fiscal 1995 to board members: Dr.
Bayne was granted an option to acquire  20,000  shares of common  stock at $1.50
per share,  expiring June 1, 2000 on June 2, 1995.  Mr.  Bilanich was granted an
option to acquire  20,000  shares of common  stock at $1.50 per share,  expiring
June 1, 2000 on June 2, 1995.  Dr.  Edwin Adair was granted an option to acquire
44,000 shares of common stock at $1.50 per share,  expiring June 1, 2000 on June
2, 1995.  Pat Horsley  Adair was granted an option to acquire  23,600  shares of
common  stock at $1.50 per share,  expiring  June 1, 2000 on June 2,  1995.  All
these options were exercised during the fiscal year ended September, 1996.

     Royalty Agreements.  Dr. Adair and Dr. Bayne,  directors of the Registrant,
are each entitled to receive  royalties equal to two percent of the net sales of
products each assigned to the Company. No royalties have been accrued or paid to
Dr. Bayne, however,  $600,000 has been paid and $0 has been accrued to Dr. Adair
through the end of fiscal  1996.  The  Registrant  is required to pay Dr.  Adair
minimum annual royalties of $120,000.  In an effort to help reduce negative cash
flow during fiscal 1996, on December 1, 1995 Dr. Adair signed an agreement  with
the  Registrant  where he has accepted  120,000  common stock options  priced at
$1.00 per share in  substitution  for his customary cash royalty payment for the
1996 fiscal  year.  A non-cash  expense was  recorded  for the  issuance of this
option per the requirements of FASB 123. See Consolidated Notes to the Financial
Statements No. 4 for additional information. See Item 13 for further information
regarding the royalty agreement, Certain Relationships and Related Transactions.

     Indemnification Agreements. The Registrant has entered into indemnification
agreements with each of its directors and officers providing for indemnification
of each such  director by the  Registrant  to the full extent  permitted  by the
Colorado  Corporation Code. The agreements  provide that in all circumstances in
which a  director  or officer  may  receive  indemnification  by  statute,  such
indemnity shall be provided.

     Officer's Life Insurance and  Split-Dollar  Agreement.  In August 1990, the
Registrant  purchased  a  $1,000,000  convertible  term key- man life  insurance
policy on its Chairman.  Additionally,  in August 1990, the  Registrant  entered
into  a  split-dollar  life  insurance   agreement  with  an  irrevocable  trust
established by the Chairman and Secretary of the Registrant.  The Registrant had
agreed to pay  substantially all of the annual premiums on the $2,000,000 whole-
life, second-to-die policy which had the insurance trust as the beneficiary. The
split-dollar  agreement  specified that the Registrant would receive the greater
of  premiums  paid or cash  surrender  value  upon the second  insured's  death.

                                      -33-


<PAGE>

However, should the Registrant decide not to pay the premium prior to the second
insured's  death,  the Registrant would only collect premiums paid to the extent
of the cash surrender  value.  As such, the Registrant had recorded the premiums
paid in the  accompanying  consolidated  balance  sheets  to the  extent of cash
surrender  value.  During fiscal 1996 the Registrant  terminated  both the above
policies as a  cost-cutting  measure.  The  Registrant  does however,  currently
maintain a $100,000  whole life key-man  insurance  policy on its Chairman which
was acquired in 1985.

     The Registrant has no other  arrangements  pursuant to which it compensates
its directors for acting in their capacities as such.

     (g) The Registrant has no employment  contracts with any executive officer.
The  Registrant  has  no  compensatory  arrangement  which  may  result  from  a
change-of-control  of the  Registrant  or a  change  in any  executive  officers
responsibilities.

     (h) No options were repriced during the fiscal year.

Item 11.  Security Ownership of Certain Beneficial Owners and Management.

     (a) and (b) Security ownership of certain beneficial owners and management.

     At September 30, 1996,  the  Registrant  had only one class of  outstanding
voting  securities,  its Common Stock, $.001 par value. The following table sets
forth  information as of September 30, 1996 with respect to the ownership of the
Company's  Common  Stock  for all  directors,  individually,  all  officers  and
directors as a group, and all beneficial owners of more than five percent of the
Common Stock. The following  shareholders  have sole voting and investment power
with respect to the shares, unless it has been indicated otherwise.

                                      -34-


<PAGE>

                                        Shares owned                Percent
Name of beneficial owner              beneficially (1)             of class
------------------------              ----------------             --------

Edwin L. Adair, M.D.                      1,239,298 (2)              15.9%
and Pat Horsley Adair
317 Paragon Way
Castle Pines Village
Colorado   80104

I. Dean Bayne, M.D.                          20,000                    0.3%

Van Horsley                                 303,858 (3)                3.9%
Leroy Bilanich, Ed.D.                        20,000                    0.3%

All officers and                          1,643,156 (4)               21.1%
directors as a
group (6 persons)

---------
(1)  As used in this section,  the term  beneficial  ownership with respect to a
     security is defined by Rule 13d-3 under the Securities Exchange Act of 1934
     as consisting of sole or shared voting power  (including  the power to vote
     or direct the vote) and/or sole or shared  investment  power (including the
     power to dispose or direct the  disposition)  with  respect to the security
     through  any  contract,   arrangement,   understanding,   relationship   or
     otherwise.  Unless otherwise  indicated,  beneficial ownership is of record
     and consists of sole voting and investment power.

(2)  Includes  240,000  stock  options  issued to the  Chairman of which all are
     presently exercisable. Also includes 120,000 options issued to Dr. Adair in
     December,  1995 in  consideration  for  cancellation of fiscal 1996 royalty
     payments due him totaling $120,000, also presently exercisable.

(3)  Includes 224,638 shares under presently exercisable stock options. Does not
     include  options to acquire  150,000  shares  exercisable at prices ranging
     from $2.75 to $3.75 per share  which vest  based upon  defined  performance
     goals.

(4)  Includes shares  referenced in notes (2) through (3) and 60,000  additional
     shares and options held by one officer who is not a director,  all of which
     are presently exercisable.


     (c) Changes in Control.

     The  Company  knows of no  arrangement,  the  operation  of which may, at a
subsequent date, result in change in control of the Company.


                                      -35-


<PAGE>



Item 12.   Certain Relationships and Related Transactions.

     (a) and (b) Transactions With Management and Others.

     The  Registrant  has engaged in certain  transactions  with  members of its
Board of Directors. In each case, the Board believed that the transaction was in
the  Registrant's  best interests and the terms of the transaction were at least
as fair to Registrant as could have been  obtained from an  independent  person,
and the transaction was approved by the disinterested directors. Registrant will
continue to follow this procedure in approving any transactions  with affiliated
persons. No such transactions are contemplated at this time.

     License Agreement with Dr. Adair. The Registrant has entered into a license
agreement,  as further amended and explained below, effective June 3, 1987, with
its Chairman relating to the use of certain technology invented and developed by
him. Originally, the agreement licensed technology relating to certain malleable
endoscopes,   flexible  optical  catheters,   the  Adair/Veress(TM)  needle  and
complementing  viewing systems for use in connection  with detection,  diagnosis
and treatment of disease or injury in humans and animals.  The  Registrant  used
this technology to develop the Model 5990 Optical Catheter System.

     Pursuant to an amendment, dated February 20, 1989, to the license agreement
described in the  preceding  paragraph,  the  Registrant  acquired the rights to
certain technology  including patent  applications for technology related to the
Registrant's (a) speculum camera which uses a small,  video camera attached to a
speculum  for  magnified  viewing of the cervix as a  diagnostic  tool;  and (b)
camera with a sterilizable sheath  (disposable),  a molded or machined container
used to hold the camera in place,  and which utilizes a standard,  off-the-shelf
camera which is covered by a specialized  sheath which provides proper alignment
with  endoscopes,  sterility  of the system and reduced  cost to the hospital or
other end-user.

     Pursuant to an  amendment  dated June 22,  1989,  to the license  agreement
described above, the Chairman agreed not to exercise his right of termination of
the license if the Registrant  used its best efforts to  manufacture  and market
all products developed  utilizing the technology included within the license. In
exchange  for the  agreement  not to  exercise  his  right of  termination,  the
Registrant  agreed to pay the  Chairman  minimum  annual  royalties  of $60,000,
$80,000 and $100,000  for the years ended  September  30,  1990,  1991 and 1992,
respectively.  Thereafter, the Registrant has agreed to pay the Chairman minimum
annual  royalties  of  $120,000.  The  license  agreement  does  not  specify  a
termination  date.  Through  September  30, 1995,  the  Registrant  has paid the
Chairman $600,000 as specified under the agreement.


