SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C.  20549

                                   FORM 10-K

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

                  For the Fiscal Year Ended December 31, 1996

                         Commission File Number 0-8828

                                OPTELECOM, INC.
                                ---------------
             (Exact name of registrant as specified in its charter)

                                    DELAWARE
                                    --------
         (State or other jurisdiction of incorporation or organization)

                                   52-1010850
                                   ----------
                    (I.R.S. employer identification number)

                9300 GAITHER ROAD, GAITHERSBURG, MARYLAND 20877
                -----------------------------------------------
               (Address of principal executive offices)(Zip code)

Registrant's telephone number, including area code: (301) 840-2121.

Securities registered pursuant to Section 12(b) of the Act: None.

Securities registered pursuant to Section 12(g) of the Act: Common Stock $0.03
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 (or for such  shorter  period that the  registrant  was
required  to file  such  reports),  and  (2) has  been  subject  to such  filing
requirements for the past 90 days.
Yes X  No
   ---    ---

Indicate by check mark if disclosure of delinquent  filers  pursuant to Item 405
of Regulations S-K is not contained  herein,  and will not 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-K or any amendment to this
Form 10-K. [ ]

At March 17, 1997,  shares of the  registrant's  Common Stock,  $0.03 Par Value,
held by persons  other than  "affiliates"  of the  registrant  had an  aggregate
market value of  $13,044,877,  based on the average closing bid and asked prices
as  reported  by  the  National  Association  of  Securities  Dealers  Automated
Quotation System for such date.

At March  17, 1997, the registrant had outstanding 1,213,477  shares of Common
Stock, $.03 Par Value.

                       DOCUMENT INCORPORATED BY REFERENCE

Part III of Form 10-K -- Proxy Statement for the 1997 Annual Meeting of
Stockholders.


                                     PART I

Item 1.  BUSINESS

GENERAL

Optelecom, Inc. (the Company) is a Delaware corporation that was organized in
1972.  The Company's business consists primarily of the development,
manufacture, and sale of fiber optic communications products and laser systems
for commercial and military customers.

The Company is organized  into three  operating  divisions;  the  Communications
Products Division (CPD), which develops,  manufactures,  and sells optical fiber
based data communication equipment to the commercial marketplace, the Government
Products Division (GPD) which is primarily focussed on electro-optic  technology
development  for  government-related  defense  business,  and the  Research  and
Development   Division,   which  addresses   technology   development   business
opportunities.  In 1996, the Research and  Development  Division had no revenues
and  no  significant  expenses.   GPD  is  composed  of  two  operating  groups,
Electro/Optics (E/O) Technology, and Laser Illuminator Technology. This Division
was formed in 1996 from two former divisions,  R & D and GLINT.  These divisions
were combined into one to provide a natural  grouping of similar  operations and
functions.  Currently,  the  business  addressed  by the  individual  groups  is
essentially the same as in prior years.

Fiber optic communication  equipment, the main thrust of the Company's sales, is
an area of unprecedented growth and change. Technology development is constantly
and rapidly improving the capability to transmit ever increasing data rates over
ever greater distances with fiber-based communication systems.

Most signals,  voice, video and data are in electrical form. The transmission of
electrical  signals  from one point to  another  by  converting  them to optical
(light) signals has many advantages over electrical  transmissions.  Compared to
copper wire,  optical  fibers can transmit  signals at a much greater data rate,
over a greater  distance  and without  disturbance  from  electrical  machinery,
lightning or other noise sources.

The fiber  optic  communication  business  has many  parts,  but can be  divided
generally into two segments: the optical fiber/cable portion, which supplies the
media for transporting  optical and the transmission  equipment  portion,  which
generates and receives  optical  signals.  A few companies  manufacture  optical
fiber, while many more manufacture optical fiber cables.  Optelecom participates
by providing the equipment that interfaces electrical signals to optical signals
at  the  transmitter  end of a  fiber  optic  communication  link  and  provides
complementary  equipment that converts the optical signals to electrical form at
the other end of the communications link. Optelecom sells its equipment to users
of these  communication  systems  or to  system  integrators  that  install  the
Company's equipment in large communication nets.

There are a large number of communication  applications  that require  different
communication rates, distances and signal formats.  Optelecom provides equipment
specifically  designed for transmission of various  combinations of voice,  data
and  video  for a  range  of  applications.  The  Company  also  addresses  U.S.
Government defense related markets for specialized and proprietary  applications
of fiber optic and laser system technology that make it unique among traditional
fiber optic communication equipment

                                       2

<PAGE>

manufacturers. While government business can provide  an  offset to  periodic
cycles in the  commercial  sector,  it is also subject to changing world
conditions. Therefore, the Company attempts to balance revenues  generated  by
both  types of markets  to avoid  severe  changes in its business  posture.  The
Company is unable to predict  future  defense  business activity or the related
impact on the Company's business.

Because of the  advanced  nature of the  technology  inherent  in the  Company's
products,  the expertise of certain officers and directors of the Company is one
of its principal assets. In particular,  Dr. William H. Culver and Mr. Edmund D.
Ludwig, who are officers and directors of the Company,  provide the Company with
important  technical  expertise and have major  responsibilities in managing the
Company.  Although  the Company  pays for and is the  beneficiary  of a $300,000
insurance  policy on the life of each of such persons,  the loss of the services
of either of them,  through death or otherwise,  could have a negative impact on
the Company.  Furthermore,  because of the Company's  relatively small size, the
loss of the  services of certain  other key  employees  could have a  disruptive
effect on the Company's operations.