                                      -36-


<PAGE>

     Pursuant to an amendment dated July 2, 1992, to the license agreement noted
above,  the  Chairman  agreed to add  further  developed  technology  along with
patents and  trademarks to the license  agreement at no  additional  cost to the
Registrant. This amendment added 23 technologies that had either patents pending
or fully- issued patent coverage.

     Pursuant to Amendment No. 4 dated October 8, 1992, to the license agreement
noted above, the Chairman and Registrant  agreed to continue the  aforementioned
royalty  payments  indefinitely and issue to the Chairman options to purchase an
additional  300,000 shares of the Registrant's  common stock at $4.00 per share.
In exchange for the issuance of additional  options and the continua tion of the
royalty payment stream,  the Chairman agreed to contribute certain patent rights
and technology  (including  some as yet to be issued patent rights)  relating to
rigid video endoscopes using advanced chip technology.

     The amendment  includes  future  technology  relating to operative  channel
endoscopes, thoracic endoscopes, 3-D endoscopes and related disposable products.
Specifically  excluded  from the license  agreement  is  technology  relating to
flexible or steerable endoscopic devices.

     Other provisions included in this amendment include an option issued to the
Chairman  allowing him to require the Registrant to register the options granted
pursuant  to  Amendment  No.  4. The cost of  registration  will be borne by the
Registrant.  In addition, the Registrant agreed to sub-license technology to the
Chairman  relating  to the use of laser  light  through  flexible  or  steerable
endoscopes on a non-exclusive basis.

     The  Registrant  further  agreed that, if within a three year period of the
issuance  of any patent  included  in the license  agreement,  as  amended,  the
Registrant fails to commercialize  such technology,  the Chairman,  upon written
request,   may  terminate  the  license   agreement  on  that  specific  patent.
Furthermore,  the Chairman has the right to terminate  the license  agreement on
specific  technologies  upon acquisition by another person of 20% or more of the
outstanding  stock of the  Registrant  unless the  acquiror  provides  notice in
writing,  within 30 days, of its intention to commercially  exploit the specific
technologies.

     The Chairman is free to research and develop future technology and know-how
at his own expense.  Such as yet unnamed future  technology is not a part of the
aforementioned  license  agreement and the Registrant has no ownership rights to
such  technology.  However,  the Chairman  has agreed to offer the  Registrant a
first  right  of  refusal  on such  future  technology  prior to  offering  such
technology to an unrelated third party. The first right of refusal shall be made
in writing to the Registrant and remain open for a period of 60 days. During the
development of this technology, the Registrant will allow the Chairman access to

                                      -37-


<PAGE>


facilities,  equipment and  inventory of the  Registrant at no cost provided the
activities  do not  interfere  with the ongoing  business of the  Registrant  or
result in an unreasonable expense to the Registrant.

     Should the Registrant  accept the technology and know-how,  such technology
shall  automatically  be included  within the license  agreement,  including all
amendments.  Furthermore,  the Registrant shall be responsible to pay all future
patent  and  development  costs  associated  with  the  new  technology.  If the
Registrant  rejects the new  technology,  the  Chairman is free to pursue  third
party alliances and has no further obligation to re-offer such technology to the
Registrant.  However,  the  Chairman  may  not use  the  facilities,  equipment,
inventory or other resources of the Registrant for any such further  development
of said technology.

     The Registrant is free to terminate the license agreement,  as amended,  at
any time and without  penalty.  The Chairman  must give the  Registrant  45 days
prior written  notice of his intent to terminate the license upon default by the
Registrant of its obligations  under the license  agreement.  Additionally,  the
license will terminate  automatically  immediately if (i) the Registrant files a
voluntary case in bankruptcy or (ii) any order for relief against the Registrant
shall be entered in an  involuntary  case in bankruptcy or (iii) the  Registrant
shall fail, or admit in writing an inability, to pay its debts as they mature.

     The technology added to the license  agreement over the years has increased
MEDY's patent  maintenance costs and management  recently  performed a review of
the viability of certain of the technology  based upon MEDY's  current  business
and  marketing  plans.  Management  has  determined  that MEDY  would not likely
develop  certain  of  the  technology  into  saleable  products  because  of the
anticipated costs involved and the recent difficulties MEDY has had in obtaining
approval of new devices from the federal Food and Drug  Administration  ("FDA").
As a result,  management  recommended,  and the Board  approved,  the  return of
twelve items of  technology  to Dr.  Adair.  Medical had  approximately  $73,000
invested in this technology, and the maintenance costs for this technology which
was not likely to be commercialized by MEDY in the near future were in excess of
$20,000 per year. To conserve cash flow and to allow  management to  concentrate
on MEDY's other  products,  the Board of  Directors  approved the return of this
technology to Dr. Adair.

     At the same time,  the Board  approved  an  amended  and  restated  license
agreement with Dr. Adair which  consolidated the original license  agreement and
the four amendments thereto,  and added an expanded right of first refusal.  The
principal amendments are:
          

                                      -38-


<PAGE>

          The definition of "Technology"  included within the license  agreement
          was modified to more accurately  describe the technology  developed by
          Dr.  Adair  which  is of  continuing  interest  to MEDY:  the  Optical
          Catheter(TM) technology (including the fluorescence detection system);
          the  Adair-Veress  needle(TM),  the  technology  associated  with  the
          Electronic  Video  Laparoscope(TM),  and  Lap-Wrap(TM).  The  restated
          license  agreement  continues to  specifically  exclude from its terms
          technology relating to flexible or steerable endoscopic devices (other
          than the Optical Catheter).  In the restated license  agreement,  MEDY
          continues to agree to sub-license  technology to the Chairman relating
          to the use of laser light through flexible or steerable  endoscopes on
          a non-exclusive basis.

          Under  the  restated  license  agreement,  Dr.  Adair is  specifically
          permitted to research and develop new  technology  and know-how at his
          own expense.  Such  technology  and know-how will not be a part of the
          restated  license  agreement  unless MEDY exercises its right of first
          refusal  to acquire  the new  technology  or  know-how.  Dr.  Adair is
          obligated to offer all new  technology  which he may develop to MEDY's
          Board of  Directors  under  the  license  agreement,  subject  only to
          reimbursement  to him of costs he has in the development and patenting
          of the technology. Neither Dr. nor Mrs. Adair would participate in the
          Board's vote whether to accept the proffered  technology.  Should MEDY
          accept  the   technology   and   know-how,   such   technology   shall
          automatically be included within the license agreement,  including all
          amendments.  Furthermore,  MEDY shall be responsible to pay all future
          patent and development  costs  associated with the new technology.  If
          MEDY rejects the new technology,  the Chairman is free to pursue third
          party  alliances  and  has no  further  obligation  to  re-offer  such
          technology to MEDY.

     The financial  provisions of the license agreement were not modified in any
material  respect.  The  restated  license  agreement  continues  to provide for
minimum  royalties  payable  to Dr.  Adair of  $120,000  per year.  The  license
agreement does not specify a termination date.  Currently MEDY is accruing these
royalties  for future  payment to Dr.  Adair,  without  interest.  These accrued
royalties are  collateral  for a guarantee from Dr. Adair of a loan made by MEDY
to an affiliated company,  Micro-Medical  Devices,  Inc. (See further discussion
under  "Distribution  Agreement,"  below.) As noted above,  Dr.  Adair  accepted
120,000 of the  Registrants  common  stock  options in lieu of the cash  royalty
payments due him for fiscal 1996.

     The restated license agreement continues to provide that, if within a three
year period of the issuance of any patent included in the license agreement,  as
amended,  MEDY fails to commercialize  such technology,  Dr. Adair, upon written


                                      -39-


<PAGE>

request,   may  terminate  the  license   agreement  on  that  specific  patent.
Furthermore,  Dr.  Adair has the right to  terminate  the license  agreement  on
specific  technologies  upon acquisition by another person of 20% or more of the
outstanding  stock of the  Registrant  unless the  acquirer  provides  notice in
writing,  within 30 days, of its intention to commercially  exploit the specific
technologies.

     As noted, the restated license  agreement  contemplates that Dr. Adair will
continue to develop new technology and know-how for his own account,  subject to
the right of first refusal.  During the development of any new technology,  MEDY
will allow the Chairman  access to  facilities,  equipment  and inventory of the
Registrant at no cost provided the  activities do not interfere with the ongoing
business of MEDY or result in unreasonable  expense to MEDY. If,  however,  MEDY
rejects  the  technology,  Dr.  Adair  will  not be  entitled  to use any of the
equipment, facilities, or inventory of MEDY for further development.

     The  termination  provisions  were not changed  materially  in the restated
license agreement.  MEDY is free to terminate the license agreement, as amended,
at any time and without penalty.  Dr. Adair must give MEDY 45 days prior written
notice of his  intent to  terminate  the  license  upon  default  by MEDY of its
obligations  under  the  license  agreement.   Additionally,  the  license  will
terminate  automatically  immediately  if (i)  MEDY  files a  voluntary  case in
bankruptcy  or (ii) any order for  relief  against  MEDY  shall be entered in an
involuntary  case in bankruptcy or (iii) MEDY shall fail, or admit in writing an
inability, to pay its debts as they mature.

     Distribution Agreement.

     The  Registrant  entered into a distribution  agreement with  Micro-Medical
Devices,  Inc. ("MMD"),  a corporation  wholly-owned by Dr. Adair during June of
fiscal year 1995. The distribution  agreement includes all products developed by
Dr. Adair related to his Universal Sterile Endoscopy System(TM)  ("USES").  MEDY
had  previously  owned  certain  rights to this  technology  under  the  License
Agreement  but was required to return the  technology to Dr. Adair due to MEDY's
inability to  commercialize  the product  within the required three year period.
MEDY was  unable to do so because of its lack of  financial  capability  and its
inability to obtain  approval of products  from the FDA. Dr.  Adair,  therefore,
continued the research and development necessary to develop USES and the related
products at his own expense, and through MMD, obtain FDA approval thereof.

     MMD has appointed MEDY as its exclusive worldwide  distributor for the USES
products  through June 30, 2000.  MMD also granted MEDY a right of first refusal
to  distribute  any  further  products  MMD may  develop.  There are no  minimum
performance  requirements under the distribution  agreement,  and MEDY need only
purchase products it has already sold to third parties.

                                      -40-


<PAGE>

     As a condition of the distribution  agreement,  however, MEDY agreed during
fiscal 1995 to loan MMD up to $120,000  pursuant to a promissory  note signed by
MMD. The note was collateralized by the amounts due Dr. Adair under the restated
license agreement as the sole shareholder of MMD, and he had pledged all amounts
due to  him  under  the  restated  license  agreement  as  collateral  for  this
guarantee.  MEDY  was  accruing  these  amounts  payable  to Dr.  Adair  without
interest.  MEDY was not  obligated  to advance  any amounts to MMD except to the
extent these amounts are fully  collateralized  by amounts due to Dr. Adair. The
promissory  note  from  MMD to MEDY  earned  interest  at a rate of 1% over  the
current prime rate per annum.  Furthermore,  the distribution agreement provided
that MEDY could credit 100% of the purchase price of any products purchased from
MMD  under  the  distribution  agreement  against  any  amounts  due  under  the
promissory  note.  At September  30, 1995 MMD had owed the  Registrant  $110,000
under the terms of the note, plus accrued interest. This amount was paid in full
during February, 1996. The September 30, 1996 balance owed MEDY by MMD was $-0-.
See note 4. to the consolidated financial statements.

     MMD also agreed to sublease space from MEDY for administration  purposes at
cost.  The amount of space has not yet been defined,  but the rental payment and
reimbursement  to MEDY for  employees MMD may utilize are intended to compensate
MEDY for all associated expenses, including rent on a per-square-foot basis.

Other Related Party Transactions.

     In October 1987, I. Dean Bayne,  M.D., a director,  assigned his rights and
interest in a then pending patent application related to the Bayne Pap Brush(TM)
described in "Item 1 - Business Patents,  Trademarks and Licenses." To reimburse
him for his  expenses in  developing  that product and as  compensation  for the
assignment,  the  Registrant  paid Dr. Bayne 10,000 shares of restricted  common
stock and will pay him a royalty  for the  duration  of the patent  equal to two
percent of the net sales of the Bayne Pap Brush(TM),  less certain expenses.  As
of  September  30,  1996,  no  royalties  have been  accrued  or paid under this
arrangement. See "Item 1 - Business."

     The  Registrant  employs  two sons of Dr.  Adair and one son of Pat Horsley
Adair at annual salary rates of approximately  $45,600,  $45,600,  and $105,000.
During the most recently  completed  fiscal year those persons received no other
compensation from the registrant in addition to their salaries.
           
                                      -41-


<PAGE>

     Except as otherwise stated above, since October 1, 1991, the Registrant has
not been a party to any transaction involving in excess of $60,000, in which any
director or  executive  officer,  nominee for  election as a director,  security
holder of record or  beneficially  of more than five percent of any class of the
Regis trant's securities, or any member of the immediate family of the foregoing
had or will have a direct or indirect material interest.

     The Registrant is not aware of any other relationship  between nominees for
election as directors or its  directors and the  Registrant  that are similar in
nature and scope to those relationships listed in this Item 12.

     (c) Parents of the Company

     Not applicable, inasmuch as there are no "Parents" of the Registrant.

     (d) Transactions with Promoters

     Not applicable,  inasmuch as the Company was organized more than five years
ago.

Item 13.  Exhibits and Reports on Form 8-K.

     (a) Exhibits

     The following is a complete  list of exhibits  filed as part of this Annual
Report on Form 10-KSB, which Exhibits are incorporated herein.

Exhibit
 Number              Description
 ------              -----------

 3.1(k)              Restated Articles of Incorporation (December 30, 1988)

3.2(n)               Bylaws, as amended

10.1(m)              Amendment Number Five to Lease
                     Agreement - Englewood Office Space

10.2(a)              Stock Option Plan - Consultant's

10.3                 Omitted

10.4(j)              1988 Stock Option Plan

10.5                 Omitted

10.6(d)              Sales Representative Agreement - Form

10.7(e)              International Distributor Agreement

                                      -42-


<PAGE>

Exhibit
 Number              Description
 ------              -----------

10.8(f)            Indemnification Agreement - Edwin L.  Adair, M.D.

10.9(f)            Indemnification Agreement - Pat Horsley Adair

10.10(h)           Indemnification Agreement - I. Dean Bayne

10.11(a)           Employee Confidentiality Agreement - Form

10.12(b)           Section 125 Cafeteria Plan

10.13(h)           Patent Assignment - Bayne Pap Brush

10.14(o)           Amended and restated License Agreement with Edwin L. Adair
                   effective as of June 1, 1995

10.15              Omitted

10.19              Omitted

10.20              Omitted

10.21              Omitted

10.22              Omitted

10.23              Omitted

10.24              Omitted

10.25(n)           401(k) Plan

10.26(b)           Indemnification Agreement - Van A. Horsley

10.27(b)           Indemnification Agreement - Leroy A.Bilanich

21.1               Subsidiaries of the Registrant:  MedPacific
                   Corporation, a Washington corporation

23.1*              Consent of McGladrey & Pullen, LLP
23.2               Consent of Hein + Associates, LLP

*                  Filed herewith.

(a)                Incorporated by reference from Registration
                   Statement on Form S-1, SEC File No. 2-82856.

                                      -43-


<PAGE>

Exhibit
 Number              Description
 ------              -----------

(b)              Incorporated by reference from the Registrant's
                 Form 10-K for the period ended September 30, 1991.

(c)              Omitted.

(d)              Incorporated by reference from the Registrant's
                 Form 10-K for the year ended September 30, 1984.

(e)              Incorporated by reference from the Registrant's
                 Form 8-K reporting an event of February 8, 1985.

(f)              Incorporated by reference from the Registrant's
                 Form 10-K for the year ended September 30, 1986.

(g)              Omitted.

(h)              Incorporated by reference from the Registrant's
                 Form 10-K for the fiscal year ended September 30,
                 1987.

(i)              Omitted.

(j)              Incorporated by reference from the Registrant's
                 Form 8-K reporting an event of October 12, 1988.

(k)              Incorporated by reference from the Registrant's
                 Form 10-Q for the quarter ended December 31, 1988.

(l)              Omitted.

(m)              Incorporated by reference from Amendment No. 1 to Registration
                 Statement on Form S-1, Commission File No. 33-29497, filed
                 with the Commission on July 26, 1989.

(n)              Incorporated by reference from the Registrant's Form 10-K for
                 the fiscal year ended September 30, 1990.

(o)              Incorporated by reference from the Registrant's Form 10-QSB
                 for the quarter ended June 30, 1995.


                                      -44-


<PAGE>




     (b) Reports on Form 8-K

     During  the period  covered by this  Report up to  January  14,  1997,  the
Company filed the following reports on Form 8-K:

     September 30, 1996,  reporting an event under Item 5 - Other Events,  filed
on October 15, 1996.

     September 5, 1996, reporting an event under Item 4 - Changes In Registrants
Certifying Accountant, filed on September 11, 1996.

         April 17, 1996,  reporting an event under Item 5 - Other Events,  filed
on July 12, 1996.