On March 18, 1997, the Company had 61 employees.

The table below displays the Company's  three-year  revenue and operating income
(loss) by division.

<TABLE>
<CAPTION>

                         1996                      1995                      1994
                  ---------------------------------------------------------------------------
                              Operating                 Operating                   Operating
Operating                      Income                    Income                      Income
Divisions         Revenue      (Loss)       Revenue      (Loss)      Revenue         (Loss)
<S><C>
Company Totals  $8,910,263   $1,075,338    $6,430,136  $(424,427)   $7,036,069      $412,690

CPD             $6,453,686      $60,664    $5,319,556  $(470,866)   $5,562,130      $174,084

GPD:

E/O TECHNOLOGY
GROUP (formerly
R&D)              $592,981     $(31,903)     $395,284  $(263,930)     $554,542      $175,589

LASER
ILLUMINATOR
TECHNOLOGY
GROUP (formerly
GLINT)          $1,863,596   $1,046,577      $715,296   $307,369      $919,397      $414,195
</TABLE>

See Note 12 to the financial statements for identifiable assets by segment.

                                       3

<PAGE>

GOVERNMENT PRODUCTS DIVISION (GPD)

ELECTRO/OPTICS TECHNOLOGY GROUP (Formerly R & D DIVISION)

INTERFEROMETRIC FIBER OPTIC GYROS (IFOGS)

The E/O Technology group's business consists of providing technology development
and engineering services to the U.S. Government and its prime contractors.  This
field of  investigating  techniques  for design and  manufacture  of specialized
sensing coils for fiber optic gyros is unique and has few  competitors.  A small
portion of revenue is also derived from sales of custom  optical fiber coils for
sensing and communication applications.

In 1996, the group's  activities  continued to  concentrate  on  interferometric
fiber optic gyros  (IFOGs),  which are  rotation  sensing  instruments  that are
expected to replace mechanical and laser gyros in aircraft,  missiles, and other
vehicles.  Optelecom has used its expertise in winding  high-speed  payout coils
for fiber optic guided  missiles to develop  winding  technology for IFOG coils,
and to  manufacture  these  coils in limited  production.  These  complex  coils
present key technical and cost challenges to the future of IFOG viability.

In prior  years,  the  group's  activities  and  major  source of  revenue  were
concentrated on fiber optic missile payout technology,  payout experiments,  and
field  demonstrations.  These activities led to the development of the IFOG coil
winding  capability  and  products.  The U.S.  Department  of Defense  (DoD) has
identified   the  IFOG  as  a  critical   technology   that  will  benefit  from
manufacturing  technology  (MANTECH)  funding and, in 1993, had authorized a $15
million Air Force MANTECH  program.  The Company received  multi-year  contracts
from the  Defense  Advanced  Projects  Research  Agency  (DARPA)  and  Honeywell
beginning in 1995. Through 1996, total funding from these contracts was $540,228
(DARPA) and $322,161  (Honeywell) as part of the MANTECH effort.  Both the DARPA
and  Honeywell  contracts  were active  through  1996 and  together  contributed
$462,215 in revenue;  these  contracts are  continuing in 1997 and represent the
group's entire year end backlog of approximately $214,000.

FIBER OPTIC GUIDED MISSILES AND ROBOTIC VEHICLES

There was no business activity in this area in 1996.

LASER ILLUMINATOR TECHNOLOGY GROUP (Formerly GLINT DIVISION)

The  group  derives  its  revenues  entirely  from the U.S.  Government  and its
agencies. GLINT is an acronym associated with the U.S. Air Force's C-130 Gunship
laser  illuminator  system  supported  by  Optelecom.  Due to the  nature of the
application  of this system,  contractual  revenues are  dependent on government
budgets,  the  worldwide  political   situation,   and  specific  crew  training
schedules.  In January  1996,  the Company  received a $6.5  million,  four-year
contract  (one base year and three  one-year  options) to provide  refurbishment
services.  First year work  totalled  $1,863,596,  and the  Company  anticipates
additional refurbishment requirements in succeeding years. Backlog at the end of
1996 was $1,284,467.

                                       4


<PAGE>

COMMUNICATION PRODUCTS DIVISION (CPD)

The Communication  Products  Division  addresses  business  opportunities in the
world-wide commercial  communication  equipment marketplace,  and specializes in
optical fiber technology.  Currently,  the majority of its revenues are provided
from several niche market areas including original equipment  manufacturer (OEM)
equipment for process control, video signal transmission equipment for financial
brokerage desks, and  communications  systems for highway traffic monitoring and
advanced air traffic control video monitor displays.  In 1996, CPD order booking
levels and shipments increased significantly, resulting in a small profit.

Business Activity        1996            1995        Change

Order Booking        $6.03 million   $5.36 million    +13%
Shipments            $6.45 million   $5.32 million    +21%

The Division's year-end backlog was approximately  $417,000,  down from $724,000
at year-end 1995.