                                      -45-


<PAGE>


                                   SIGNATURES

     In accordance  with Section 13 or 15(d) 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.

                                           MEDICAL DYNAMICS, INC.


                                           By:  /s/ Van A. Horsley
                                               --------------------------------
                                              Van A. Horsley, President

Date:  January 14, 1997


     In accordance with the requirements of the Securities Exchange Act of 1934,
this  report has been  signed  below by the  following  persons on behalf of the
Company and in the capacities and on the dates indicated.



January 14, 1997                 /s/ Van A. Horsley
                                 ----------------------------------------------
                                 Van A. Horsley, Principal
                                 Executive Officer, Principal
                                 Financial Officer, and Director



January 14, 1997                 /s/ Edwin L. Adair
                                 ----------------------------------------------
                                 Edwin L. Adair, M.D., Chairman
                                 of the Board and Director



January 14, 1997                 /s/ I. Dean Bayne
                                 ----------------------------------------------
                                 I. Dean Bayne, M.D., Director




January 14, 1997                 /s/ Pat Horsley Adair
                                 ----------------------------------------------
                                 Pat Horsley Adair, Director




January 14, 1997                 /s/ Leroy Bilanich
                                 ----------------------------------------------
                                 Leroy Bilanich, Director


                                      -46-





<PAGE>


                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS



                                                                        PAGE
                                                                        ----

Independent Auditors' Reports..........................................  F-2

Consolidated Balance Sheets - September 30, 1996 and 1995..............  F-4

Consolidated Statements of Operations - For the Years Ended
  September 30, 1996 and 1995..........................................  F-5

Consolidated Statements of Stockholders' Equity - For the Years Ended
  September 30, 1996 and 1995..........................................  F-6

Consolidated Statements of Cash Flows - For the Years Ended
  September 30, 1996 and 1995..........................................  F-7

Notes to Consolidated Financial Statements.............................  F-8




                                       F-1

<PAGE>


                          INDEPENDENT AUDITOR'S REPORT




Board of Directors
Medical Dynamics, Inc.
Englewood, Colorado

We have audited the accompanying consolidated balance sheet of Medical Dynamics,
Inc. and  subsidiary  (the  "Company") as of September 30, 1996, and the related
consolidated  statements of operations,  stockholders' equity and cash flows for
the year then ended.  These financial  statements are the  responsibility of the
Company's  management.  Our  responsibility  is to  express  an opinion on these
financial statements based on our audit.

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

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material  respects,  the financial  position of Medical Dynamics,
Inc.  and  subsidiary  as of  September  30,  1996,  and the  results  of  their
operations  and their cash flows for the year then  ended,  in  conformity  with
generally accepted accounting principles.

The accompanying  consolidated  financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 2 to the
financial  statements,  the Company has suffered  recurring  losses and negative
cash flows from operations.  This raises  substantial  doubt about the Company's
ability to continue as a going  concern.  Management's  plans in regard to these
matters are also  described in Note 2. The  financial  statements do not include
any adjustments that might result from the outcome of this uncertainty.




HEIN + ASSOCIATES LLP

Denver, Colorado
December 6, 1996



                                       F-2

<PAGE>

                          INDEPENDENT AUDITOR'S REPORT




Board of Directors and Shareholders
Medical Dynamics, Inc. and Subsidiary
Englewood, Colorado

We have audited the accompanying consolidated balance sheet of Medical Dynamics,
Inc. and its wholly-owned subsidiary, MedPacific Corporation (the "Company"), as
of September 30, 1995,  and the related  consolidated  statements of operations,
stockholders'  equity and cash flows for the year then ended. These consolidated
financial  statements are the  responsibility of the Company's  management.  Our
responsibility  is to express an opinion on these financial  statements based on
our audit.

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

In our opinion, the consolidated  financial statements referred to above present
fairly, in all material  respects,  the financial  position of Medical Dynamics,
Inc.  and  Subsidiary  as of  September  30,  1995,  and the  results  of  their
operations  and their cash flows for the year then  ended,  in  conformity  with
generally accepted accounting principles.

The accompanying  consolidated  financial statements have been prepared assuming
that the Company will continue as a going concern. As discussed in Note 2 to the
financial  statements,  the Company has suffered  recurring  losses and negative
cash flows from operations.  This raises  substantial  doubt about the Company's
ability to continue as a going  concern.  Management's  plans in regard to these
matters are also  described in Note 2. The  financial  statements do not include
any adjustments that might result from the outcome of this uncertainty.




McGladrey & Pullen, LLP

Denver, Colorado
November 27, 1995


                                       F-3

<PAGE>

                                    MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                              SEPTEMBER 30,
                                                                        ----------------------------
                                                                            1996           1995
                                                                        ------------   -------------
                                              ASSETS
                                              ------
<S>                                                                     <C>              <C>    
CURRENT ASSETS:
  Cash and equivalents                                                  $    993,200    $  1,071,700
  Note receivable - related party                                               --           110,000
  Trade receivables, less allowance for
    doubtful accounts of $25,000
    and $45,000, respectively                                                181,600         391,600
  Inventories                                                                264,400         948,500
  Prepaid expenses and other                                                  19,400          35,100
                                                                        ------------    ------------
     Total current assets                                                  1,458,600       2,556,900
                                                                        ------------    ------------

PROPERTY AND EQUIPMENT:
  Demonstration and loaner equipment                                         853,800         678,100
  Machinery and equipment                                                    266,800         343,100
  Furniture and fixtures                                                     266,700         270,200
  Leasehold improvements                                                      54,500          54,500
                                                                        ------------    ------------
                                                                           1,441,800       1,345,900
  Less accumulated depreciation and amortization                          (1,225,300)     (1,202,000)
                                                                        ------------    ------------
   Property and equipment, net                                               216,500         143,900
OTHER ASSETS:                                                           ------------    ------------
  Inventories                                                                450,000            --
  Patents, patents pending, and trademarks, net
   of accumulated amortization of $681,400 and $609,400,
   respectively                                                               96,700         155,500
  Other                                                                       14,900          29,400
                                                                        ------------    ------------
       Total other assets                                                    561,600         184,900
                                                                        ------------    ------------

TOTAL ASSETS                                                            $  2,236,700    $  2,885,700
                                                                        ============    ============

                     LIABILITIES AND STOCKHOLDERS' EQUITY

Current Liabilities:
  Accounts payable                                                      $    217,900    $    188,400
  Accrued expenses                                                            77,500          50,900
  Warranty reserve                                                            15,000          25,000
  Accrued royalties - related party                                             --            90,000
                                                                        ------------    ------------
       Total current liabilities                                             310,400         354,300
                                                                        ------------    ------------

COMMITMENTS AND CONTINGENCIES (Notes 2, 4, 5, and 7)

STOCKHOLDERS' EQUITY:
 Preferred stock,  $.001 par value;  authorized
   5,000,000 shares;  none issued                                               --               --
 Common stock, $.001 par value;  authorized
   15,000,000 shares, issued 7,180,200 and
   6,895,400 shares, respectively                                              7,200           6,900
 Additional paid-in capital                                               17,721,900      16,585,500
 Accumulated deficit                                                     (15,723,500)    (13,981,700)
                                                                        ------------    ------------
                                                                           2,005,600       2,610,700
 Treasury stock, at cost, 15,900 shares                                      (79,300)        (79,300)
                                                                        ------------    ------------
        Total stockholders' equity                                         1,926,300       2,531,400
                                                                        ------------    ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY                              $  2,236,700    $  2,885,700
                                                                        ============    ============

                           See accompanying notes to these consolidated financial statements.