PRODUCT MIX SALES ANALYSIS

Although  revenues  from sales of data  products  increased in terms of absolute
dollars,  they continued a decreasing trend as a portion of total revenues,  due
to our increased emphasis on video products for the transportation market. Sales
of RGB video systems (i.e., Red, Green, Blue - a transmission  standard for high
quality  video  displays)  increased  significantly  in the fourth  quarter with
receipt  of  a $  500,000  order  to  provide  terminal  display  communications
equipment  used  in  trading  floor  workstations  for a  major  New  York  City
investment  bank.  Products  transmitting  closed  circuit TV (CCTV) video using
Optelecom's  proprietary  pulse frequency  modulated (PFM) technology  continued
strong  sales with  installation  of systems in new  intelligent  transportation
systems (ITS) projects for state Departments of Transportation in Washington and
California.  Sales  of  ancillary  products  such  as  cables,  connectors,  and
custom-engineered   communication   products  increased  slightly,   since  many
customers   ordered  complete  system   configurations   rather  than  procuring
individual items from multiple vendors.  The following table summarizes sales by
product line as a percentage of total sales:

Communication Fiber Optic Product Categories     1996      1995     1994

Data Transmission Products                        29%       32%      47%

High Resolution RGB Video                         18%        9%       8%

Standard PFM Video                                42%       50%      33%

Cables/Connectors                                  3%        2%       3%

Other                                              8%        7%       9%

                                       5

MARKET MIX ANALYSIS

The mix of CPD product sales for different  market  segments over the last three
years was as follows:

Markets                                   1996             1995            1994

Government                                 18%              11%             23%

Industrial (including process control)     21%              18%             11%

International                              19%              16%             17%

Commercial Integrators and Resellers       42%              55%             49%


The proportion of sales to government  organizations increased to 18% due to our
focus  on  selling  Commercial   Off-The-Shelf  (COTS)  products  into  military
communications  applications.  Although  down  slightly  as a  percent  of total
revenue,  process control and industrial  sales  increased in absolute  dollars,
primarily due to increased sales to our major OEM customer.  International sales
increased slightly,  reflecting our increased emphasis on Europe and Pacific Rim
countries.  Currently,  Optelecom has a sales  presence in 19 countries  through
distributors  and resellers.  Revenue from commercial  integrators and resellers
decreased,  as more  sales  were  achieved  from our direct  sales  force.  This
reflects the requirement,  in many cases,  for a "consultive"  sales approach to
properly  specify  and  apply  highly  technical  products  in  the  intelligent
transportation control and surveillance market segments.

CUSTOMER MIX ANALYSIS

In 1996,  the mix of customer  types  changed  compared to 1995.  OEM sales as a
percent of total revenue was 26%,  compared to 21% in 1995,  and 40% in 1994. Of
the total  revenue,  50% was  generated by sales to the top 10 customers for the
division;  in 1995 the figure was 43%. This  continued a trend of a slight shift
to a larger pool of customers with smaller individual system  requirements.  The
two largest  accounts  included a new customer (an  integrator for the financial
trading  segment) at $705,000,  and a  long-standing  OEM account which provided
$864,000  of revenue,  compared  to  $710,000  for the same OEM account in 1995.
Other major  customers  included  organizations  such as Traffic Control Devices
($150,000), Pacific Teleoptics ($291,000), and McDonnell Douglas ($188,000).

Financial Information Relating to Company
Sponsored Research and Development                  1996       1995       1994

Expenditures on Company sponsored research
and development activities                        $517,654   $538,977   $477,089


Research  and  development  of new fiber optic  communication  products is a key
component of the Company's overall business strategy.  This research is focussed
on existing product  improvement and enhancement,  and on adaptation of existing
products to alternative uses.  Research into new product  technology is focussed
on the utilization of fiber optic technology in markets not previously addressed
by the Company's current product offering or development contracts. During 1996,
a new series of high  resolution  video  products was designed,  developed,  and
qualified for a major international customer.  Beginning in 1997, these systems,
with improved performance  characteristics and a lower cost design, will replace
an existing  Optelecom  product  supplied to RGB customers over the past several
years.  CPD  Engineering  continued  to add  products  to the  family of systems
developed for fiber optic communication


                                       6

<PAGE>

equipment for intelligent transportation system and traffic  signal  control.
Our first  telecommunications  product,  a protected  T1/E1  fiber  extender
for  digital  local  loop  applications,  was developed and delivered to a
foreign telephone company.  Also,  development work continued on our  Compressed
Digital Video codec system (DVS) which,  with it's telecom  interfaces,  will
have  applications  in a variety of our  existing and proposed markets.

MARKETING

GOVERNMENT PRODUCTS DIVISION

E/O TECHNOLOGY GROUP

The group  markets its services to both  Government  and  commercial  customers;
however,  for the past four years all of its business has been obtained from the
Government  and its prime  contractors.  Successfully  marketing new  technology
initiatives directly to the Government is difficult due to increased competition
from larger companies with far greater resources.  Traditionally,  the group has
concentrated  on markets  providing  research and  products  used in fiber optic
communication  systems  for  airborne  missiles,  ground  robotic  vehicles  and
underwater sensors.  Optelecom had historically  received contracts from certain
key  Government  organizations  whose budgets have been reduced in recent years;
there are few new development  opportunities  available in the technology  areas
pertinent to the Company's  expertise.  As a result of the  utilization  of IFOG
sensing coil technology  developed by Optelecom in 1993 and our prior experience
with the  development  of fiber  coils  for high  speed  payout,  we  identified
opportunities  in the area of optical fiber gyro coil winding.  Gyro coils are a
defense  related  Government  program area which we see as  receiving  continued
focus amid shrinking defense  spending.  Additional  potential  opportunities to
diversify  into  commercial  markets for fiber optic  amplifiers,  sensors,  and
similar components, have been identified as well. We continue to seek to develop
new markets for the group's services and products in these technical areas.