                                                           F-4
</TABLE>

<PAGE>
<TABLE>
<CAPTION>

                            MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                            CONSOLIDATED STATEMENTS OF OPERATIONS



                                                               FOR THE YEARS ENDED
                                                                   SEPTEMBER 30,
                                                            --------------------------
                                                                1996           1995
                                                            -----------    -----------
                  
<S>                                                          <C>            <C>   
NET SALES                                                   $   667,800    $ 1,195,200

COST OF GOODS SOLD, including under
  applied overhead of $281,300 and $155,500, respectively       652,300      1,012,400
                                                            -----------    -----------

GROSS PROFIT                                                     15,500        182,800
                                                            -----------    -----------

OTHER OPERATING REVENUE                                         102,800         84,700
                                                            -----------    -----------

OPERATING EXPENSES:
   Selling, general and administrative                          878,300      1,095,800
   Fair value of common stock options
    granted for compensation and other services
                                                                405,000           --
   Research and development                                     206,900        228,100
   Depreciation and amortization                                207,600        268,600
   Royalties - related party                                    120,000        120,000
   Provision for obsolete and slow-moving inventory              87,300        100,000
   Loss from patents transferred to related party                  --           73,000
                                                            -----------    -----------
            Total operating expenses                          1,905,100      1,885,500
                                                            -----------    -----------

OPERATING LOSS                                               (1,786,800)    (1,618,000)
                                                            -----------    -----------

OTHER INCOME (EXPENSE):
   Gain on sale of loaner and demonstration equipment             7,400         51,200
   Interest income                                               39,000         82,900
   Interest expense                                              (1,400)          (100)
                                                            -----------    -----------
            Total other income                                   45,000        134,000
                                                            -----------    -----------

NET LOSS                                                    $(1,741,800)   $(1,484,000)
                                                            ===========    ===========

NET LOSS PER SHARE                                          $      (.25)   $      (.22)
                                                            ===========    ===========

WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING                 6,898,300      6,879,500
                                                            ===========    ===========




           See accompanying notes to these consolidated financial statements.
                                        F-5
</TABLE>

<PAGE>
<TABLE>
<CAPTION>

                                             MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                                        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
                                        FOR THE YEARS ENDED SEPTEMBER 30, 1996 AND 1995

                                                                                                   
                                      COMMON STOCK         ADDITIONAL                      TREASURY STOCK
                                 ----------------------     PAID-IN      ACCUMULATED     --------------------
                                   SHARES       AMOUNT      CAPITAL        DEFICIT        SHARES     AMOUNT          TOTAL
                                 ----------   ---------   ------------   ------------    -------   ----------    ------------
<S>                               <C>         <C>         <C>            <C>              <C>      <C>           <C>         
BALANCE, October 1, 1994          6,885,400   $   6,900   $ 16,575,500   $(12,497,700)    15,900   $  (79,300)   $  4,005,400

  Common stock issued to
   purchase equipment                10,000        --           10,000           --         --           --            10,000       
   Net loss                            --          --             --       (1,484,000)      --           --        (1,484,000)
                                 ----------   ---------   ------------    ------------   -------    ----------    -----------

BALANCE, September 30, 1995       6,895,400       6,900     16,585,500    (13,981,700)    15,900      (79,300)      2,531,400

  Exercise of options to
   purchase common stock            284,800         300        611,400           --         --           --           611,700
  Fair value of common stock
   options granted for:
     Royalty obligation                --          --          120,000           --         --           --           120,000
     Employee compensation             --          --          271,400           --         --           --           271,400
     Marketing arrangements            --          --           78,500           --         --           --            78,500
     Other services                    --          --           55,100           --         --           --            55,100

   Net loss                            --          --             --       (1,741,800)      --           --        (1,741,800)
                                  ---------   ---------   ------------    -----------   --------   ----------      ----------


 BALANCE, September 30, 1996      7,180,200   $   7,200   $ 17,721,900   $(15,723,500)    15,900   $  (79,300)      1,926,300
                                  =========   =========   ============   ============   ========   ==========      ==========






                              See accompanying notes to these consolidated financial statements.

                                                              F-6
</TABLE>

<PAGE>

                      MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                      CONSOLIDATED STATEMENTS OF CASH FLOWS


                                                      FOR THE YEARS ENDED
                                                          SEPTEMBER 30,
                                                   ----------------------------
                                                      1996             1995
                                                   -----------      -----------

 Net loss                                          $(1,741,800)    $(1,484,000)
 Adjustments to reconcile net loss to net cash
  used ub operating activities:
   Fair value of common stock  options
    granted for:
      Royalty obligation                               120,000             -
      Compensation and other services                  405,000             -
   Depreciation                                        130,400         165,400
   Amortization                                         77,200         103,200
   Provision for obsolete inventory                     87,300         100,000
   Decrease in warranty reserve                        (10,000)        (25,000)
   Gain on sale of loaner equipment                     (7,400)        (51,200)
   Loss on disposal of patents                             -            76,700
   Changes in operating assets and liabilities:
      Decrease (increase) in:
         Trade receivables                             170,000          66,200
         Inventories                                    (1,700)        (79,900)
         Prepaid expenses                               15,700           9,200
      Increase (decrease) in:
         Accounts payable                               29,500          26,500
         Accrued expenses                               26,600          (9,300)
         Accrued royalties                             (90,000)            -
                                                    ----------        -------- 
    Net cash used in operating activities             (789,200)     (1,102,200)
                                                    ----------      ---------- 

 CASH FLOWS FROM INVESTING ACTIVITIES:
   Proceeds from sale of demonstration
     and loaner equipment                                7,400          52,600
   Proceeds from maturity of certificate of deposit        -            25,000
   Proceeds from sale of investments                       -           985,500
   Advances on note receivable - related party             -          (110,000)
   Collections on note receivable - related party      110,000             -
   Additions to patents                                (18,400)        (22,100)
   Purchase of property and equipment                  (14,500)        (12,000)
   Purchase of certificate of deposit                      -           (10,000)
   Reductions in deposits and cash surrender
     value of life insurance                            14,500         113,300
                                                    ----------      ----------
    Net cash provided by investing activities           99,000       1,022,300
                                                    ----------      ---------- 

CASH FLOWS FROM FINANCING ACTIVITIES -
   Proceeds from exercise of options to
     purchase common stock                             611,700             -
                                                    ----------      ----------  

NET DECREASE IN CASH AND EQUIVALENTS                   (78,500)        (79,900)

CASH AND EQUIVALENTS, beginning of year              1,071,700       1,151,600
                                                    ----------      ----------

CASH AND EQUIVALENTS, end of year                   $  993,200      $1,071,700
                                                    ==========      ==========


SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION -
    Cash paid for interest                          $    1,400      $     100
                                                    ==========      =========

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND
  FINANCING ACTIVITIES:
    Net demonstration and loaner
     equipment transfers from inventory             $  148,500      $  15,700
                                                    ==========      =========

    Common stock issued to purchase equipment       $      -        $  10,000
                                                    ==========      =========



       See accompanying notes to these consolidated financial statements.

                                       F-7

<PAGE>

                      MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1. SIGNIFICANT ACCOUNTING POLICIES:
-----------------------------------

     Nature of Business  Operations - Medical Dynamics,  Inc. (the "Company") is
     engaged in the design,  development,  manufacture  and marketing of medical
     video  cameras and related  surgical  disposable  products for a variety of
     medical specialties.  These products are sold directly to hospitals, health
     care  professionals,  wholesalers,  and  original  equipment  manufacturers
     throughout the United States and foreign markets.  Sales are typically made
     on terms of net 30 days,  though some extended terms are offered on foreign
     sales, to match terms normally  offered in certain  countries.  The Company
     markets its products primarily through a group of sales representatives and
     distributors.

     Principles of Consolidation - The financial statements include the accounts
     of the Company and its wholly-owned subsidiary, MedPacific Corporation. All
     significant  intercompany  accounts and transactions  have been eliminated.
     MedPacific  Corporation  is an  inactive  corporation,  and  there  was  no
     activity during the years ended September 30, 1996 and 1995.

     Use of Estimates - The preparation of the Company's  consolidated financial
     statements in conformity  with  generally  accepted  accounting  principles
     requires the Company's  management to make estimates and  assumptions  that
     affect the amounts  reported in the financial  statements and  accompanying
     notes. The actual results could differ from those estimates.

     The Company's  consolidated  financial  statements are based on a number of
     estimates, including the allowance for doubtful accounts, the provision for
     obsolete and slow-moving inventory, the selection of estimated useful lives
     of  property  and  equipment,   realization  of  long-lived   assets,   and
     assumptions   affecting  the   valuation  of  stock   options   granted  to
     non-employees.  It is  reasonably  possible  that  estimates  affecting the
     provision  for  obsolete  and  slow-moving  inventory  and  realization  of
     long-lived  assets will change in the  forthcoming  year and such revisions
     could be material.

     Cash  Equivalents  - For purposes of the  consolidated  statements  of cash
     flows, the Company  considers all highly liquid debt instruments  purchased
     with an original  maturity of three months or less to be cash  equivalents.
     At September 30, 1996 and 1995, cash equivalents include a mutual fund that
     invests in money market instruments.

     Inventories  -  Inventories  are  stated  at the  lower of cost  (first-in,
     first-out method) or market.

     Property  and  Equipment  -  Property  and  equipment  is  stated  at cost.
     Depreciation is computed  principally by the straight-line  method over the
     following estimated useful lives:

                                                             Years
                                                             ------
       Demonstration and loaner equipment                      3
       Machinery and equipment                               3 - 10
       Furniture and fixtures                                3 - 10


                                      F-8

<PAGE>

                      MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     Leasehold  improvements  are  amortized  over the lesser of the life of the
     lease or the estimated useful life of the improvement.

     Patents and  Trademarks - Patents and trademarks are stated at cost and are
     amortized over their estimated economic lives of three to ten years. In the
     event  patents  pending are not granted,  the related  costs are charged to
     operations. The Company reviews its patents annually to determine potential
     impairment by comparing the carrying value of the intangible  with expected
     future net cash flows related to the patent.  An  impairment  loss would be
     recognized  if the Company  determined  the  carrying  value  exceeded  the
     estimated net cash flows.

     Impairment  of  Long-Lived  Assets - Management  periodically  assesses the
     Company's  long-lived  assets for impairment.  If it is determined that the
     carrying  value  exceeds the  estimated  fair value of the  assets,  then a
     charge to operations  will be recognized if the deficiency is considered to
     be other than temporary.

     Warranty  Reserve - The  Company  provides  a warranty  against  defects in
     materials and workmanship, generally for a period between one month and one
     year following the date of sale of the equipment. Estimated future costs of
     product warranties are included in current  liabilities in the accompanying
     balance sheets.

     Research and  Development - Research and  development  costs are charged to
     operations in the period incurred.

     Net Loss Per Share - Net loss per common  share is  calculated  by dividing
     the net loss by the  weighted  average  number of  shares  of common  stock
     outstanding   during  each  fiscal  year.  Common  stock  equivalents  were
     anti-dilutive  for  fiscal  1996  and  1995  and  were  excluded  from  the
     computation.

     Income Taxes - The Company  accounts  for income taxes under the  liability
     method,  which requires  recognition of deferred tax assets and liabilities
     for the expected future tax  consequences of events that have been included
     in the financial statements or tax returns. Under this method, deferred tax
     assets and liabilities are determined  based on the difference  between the
     financial  statement and tax bases of assets and liabilities  using enacted
     tax rates.

     Revenue  Recognition - The Company recognizes sales when finished goods are
     shipped to a customer.

     Fair Value of Financial  Instruments - Management  estimates  that the fair
     value of cash  equivalents,  accounts  payable,  and  accrued  expenses  is
     approximately  equal to carrying value due to the relatively short maturity
     for these  instruments.  Management  estimates  that the carrying  value of
     accounts receivable is in excess of fair value by approximately $10,000 due
     to delayed payment terms for some of the receivables.

     Impact  of  Recently  Issued  Accounting  Standards  - In March  1995,  the
     Financial   Accounting  Standards  Board  issued  a  new  statement  titled
     "Accounting  for  Impairment  of  Long-Lived  Assets." This new standard is
     effective for years  beginning  after December 15, 1995 and will change the
     Company's method of determining  impairment of long-lived assets.  Although
     the Company has not performed a detailed analysis of the impact of this new
     standard  on the  Company's  financial  statements,  the  Company  does not
     believe that  adoption of the new standard  will have a material  effect on
     the financial statements.

                                      F-9

<PAGE>


                     MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

     Stock-Based   Compensation   -  The  Company   accounts   for   stock-based
     compensation  using the  intrinsic  value method  prescribed  in Accounting
     Principles   Board  Opinion  No.  25,   "Accounting  for  Stock  Issued  to
     Employees," and related interpretations. Accordingly, compensation cost for
     stock  options  granted to employees is measured as the excess,  if any, of
     the quoted  market price of the Company's  common stock at the  measurement
     date (generally, the date of grant) over the amount an employee must pay to
     acquire the stock.

     In October 1995,  the  Financial  Accounting  Standards  Board issued a new
     statement titled  "Accounting for Stock-Based  Compensation" (FAS 123). FAS
     123 encourages,  but does not require,  companies to recognize compensation
     expense for grants of stock, stock options, and other equity instruments to
     employees  based on fair value.  Companies that do not adopt the fair value
     accounting rules must disclose the impact of adopting the new method in the
     notes to the financial statements. The Company does not intend to adopt the
     fair value  accounting  prescribed  by FAS 123,  and will be subject to the
     disclosure  requirements  prescribed by FAS 123  beginning  with the fiscal
     year ending September 30, 1997.

     FAS 123 also prescribes accounting requirements for options,  warrants, and
     similar  instruments which are granted to non-employees  after December 15,
     1995,  and requires that all such  instruments be recorded at fair value on
     the grant date. Fair value is generally  determined under an option pricing
     model using the criteria set forth in FAS 123.

     Reclassifications  - Certain amounts in the 1995 financial  statements have
     been   reclassified   to  conform   with  the  1996   presentation.   These
     reclassifications had no effect on the 1995 net loss.


2. BASIS OF PRESENTATION:
-------------------------

     The  accompanying  financial  statements  have been  presented on the going
     concern basis, which contemplates the realization of assets and liquidation
     of liabilities  in the normal course of business.  The Company has incurred
     continued substantial operating losses, negative cash flows from operations
     and has experienced  difficulty obtaining U.S. Food and Drug Administration
     (FDA)  approval  for new  products.  Recently,  the cost of health care has
     risen  significantly,   and  there  have  been  proposals  by  legislators,
     regulators  and third  party  health  care  payors to  curtail  these  cost
     increases.  Some  proposals  have  involved  limitations  on the  amount of
     reimbursement  for specific surgical  procedures.  The Company is unable to
     predict the changes to be made in the reimbursement  procedures utilized by
     third party health care payors.  In  addition,  hospitals  and other health
     care  providers have become  increasingly  price  competitive,  and in some
     instances,  put pressure on medical  suppliers to lower their prices.  As a
     result,  the  Company is unable to predict  the  financial  impact of these
     factors.

                                      F-10

<PAGE>


                     MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

     The Company's future viability depends on its ability to increase sales and
     become profitable. To this end the Company will look for new OEM customers,
     increase  marketing  efforts on new products,  explore  distribution of new
     products  to medical  and  dental  specialties,  continue  to expand in the
     foreign  market  place,  and  believes  it will no longer  have  difficulty
     obtaining  FDA approval on new products.  However,  there are no assurances
     that  these  efforts  will  result  in  a  sufficient  increase  in  sales,
     profitability  and cash flows, to allow for the long-term  viability of the
     Company. The financial statements do not include any adjustment relating to
     the recoverability of recorded asset amounts, or the amounts of liabilities
     that might be  necessary  should the  Company  not be able to  continue  in
     existence, including the write-off of patents that would revert back to the
     Chairman under a licensing agreement.


3. INVENTORIES:
---------------

     Inventories consist of the following at September 30, 1996 and 1995:

                                                        September 30,
                                                -----------------------------
                                                   1996               1995
                                                ----------         ----------

      Raw materials and replacement parts       $  444,600         $   466,100 
      Finished goods                               479,800             656,400
      Work in process                                 --                26,000
                                                ----------          ----------
          Total inventory                          924,400           1,148,500
      Less provision for obsolete and
       slow-moving inventory                      (210,000)           (200,000)
                                                ----------          ----------

          Net inventories                       $  714,400          $  948,500
                                                ==========          ==========


     At  September  30,  1996,  inventories  of  $450,000  are  classified  as a
     long-term  asset in the  accompanying  balance  sheet.  This  estimate  was
     determined by considering both historical and projected levels of sales for
     goods included in  inventories.  A substantial  portion of raw materials is
     expected to be utilized for repairs of equipment sold over the past several
     years.  Management  believes  that it may  take up to five  years  to fully
     utilize this portion of the Company's inventories based upon current levels
     of repairs and expected production levels of new products.

     Due to the declining  level of production  for the company's  medical video
     cameras, the Company incurred under applied overhead costs of approximately
     $281,300  and  $155,500  for the years ended  September  30, 1996 and 1995,
     respectively.  These  amounts  are  included  in cost of goods  sold in the
     accompanying statements of operations.