LASER ILLUMINATOR TECHNOLOGY GROUP

The sole customer for this division is the  Warner-Robins  Air Logistics Support
Center  of  the  U.S.  Air  Force.  Optelecom  maintains  a very  close  working
relationship   with  the  individual   component   item  managers   assigned  at
Warner-Robins  and the operations  group at Hurlburt Field,  Florida.  We insure
that these support  personnel  fully  understand  Optelecom's  capabilities  and
capacity to perform the required  work.  Bids are carefully  reviewed to be sure
that the customer's requirements are satisfied.  The value of this approach to a
working  relationship  can be  judged  by the  receipt  in 1996 of a four  year,
multi-million  dollar contract to provide  training and equipment  refurbishment
services for the GLINT laser illuminator system.

COMMUNICATION PRODUCTS DIVISION

In late 1996, a General Manager for CPD was hired to provide  additional  market
and business  process  knowledge for the division.  Also, at the same time,  the
Director of  Optelecom's  west coast office was moved to our east coast facility
and appointed Vice  President of Sales and  Marketing.  These staff changes will
greatly strengthen CPD's ability to define, enter, and service new communication
systems markets. Since 1992, CPD has used selected sales representative firms in
foreign  countries to promote and sell our products.  These firms have gradually
established awareness of our products in their respective countries, and we have
seen a trend of increasing business from foreign sources.

                                       7

<PAGE>


MANUFACTURING PROCESSES

Beginning  in  mid-1995,  the  company  initiated  a  corporate-wide  effort  to
implement a Quality  Assurance  system fully compliant with the  requirements of
ISO-9001 (an internationally-recognized quality system standard). In June, 1996,
all operating divisions of the company received certification to the standard.

GOVERNMENT PRODUCTS DIVISION

E/O TECHNOLOGY GROUP

In 1991, the Company  developed a winding  machine to fabricate coils of optical
fiber wound in very  specific  configurations  for fiber gyro systems for Smiths
Industries. Additional work in this area through 1995 was conducted to develop a
winding machine concept  directed  toward  automated  techniques for fabricating
similar fiber gyro coils.  The number of companies  from which the group obtains
raw  materials  and optical  fiber is  limited;  however,  the Company  does not
anticipate any problems with adequate supplies.

LASER ILLUMINATOR TECHNOLOGY GROUP

Optelecom has established a specialized facility adjacent to its headquarters to
support  fabrication  and  repair  operations  for the GLINT  laser  illuminator
system.  The  processes  used to  fabricate  laser  modules  for this system are
proprietary to Optelecom and depend on  sophisticated  understanding of specific
semiconductor  processing techniques.  Proper use of the equipment and materials
associated  with these  activities  depends on highly  skilled  personnel  whose
technical  knowledge is key to the successful  fabrication of the final product.
The number of companies  from which the group  obtains raw materials is limited;
however the company does not anticipate any problems with adequate supplies.

COMMUNICATION PRODUCTS DIVISION

The  Company  performs  routine and  specialized  manufacturing,  assembly,  and
product testing functions in its corporate headquarters.  In past years, routine
fabrication  had been  subcontracted  to other  manufacturers.  During 1995, the
Company   purchased,   installed  and  placed  into  service   equipment   which
automatically  assembles  components  onto printed circuit boards at high speed.
This action was taken to lower manufacturing costs and reduce the time-to-market
for new product  designs.  The success of this decision has been apparent in the
significant  manufacturing  cost reduction  realized on all assemblies  produced
using the equipment. The Company also maintains a quality assurance function and
testing area that performs optical and electrical testing,  and quality control.
Raw  materials  and supplies  used in the  Company's  business  include  optical
materials,  plastic products, and various electronic  components,  most of which
are available  from  numerous  sources.  The number of companies  from which the
division  can obtain  optical  emitters  and  detectors  for use in its  circuit
assemblies  is limited;  however,  Optelecom  has  negotiated  long-term  supply
contracts  with  these  vendors  and  does  not  anticipate  significant  supply
problems.

                                       8

<PAGE>

COMPETITION

The Company's  products fall within three (3) separate and distinct markets.  As
such,  the  characteristics  of  competition  in these markets  differ  greatly.
Optelecom's Communication Products Division competes mainly with other companies
of roughly equal size, having similar  resources.  For low technology  products,
such as fiber optic data modems,  competition is intense, as these products have
reached a commodity  status.  In the areas of engineering  products for specific
applications,  Optelecom  competes against companies of the same size or larger.
Competitors with larger research staffs have an advantage in these markets.

The market in which the E/O  Technology  group  competes is  dominated by larger
Defense   prime   contractors.   These   companies   have   greater   marketing,
manufacturing,  financial,  research, and personnel resources than Optelecom. In
addition,  as Department  of Defense  contracting  activity has declined,  these
companies have started to compete in markets which were  primarily  addressed by
companies with resources similar to Optelecom's. As a result, the E/O Technology
group is at a competitive disadvantage when competing against prime contractors.
Optelecom  does feel that its IFOG coil winding  technology is at least equal to
the technology developed by much larger prime contractors and in this market, it
can compete equally.

The Laser Illuminator Technology group is a sole-source provider of the products
it supplies to the U.S. Air Force.  Optelecom is not aware of any competition in
this market.

SEASONALITY

The Company's products are based on fiber optic technology. As such, seasonality
does not materially affect our revenues.

PATENTS

The Company  holds  certain  patents;  however,  its  business as a whole is not
materially  dependent  upon its ownership of any one patent or group of patents.
The Company does not license any patents from other parties,  nor is it aware of
any restrictions on its current business imposed by patents of other parties.

CONTRACT RENEGOTIATION AND TERMINATION

None of the  Company's  current  contracts  are subject to price  renegotiation.
However,  the Company's contracts with the U.S. Government are always subject to
termination,  which is a standard clause in any contract with the government. In
February, 1995, a subcontract from Litton Systems was terminated.

                                       9


<PAGE>

Item 2.  PROPERTIES

In 1992,  the Company  moved its  operations  to new leased  facilities  at 9300
Gaither  Road,  Gaithersburg,  Maryland,  near  Washington,  DC. The  facilities
consist of space in two adjacent  buildings,  one occupying  21,000 square feet,
with a ten-year lease term, beginning September 1, 1992, and the other occupying
4,000 square feet,  with a one-year term,  beginning in December,  1992, and two
one-year  options.  Current monthly rent is $16,582.50 on the larger space,  and
$2,584.99 on the smaller one. All of the  facilities  are in good repair and are
adequate for the Company's current production requirements.

Item 3.  LEGAL PROCEEDINGS

The Company is not a party to any material legal proceedings.

Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No  matters  were  submitted  during  the  fourth  quarter  of 1996 to a vote of
security-holders.

                                       10

<PAGE>


                                    PART II

Item 5.  MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS

The  Company's  Common Stock,  $0.03 par value  (Common  Stock) is traded in the
over-the-counter  market. Set forth below are the highest and lowest closing bid
prices  for  the  Common  Stock  as  reported  by the  National  Association  of
Securities Dealers Automated  Quotation Service (NASDAQ) during each quarter for
the three years  ended  December+31,  1996,  1995 and 1994,  respectively.  Such
quotations do not necessarily reflect actual transactions.

                           Bid Price
Quarter Ended              High/Low
-------------              ---------
December 31, 1996         12 7/8 - 5 1/8
September 30, 1996         6 3/8 - 3 3/8
June 30, 1996              6 5/8 - 3 5/8
March 31, 1996             5     - 2 3/4

December 31, 1995          3     - 2 1/2
September 30, 1995         4 1/8 - 2 7/8
June 30, 1995              4 3/4 - 2 7/8
March 31, 1995             4 1/8 - 3

December 31, 1994          4 3/4 - 2 7/8
September 30, 1994         4 1/8 - 2 5/8
June 30, 1994              3 3/4 - 2 3/4
March 31, 1994             5 3/8 - 3 1/4

There are approximately 1,209 record-holders of the Common Stock as of March 17,
1997.

The Company has not declared any  dividends to date and does not expect to do so
in the foreseeable future.

                                       11

<PAGE>

Item 6.  SELECTED FINANCIAL DATA

Set forth below is selected financial data for the Company's most recent five
fiscal years.

<TABLE>
<CAPTION>

                                                     Year Ended December 31,

                                1996          1995         1994         1993         1992
                             ---------------------------------------------------------------
<S><C>
Net Revenue                  $8,910,263    $6,430,136   $7,036,069   $7,083,229   $6,001,057

Net (Loss) Income              $722,081     $(208,384)    $382,347      $95,633     $400,274

Earnings per Common and
Common Equivalent Share
before Extraordinary Item
and Accounting Change             $0.59        $(0.18)       $0.33        $0.06        $0.31

Extraordinary Item              -------        ------       ------       ------        $0.05

Accounting Change               -------        ------       ------        $0.02       ------

Net (Loss) Income per Share       $0.59        $(0.18)       $0.33        $0.08        $0.36

Total Assets                 $4,466,463    $3,674,004   $3,617,298   $3,115,032   $2,871,896

Long-Term Obligations           $11,607       $46,426       ------       ------     $158,296

Stockholders' Equity         $3,041,631    $2,188,777   $2,384,303   $1,981,821   $1,771,833

Cash Dividends Declared
per Common Share                 ------        ------       ------       ------       ------
</TABLE>

Item 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS

FINANCIAL CONDITION

Due to the nature of the Company's business, the key components of its financial
condition constitute receivables, inventory, fixed assets, accounts payable, and
debt.  The Company saw an increase  in net worth to  $3,041,631  in 1996.  Prior
years's trends of key financial  indicators show a change in corporate net worth
of $2,188,777  for 1995  compared to $2,384,303 in 1994.  The 1996 current ratio
increased to 3.0 from 2.2 in 1995 and 2.8 in 1994.

Year-end  1996  billed  accounts  receivable  was  $1,246,388.  Billed  accounts
receivable at year-end 1995 was  $1,378,424,  and  $1,574,656 in 1994.  The 1996
average  outstanding  days in receivables  was 52 days. The days  outstanding in
accounts receivable averaged 69 days in 1995, and 66 days in 1994. The reduction
in days receivable was achieved by instituting an aggressive accounts collection
program.  Bad debt  write-offs  represent  less than 1/10 of one  percent of the
total  yearly  revenues.  The  low  level  of bad  debts  is due  partly  to the
percentage of business the Company does with the U.S. Government and Fortune 500
companies. The Company also uses a careful screening process and performs credit
qualification of customers  before accepting their orders.  For any new account,
credit  checks are always  conducted,  and  questionable  situations  are either
placed on a COD or a letter of credit  basis.  Accounts  receivable  are closely
monitored; those that are delinquent are continuously contacted until payment is
received.