                                      F-11

<PAGE>

                      MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


4. RELATED PARTY TRANSACTIONS AND COMMITMENTS:
----------------------------------------------

     License Agreement - The Company has various  agreements to pay royalties to
     both a former officer and current directors of the Company. These royalties
     are based on the sales of specified  products,  some of which are no longer
     manufactured  by the  Company.  In June 1987,  the Company  entered  into a
     license  agreement  with its then CEO and  Chairman  relating to the use of
     certain  technology  invented and developed by the Chairman.  In connection
     with the  agreement,  the  Company  agreed  to pay  royalties  based on the
     greater of 2% of sales of products  which relate to this  technology or the
     minimum annual  royalties as described below. For the years ended September
     30, 1996 and 1995 the Company incurred $120,000 in royalty expense of which
     $90,000  remained  unpaid at  September  30,  1995.  The June 1987  license
     agreement,  as further  amended,  requires  the Company to pay the Chairman
     minimum  annual  royalties  of $120,000  for fiscal  1994 and  beyond.  The
     agreement does not specify the  termination  date,  though both parties can
     terminate  the  agreement  under  certain  circumstances.  The Chairman can
     terminate the agreement  with 45 days prior written  notice upon default by
     the  Company  of its  obligations  under the  agreement,  and for  specific
     technologies  upon  acquisition  by  another  person  of 20% or more of the
     outstanding  stock of the Company,  unless the acquirer  provides notice of
     its  intention  to  commercially  exploit the  specific  technologies.  The
     agreement  will  terminate  automatically  if the  Company is involved in a
     bankruptcy proceeding.  In the circumstances  described,  the rights to the
     patents  would revert back to the  Chairman.  Also under the  agreement any
     patents  not  commercially  developed  by the  Company in three  years will
     revert back to the  Chairman.  During the year ended  September  30,  1995,
     approximately  $62,000 of patents were written off when the rights reverted
     back to the Chairman under this provision.  No patents reverted back to the
     chairman during the year ended September 30, 1996.

     In a related  transaction,  during the year ended  September 30, 1995,  the
     Company  transferred  to an  entity  owned by the  Chairman  the  rights to
     patents  with a net book value of  approximately  $21,000.  The patents had
     originally  been  obtained  from the Chairman  under the license  agreement
     described  above,  and were  transferred  because the Company was unable to
     obtain FDA approval for products using the patents.  The related entity has
     since obtained FDA approval and has entered into an exclusive  agreement to
     have the Company  distribute  all products it  manufactures.  The agreement
     expires  in June  2000.  The  Company  purchased  approximately  $25,000 of
     products  under the agreement  through  September 30, 1996. The $25,000 was
     included in accounts  payable at  September  30,  1995.  There have been no
     significant sales of the products purchased under the agreement.

     On December 1, 1995,  the  Chairman  agreed to waive all  payments  due him
     under the above license agreement for the year ended September 30, 1996, in
     exchange for stock  options to purchase  120,000  shares of common stock at
     $1.00 per share.  The Company  recorded  $120,000  of royalty  expense as a
     result of this transaction.

     Note  Receivable - Note  receivable - related party  consists of a note due
     from an entity owned by the Company's  Chairman (the "Chairman").  The note
     was due January 15, 1996 and  provided for interest at prime plus 1% (8.75%
     at September 30, 1995). The note was  collateralized  by all amounts due or
     which may become due to the Chairman under the license agreement  discussed
     above.  In February  1996,  the note was repaid.

                                      F-12

<PAGE>

                      MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     Officers  Life  Insurance  Arrangements  - In  August,  1990,  the  Company
     purchased a $1,000,000  convertible  term key-man life insurance  policy on
     its  Chairman.  During the year  ended  September  30,  1996,  the  Company
     terminated this plan due to cost cutting  measures.  The Company also has a
     $100,000  whole life key-man  insurance  policy on its  Chairman  which was
     acquired in 1985. The convertible term policy is renewable annually through
     2003.

     Additionally, in August, 1990, the Company entered into a split-dollar life
     insurance  agreement with an irrevocable  trust established by the Chairman
     and Secretary of the Company.  The Company has agreed to pay  substantially
     all of the annual premiums on a $2,000,000 whole-life, second-to-die policy
     which  has  the  insurance  trust  as  the  beneficiary.  The  split-dollar
     agreement  specifies  that the Company will receive the greater of premiums
     paid or cash  surrender  value upon the second  insured's  death.  However,
     should  the  Company  decide  not to pay the  premium  prior to the  second
     insured's death, the Company would only collect premiums paid to the extent
     of the cash surrender value. As such, the Company has recorded the premiums
     paid in the accompanying  consolidated balance sheets to the extent of cash
     surrender value. At September 30, 1995, $13,000 of cash surrender value was
     recorded.  During the year ended September 30, 1996, the Company terminated
     this plan due to cost cutting measures.

5. STOCK OPTIONS:
-----------------

     Stock  Option  Plan - The  Company  has a stock  option  plan  under  which
     incentive  and  non-qualified  stock  options  may be granted to  officers,
     directors, employees, and consultants. Incentive stock options are required
     to have an exercise  price which is not less than the fair market  value of
     the stock at the date of grant.  The Company's Board of Directors  approved
     the plan on July 14,  1988 and a  majority  of the  Company's  stockholders
     approved  the plan in  October  1988.  The  maximum  term is ten  years for
     options  granted  under the plan.  An aggregate  of  1,000,000  shares were
     reserved  for issuance  pursuant to the terms of the plan.  Activity in the
     stock  option  plan for the years ended  September  30, 1996 and 1995 is as
     follows:
                                                                Weighted
                                                                 Average  
                                               Number of     Exercise Price
                                                Shares          Per Share
                                              ----------     --------------
       
       Outstanding, October 1, 1994              159,800        $   2.47
           Granted                                   -                -
           Exercised                                 -                -
           Expired                               (26,700)           1.33
                                              ----------        --------
       Outstanding, September 30, 1995           133,100            2.69
           Granted                                94,300            1.49
           Exercised                             (30,000)           1.73
           Expired                               (94,300)           2.52
                                              ----------        --------
       
       Outstanding, September 30, 1996           103,100        $   2.02
                                              ==========        ========

                                      F-13

<PAGE>

                      MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                  
     For options  granted during the year ended September 30, 1996, the weighted
     average  fair value of the  Company's  common  stock was $2.38 on the grant
     date.  Options  available  for future grant at  September  30, 1996 totaled
     138,000 shares.

     If not  previously  exercised,  options  outstanding at September 30, 1996,
     will expire as follows:



                                                  Number of         Exercise
          Year Ending September 30:                 Shares           Price
          -------------------------               ---------         --------

                   1997                             23,800          $   3.88
                   1998                             15,000              1.88
                   2001                             64,300              1.38
                                                   -------
                                                   103,100
                                                   =======

     Non-Qualified  Stock  Options - The Company has also granted  non-qualified
     stock  options to officers,  directors,  employees,  and  consultants.  The
     following  is a summary of activity  during the years ended  September  30,
     1996 and 1995.

<TABLE>
<CAPTION>                                      

                                                                            Weighted
                                                                 Number      Average
                                                                   of     Exercise Price     Expense
                                                                 Shares      Per share      Recognized
                                                                --------  --------------    ----------
<S>                                                              <C>        <C>              <C>  
     Outstanding and vested, October 1, 1994                     781,900    $    3.00        $    -
         Vested options granted to officers,
          directors, employees and consultants                   216,200         1.50             -
                                                                --------    ---------        --------
     Outstanding and vested, September 30, 1995                  998,100         2.68             -
         Vested options granted to:
                Employees and officer                             84,300         1.45          51,100
                Director for royalty obligation
                  (Note 4)                                       120,000         1.00         120,000
                Consultants                                       98,800         2.56          55,000
         Performance options granted to:
                Employees                                        200,000         2.88          73,400
                Officers and directors                           260,000         2.88         146,900
                Marketing consultants                            735,000         3.03          78,600
         Vested options expired due to:
                Repricing                                        (77,100)        4.20             -
                End of term                                      (94,300)        2.52             -

         Vested options exercised by:
                Directors                                       (167,600)        2.39             -
                Employees and consultants                        (37,200)        1.57             -
                Marketing consultants                            (50,000)        2.00             -
                                                               ---------    ---------       ---------

     Outstanding, September 30, 1996                           2,070,000    $    2.74       $ 525,000
                                                               =========    =========       =========


                                                          F-14
</TABLE>

<PAGE>

                     MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


     At September 30, 1996, a total of 1,110,000 non-qualified stock options are
     vested. If not previously exercised, these options expire as follows:

                                            Number of            Exercise
        Year Ending September 30:            Shares                Price 
        -------------------------           ---------            --------- 
                  1997                        4,000              $   1.91
                  1998                      100,000                  1.13
                  1999                       12,000                  2.75
                  2000                      120,000                  1.00
                  2000                       78,100                  1.50
                  2001                      190,000                  2.00
                  2003                      120,000                  1.50
                  2003                      225,900                  2.75
                  2003                      260,000                  4.00
                                          ---------

                                          1,110,000
                                          =========


     At  September  30,  1996,   unvested  employee   performance  options  were
     outstanding  for 385,000  shares,  and unvested  non-employee  options were
     outstanding  for 575,000  shares.  If not previously  vested and exercised,
     these  options all expire during the year ending  September  30, 2001.  The
     following is a summary of key vesting  provisions  and exercise  prices for
     performance options granted to employees:

                                                     Number of        Exercise
               Performance Condition                   Shares           Price
               ---------------------                 ---------        --------
    
     Cumulative  revenue  for the  Company
       from  the  sale of  dental  products
       exceeds:
                   $1,000,000                          75,000         $   2.75
                   $4,000,000                          75,000             3.00
                   $9,000,000                          75,000             3.75

     Annual revenue for the Company from
       the sale of medical products exceeds:
                   $2,000,000                          40,000             2.00
                   $3,000,000                          40,000             2.75
                   $4,000,000                          40,000             3.00
                   $5,000,000                          40,000             3.75
                                                      -------

                                                      385,000
                                                      =======

     The amount of  compensation  expense  related to the  employee  performance
     options will be determined  based on market value of the  Company's  common
     stock on the date that the options vest.