                                       12

<PAGE>

The overall  composition  of the  inventory  has changed  somewhat over the last
three years as shown in the following chart:

Inventory Composition                 1996             1995              1994

Production Materials            $  765,783       $  549,277          $555,981

Work In Process                    397,123          153,203           155,676

Finished Goods                     342,062          377,861            65,339
                                ----------       ----------          --------
TOTAL                           $1,504,968       $1,080,341          $776,996


One of the tools the  Company  uses for trend  analysis is a  comparison  of our
inventory  levels to total sales. In 1996, this level was 17% compared to 17% in
1995  and 11% in  1994.  The  value  of the raw  material  and  work in  process
inventory  increased by  approximately  $460,000 in 1996  compared to 1995.  The
increase  in 1996 work in process  reflects  orders to be shipped in early 1997.
Although our objective is to reduce  inventory  levels as much as possible,  the
value of finished goods  inventory  increased  substantially  in 1995 to provide
products  available  from  stock.  This  action  was  taken to meet  competitive
pressures as customers are demanding  shorter  product  delivery  times. We will
attempt to reduce the amount of raw material  inventory to partially  offset the
higher level of finished goods inventory.  The Company believes that its reserve
for inventory  obsolescence is adequate to properly value any excess  quantities
of this inventory.

In 1996,  fixed asset  additions were $219,119  compared to $287,854 in 1995 and
$207,025 in 1994.

RESULTS OF OPERATIONS

Combined  1996  revenues  were 39% higher than 1995 and 27% higher than 1994.  A
profit of $722,081 which represented 8% of revenue for 1996,  compares to a loss
of (3%) for 1995, and profit of 5% for 1994.

GOVERNMENT PRODUCTS DIVISION (GPD)

ELECTRO/OPTICS TECHNOLOGY GROUP

E/O  Technology  Groupis  1996  revenues  increased  50%  compared to 1995.  The
increase occurred due to additional work from DARPA and Honeywell  Systems.  The
trend of increase in revenues and decrease in losses has been  significant  over
the past several years.  It appears that the unique work performed by this group
may have enough market potential to achieve break even or profitability. Revenue
for the last three years was $592,981 in 1996, $395,284 in 1995, and $554,542 in
1994. Comparable period losses were $(31,903), $(263,930), and $(175,589).

                                       13

<PAGE>

Cost of Sales

The cost of sales as a percent of revenue  has  decreased  significantly  due an
increase  in revenue as  mentioned  above and a decrease  in  overhead  costs as
discussed below. Given below are the last three years' results:

Cost Comparison                     1996          1995         1994

Cost of Sales                     $501,148       $440,411    $521,539

Gross Sales                       $592,981       $395,284    $554,542

Cost as a Percent of Revenue           85%           111%         94%


OVERHEAD AND G&A

Overhead

Overhead costs for the E/O Technology  group were $297,862 in 1996,  $316,493 in
1995 and $369,342 in 1994.  Overhead  expenses have decreased due to lower labor
costs within the group and a lower corporate expense  allocation.  The allocated
costs are apportioned as a percent of floor space assigned to revenue generating
activities and have been reduced as the group's facility space requirements have
declined.

G&A

G&A  expenses  for the  division  were  $143,982  in 1996,  $218,801 in 1995 and
$208,592  in 1994.  These  numbers  reflect a lower  expense  in 1996,  due to a
reassignment  of the  activities  of the Chairman  from  divisional  work to the
corporate area.

LASER ILLUMINATOR TECHNOLOGY GROUP

1996 was another very successful year for this group. The Air Force will require
ongoing  support  for the GLINT laser  illuminator  system for at least the next
several  years.  While it is  difficult  to  quantify  the  level  of  potential
business,  it is likely that  Optelecom  will provide  products and  maintenance
support during that period. Revenue for 1996 was $1,863,596 compared to $715,296
in 1995 and $919,397 in 1994. Net profits were $1,046,577 for 1996, $307,369 for
1995,  and $414,195 for 1994.  The increase in revenue in 1996  compared to 1995
was due to a change in the composition of the type of business addressed by this
division.  In  1996,  contract  work  consisted  of  refurbishment  of  complete
illuminator systems; in 1995, work consisted essentially of fabrication of spare
laser  arrays,   with  a  small  additional   effort  associated  with  contract
development work.


                                       14

<PAGE>

Cost of Sales

Although overhead costs for the three-year period were relatively constant,  the
large  increase  in  revenue  in 1996  caused  the cost of sales as a percent of
revenue to decrease compared to 1995 and 1994.


Cost Comparison                       1996            1995           1994

Cost of Sales                       $572,142        $305,769       $389,924

Gross Sales                       $1,863,596        $715,296       $919,397

Cost as a Percent of Revenue          31%              43%            42%


Overhead

Overhead  costs  for the GLINT  Division  were  $112,099  for 1996  compared  to
$118,197  for 1995 and  $125,382  for  1994.  Overhead  expenses  have  remained
relatively  stable  for the last  several  years due to a stable  work force and
facility size.

G&A

The general and administrative  expenses were $244,875 in 1996, $102,158 in 1995
and  $115,278  for 1994.  The  increase  over  1995  reflects  higher  corporate
allocation  which is  apportioned  on the basis of percent  revenue  compared to
corporate revenue.

COMMUNICATION PRODUCTS DIVISION (CPD)

1996  Communication  Products Division  revenues  increased by 21% over 1995 and
resulted in a net profit of $60,664.  CPD revenues in 1995  decreased by 4% from
1994  revenues  and resulted in an operating  loss of  $(470,866)  compared to a
profit of $174,084 in 1994.  The product  sales mix was more  favorable in 1996,
with OEM sales up  significantly  and low margin products down compared to 1995.
New products in fiber optic trader desks and lower cost designs  helped  reverse
1995  problems.  The Company was  successful  in  implementing  product  designs
specifically intended to be produced by automatic assembly processes to minimize
direct costs.

Cost of Sales

Cost of Sales is the sum of direct  costs to produce the  product  and  overhead
costs.

Cost Comparison                        1996            1995            1994

Cost of Sales                       $3,796,628       $3,595,328      $3,414,309

Gross Sales                         $6,453,686       $5,319,556      $5,562,130

Cost as a Percent of Revenue            59%             68%             61%

                                       15

Direct Costs

In 1996, direct costs decreased in relation to revenue. As previously mentioned,
one reason for the decrease was the change in the mix of products sales compared
to 1995. For instance,  OEM sales were up significantly in 1996 over 1995. These
sales had high margins since  engineering  costs incurred in 1995 were recovered
in the 1996 sales price and there is no direct  competition  which would require
price  reductions.  The second area of improvement  was in direct  manufacturing
cost for standard products due to automation.  Finally, the Company did not have
to discount prices as much as in 1995,  since our customers began to realize the
value of the quality of our products.  In 1995,  direct CPD costs in relation to
sales had increased by 5% over 1994. The 1995 increase was attributed to growing
competition  forcing  us to lower  our  prices.  However,  the  cost to  produce
products continued to decrease due to the investment in automated  manufacturing
facilities. As more of our product designs evolve toward automated assembly, our
ability to successfully compete at lower sale prices will continue to improve.

Direct Costs Versus Sales          1996          1995          1994

Direct Costs                    $2,773,182     $2,472,318   $2,297,661

Percent of Sales                   43%            46%          41%


Overhead

Overhead costs include facilities costs,  indirect labor costs in manufacturing,
applied overhead,  and inventory writeoffs.  In 1996, overhead cost as a percent
of  sales  fell by 4% due to an  increase  in sales  and  lower  overhead  costs
compared to 1995.  Overhead  costs fell in 1996 by  approximately  $80,000 (8%),
compared to 1995. Included below is a comparison of overhead costs for the past
three years:

Cost Comparison                                 1996        1995         1994

Overhead Costs                               $1,023,446   $1,103,323  $1,113,798

Overhead Costs as a Percent of Revenue          16%          20%         20%


Applied Overhead

Applied  overhead  allocates  costs in overhead to a final product.  The Company
uses a computation  method in which  overhead  costs are divided by direct labor
costs. This establishes the percent of overhead costs to be applied to the final
product. Examples of these costs include rent, utilities,  telephone,  inventory
variances,  and  depreciation of production  capital  equipment  costs.  Applied
overhead amounts for the past three years were $(593,871) in 1996, $(571,837) in
1995, and $(490,776) in 1994.

                                       16

<PAGE>

Inventory Write-offs

Direct inventory  write-offs  increased slightly in 1996 to $113,250 compared to
$92,119 in 1995 and  $42,870 in 1994.  Generally,  these  write-offs  are due to
engineering  changes which result in obsolete raw  materials  and  subassemblies
used on  products  we no  longer  intend  to sell  and also to  overstocking  of
particular items. Although we make every attempt to minimize obsolete inventory,
the rapid  engineering  evolution  of our  product  line and the  changes in our
product mix makes some obsolescence unavoidable.

G&A

General and Administrative costs consist primarily of expenses related to sales,
marketing and engineering activities and other administrative operational costs.
Commercial  Product  engineering   development  costs  have  remained  constant,
reflecting stable staff size and workload.  During 1996, development focussed on
additions to the product line for highway traffic monitoring equipment.  Also, a
new effort to develop video  technology was initiated,  which will result in new
product  introductions in 1997. The three-year record of these engineering costs
(exclusive  of fringe) is $475,399 in 1996,  $489,771 in 1995,  and  $469,449 in
1994. The company  implemented  changes to the sales and marketing staff to more
closely  align the  technical  aspects  of the  selling  process  with  customer
requirements  and also changed the corporate  management staff to strengthen the
divisions  efforts.  The cost of this effort, as well as profit sharing expenses
and reserves for bad debt are  reflected in the  increased G&A expenses for this
year,  which  were  $2,596,398.  Prior-year  costs were  $2,205,094  in 1995 and
$1,976,637 in 1994.

OTHER OPERATING EXPENSES

Corporate

Income tax  expense  (benefit)  was  $310,136  in 1996,  $(233,756)  in 1995 and
$188,000 in 1994.  This  reflects the  Companyis  return to  profitability.  The
effective  tax rate was 30% in 1996.  The  effective  tax rate was (53%) in 1995
primarily  as a result of  realizing  the tax benefit of carrying  back the then
current year loss to the prior year. In the prior year,  the Company  recorded a
$215,693  income  tax  refund  receivable  in 1995 for  amounts  expected  to be
received in 1996.

Interest  expense of $19,460  increased  in 1996  compared to $3,763 in 1995 and
$22,643 in 1994.  The operating  loss in 1995 forced the Company to borrow funds
from it's line of credit in 1996.

Advertising   costs  decreased   substantially  in  1996.  These  costs  include
advertising  in trade  magazines,  participation  in trade  shows,  and  product
literature,  including  catalogs  and  specification  sheets.  Compared to prior
years,  the type of  advertising  changed  as a result of a  redirection  of our
advertising emphasis.  Advertising  expenditure decreases occurred mainly in the
areas of magazines and trade shows.  The costs of advertising for the last three
years were $115,073 in 1996, $225,675 in 1995 and $162,706 in 1994.

                                       17


<PAGE>

Impact of Inflation

Inflation has not had any  significant  effect on the  operations of the Company
during 1996, and we do not expect it to have any significant effect during 1997.