                                      F-15

<PAGE>
                      MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



     The  following  is a summary  of key  vesting  provisions  for  performance
     options granted to non-employees  along with the deferred expense that will
     be recognized over the period in which vesting occurs:
<TABLE>
<CAPTION>

 

                                             Number of       Exercise      Deferred
                                              Shares          Price         Expense
                                             ---------       --------      --------
      <S>                                     <C>             <C>            <C>   
      Cumulative sales of dental products
        attributable to marketing
        consultants individually exceeds:
                    $1,000,000                150,000          2.75         $ 91,000
                    $4,000,000                150,000          3.00          116,000
                    $9,000,000                150,000          3.75          127,000
      Cumulative  purchases  of dental
        products  by  option  holder
        exceeds:
                    $1,000,000                 25,000          3.00           34,000
                    $3,000,000                 25,000          3.25           44,000
                    $5,000,000                 25,000          3.50           50,000
                    $7,000,000                 50,000          4.00          110,000
                                             --------                       --------

                                              575,000                       $572,000
                                             ========                       ========
</TABLE>


     The common stock  option  granted to the  director in  satisfaction  of the
     royalty obligation was valued based upon the $120,000  contractual  payment
     in the license agreement. Fair value for all other stock options granted to
     non-employees  during the year ended  September  30, 1996,  was  determined
     using an option pricing model. Significant assumptions included a risk-free
     interest  rate of 6.7%,  expected  volatility of 90%, and that no dividends
     would be declared  during the expected  term of the  options.  The weighted
     average  contractual  term of the  options  was  approximately  five  years
     compared to a weighted average expected term of 2.7 years.

     For  non-qualified  stock options  granted to  consultants  during the year
     ended September 30, 1996, the weighted  average fair value of the Company's
     common stock on the grant date was $1.63 for 610,000  shares of performance
     options,  $3.38 for 125,000  shares of performance  options,  and $2.01 for
     98,800 shares of vested options.

     In addition to the performance  options  granted to marketing  consultants,
     the Company has entered into agreements  with two of the  consultants  that
     provide for payment of commissions for the sale of each dental camera which
     is  attributable  to the  consultant,  provided  that certain  gross margin
     requirements are met. The consulting agreements expire in October 1999.

                                      F-16

<PAGE>

6. INCOME TAXES:
----------------

     The amounts  which give rise to the net deferred tax asset at September 30,
     1996 and 1995, are as follows:


                                                         1996           1995
                                                      ---------      ---------

     CURRENT ASSETS:
         Allowance for doubtful accounts              $   9,300      $  16,700
         Inventory allowance                               --           74,000
         Accrued expenses                                13,800         12,300
                                                      ---------      ---------
                Total current assets                     23,100        103,000
                                                      ---------      ---------

     LONG-TERM ASSETS (LIABILITIES):
         Property and equipment                          45,900         49,500
         Patents, patents pending, and trademarks       (18,000)        (1,000)
         Inventory allowance                             78,300           --
         Compensation related to stock options          171,800           --
         Net operating loss carryforwards             6,080,000      5,365,000
         Research and development tax credits
           carryforwards                                170,000        188,000
                                                      ---------      ---------
                Net long-term assets                  6,528,000      5,601,500
                                                      ---------      ---------

     NET DEFERRED TAX ASSET                           6,551,100      5,704,500

     VALUATION ALLOWANCE                             (6,551,100)    (5,704,500)
                                                     ----------      ---------

                                                     $      --      $      --
                                                     ==========     ===========

     At September 30, 1996,  the Company has  approximately  $16,300,000  of net
     operating loss  carryforwards,  and approximately  $170,000 of research and
     development tax credits,  both of which expire in varying amounts from 1997
     through 2011.

     For the years ended  September 30, 1996 and 1995,  the Company's  effective
     tax rate was -0-%  because  there was a net loss for book and tax  purposes
     without regard to prior year temporary differences.

     The Company's management has determined that a valuation allowance equal to
     the deferred  tax assets is required  since it is more likely than not that
     the  benefits of these  assets will not be  realized.  The  increase in the
     valuation allowance of approximately $850,000 and $500,000 during the years
     ended September 30, 1996 and 1995,  respectively,  was due to the change in
     the deferred tax asset balances.

                                      F-17

<PAGE>


                     MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

7. COMMITMENTS AND CONTINGENCIES:
---------------------------------

     The Company is regulated by the Federal Food and Drug Administration (FDA).
     The Company cannot ensure that an adverse  financial  impact will not occur
     should  the FDA find the  Company's  Good  Manufacturing  Practices  are in
     non-compliance  with current Federal  regulations.  If the FDA finds that a
     manufacturer is not in compliance,  the manufacturer may be prohibited from
     marketing  the  products for which they are not in  compliance,  until such
     time as the manufacturer  complies with the applicable FDA regulation.  The
     Company has recently had difficulty  obtaining FDA approval on new products
     due to past findings during FDA inspections.  However, the Company does not
     expect problems in the future due to a change in FDA policy.

     The Company  conducts  its  operations  from leased  facilities  and leases
     certain equipment. The terms of the facilities lease require the Company to
     pay all maintenance,  utilities, property taxes and insurance. Rent expense
     has been  recorded  on a  straight-line  basis  over the life of the lease.
     Following  is a schedule  of future  minimum  commitments  under  operating
     leases having an initial or remaining term of more than one year.


                  Years Ending September 30,
                  --------------------------

                            1997                              $  162,600
                            1998                                 171,100
                            1999                                  41,500
                                                              ----------
                                                              $  375,200
                                                              ==========

     Total rent expense was $163,000 and $136,000 for the years ended  September
     30, 1996 and 1995, respectively.


8. FOREIGN SALES:
-----------------

     The Company had export  sales of $235,400  and $456,600 for the years ended
     September 30, 1996 and 1995,  respectively.  These sales were transacted in
     United States dollars.


9. EMPLOYEE BENEFIT PLANS:
--------------------------

     Effective  January 1, 1990,  the Company  adopted an employee  benefit plan
     under Internal  Revenue Code Sections  401(k).  The 401(k) plan is a profit
     sharing  plan  whereby  both  employees  and the  Company  are  entitled to
     contribute  a  portion  of  compensation  and  earnings,  respectively,  to
     investment funds to supplement  employee retirement  benefits.  The Company
     incurred  $1,000 and $900 for the years  ended in  September  30,  1996 and
     1995, respectively, in 401(k) benefit expense.


                                      F-18

<PAGE>


                      MEDICAL DYNAMICS, INC. AND SUBSIDIARY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


10. SIGNIFICANT CONCENTRATIONS:
-------------------------------

     During the years ended  September 30, 1996 and 1995,  the Company had sales
     to a single customer which accounted for 16% and 25%, respectively,  of net
     sales. At September 30, 1996 and 1995, accounts receivable included $75,800
     and $145,900, respectively which was due from this customer.

     At September  30, 1996 and 1995,  the Company had an investment in a single
     mutual fund that invests in money market  instruments.  The amount invested
     is not subject to Federal  insurance  and amounted to $803,200 and $923,400
     at September 30, 1996 and 1995, respectively.

     At September 30, 1996, substantially all of the Company's inventories (with
     a carrying  value of  approximately  $714,400)  consist  of  medical  video
     cameras and other  products  related to the  micro-invasive  surgery field,
     including raw materials and  replacement  parts related to these  products.
     The Company also owns  demonstration  and loaner versions of these products
     with a net  carrying  value of  $117,200 at  September  30,  1996,  and the
     Company's net investment in patents of $96,700  relates  primarily to these
     products.


11. FOURTH QUARTER ADJUSTMENTS:
-------------------------------

     During the fourth quarter of the year ended September 30, 1996, the Company
     recognized a charge of $525,000 for the fair value of stock options granted
     during the year.  The Company also  recognized an additional  provision for
     obsolete and  slow-moving  inventory of  approximately  $50,000  during the
     fourth quarter.



                                      F-19