LIQUIDITY AND CAPITAL RESOURCES

The Company's  liquidity  requirements are largely  generated by working capital
needs. These needs are primarily focussed on financing  inventories and accounts
receivable.  In 1996, net cash provided by operating activities was $387,304. In
1995, as a result of a net operating  loss and increases in inventory  balances,
net cash used in operational  activities was $(110,497).  Non-cash costs such as
depreciation  and  amortization  were  $235,431 in 1996.  Cash used in investing
activities  in 1996  was  $(219,119),  and  included  expenditures  for  capital
equipment for manufacturing  operations,  facility upgrades,  and general office
equipment.  To finance  these  activities,  Optelecom  used existing cash flows,
borrowing in short term notes and long term  borrowings for equipment.  No other
material  changes  in cash  flow are  expected.  The  Company  has the  ability,
provided there are sufficient eligible  receivables,  to borrow up to $1,000,000
under its line of credit  as of  December+31,  1996.  The  Company  also has the
ability to borrow funds for  specific  capital  asset  purchases to a maximum of
$150,000  from a local bank.  Loans for these assets are  collateralized  by the
specific  equipment  asset and payable over no more than 5 years.  At the end of
1996, the outstanding balance on this loan was $46,426.

                                       18

<PAGE>

Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA







<PAGE>

INDEPENDENT AUDITORS' REPORT

To the Board of Directors and
  Stockholders of Optelecom, Inc.:

We have  audited  the  accompanying  balance  sheets of  Optelecom,  Inc.  as of
December  31,  1996  and  1995,  and  the  related   statements  of  operations,
stockholders'  equity,  and cash flows for the two years then ended.  Our audits
also included the financial statement schedule listed in the accompanying index.
These  financial  statements and schedule as of and for the years ended December
31,  1996 and 1995  are the  responsibility  of the  Company's  management.  Our
responsibility  is to  express  an opinion  on these  financial  statements  and
schedule  based on our  audits.

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

In our  opinion,  such financial  statements  present fairly, in all material
respects,  the financial position of  Optelecom,  Inc. at December 31, 1996 and
1995,  and the results of its  operations  and its cash flows for the years then
ended in conformity  with generally accepted accounting  principles.  Also, in
our opinion, such financial statement  schedules  as of and for the years ended
December 31, 1996 and 1995, when considered in relation to the basic financial
statements taken as a whole, presents fairly, in all material respects, the
information set forth therein.

Washington, D.C.
February 28, 1997


                                       20

<PAGE>

REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS



To the Board of Directors and Stockholders
Optelecom, Inc.

We have audited the balance sheet of Optelecom,  Inc. as of December 31,1994 and
the related  statements of income,  stockholders'  equity and cash flows for the
year then ended.  We have also audited the schedule  listed in the  accompanying
index as of and for the year ended December 31, 1994. These financial statements
and  schedule  are  the   responsibility  of  the  Company's   management.   Our
responsibility  is to  express  an opinion  on these  financial  statements  and
schedule 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  and  schedules are free of
material  misstatement.  An audit includes examining,  on a test basis, evidence
supporting the amounts and disclosures in the financial statements and schedule.
An audit also includes assessing the accounting  principles used and significant
estimates made by management,  as well as evaluating the overall presentation of
the  financial  statements  and schedule.  We believe that our audit  provides a
reasonable basis for our opinion.

In our opinion,  the financial  statements  referred to above present fairly, in
all material respects, the financial position of Optelecom, Inc. at December 31,
1994,  and the  results of its  operations  and its cash flows for the year then
ended in conformity with generally accepted accounting principles.

Also, in our opinion,  the schedule presents fairly,  in all material  respects,
the  information  set forth  therein as of and for the year ended  December  31,
1994.


                                                  BDO Seidman, LLP


Washington, D.C.
March 10, 1995


                                       21


<PAGE>

OPTELECOM, INC.

BALANCE SHEETS
DECEMBER 31,1996 AND 1995
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
ASSETS                                                                  1996            1995
<S> <C>
CURRENT ASSETS:
    Cash and cash equivalents                                         $  266,575    $   62,436
    Contract receivables                                               1,463,426     1,411,209
    Inventories                                                        1,504,968     1,080,341
    Prepaid expenses and other assets                                    306,620       108,960
    Income tax refund receivable                                               -       215,693
    Deferred tax asset                                                    66,145             -
                                                                      ----------    ----------
                      Total current assets                             3,607,734     2,878,639

PROPERTY AND EQUIPMENT - At cost less accumulated
    depreciation and amortization                                        779,053       795,365

DEFERRED TAX ASSET                                                        79,676             -
                                                                      ----------    ----------
TOTAL  ASSETS                                                         $4,466,463    $3,674,004
                                                                      ==========    ==========
LIABILITIES AND STOCKHOLDERS' EQUITY

CURRENT LIABILITIES:
    Demand note payable to bank                                       $        -    $   60,000
    Accounts payable                                                     591,682       800,409
    Accrued payroll                                                      127,172        95,956
    Accrued annual leave                                                 104,788        89,210
    Other current liabilities                                            362,808       152,962
    Current portion of note payable                                       34,819        34,819
                                                                      ----------    ----------
                     Total current liabilities                         1,221,269     1,233,356
                                                                      ----------    ----------
LONG-TERM LIABILITIES:
    Note payable                                                          11,607        46,426
    Deferred rent liability                                              191,956       205,445
                                                                      ----------    ----------
                      Total long-term liabilities                        203,563       251,871
                                                                      ----------    ----------
COMMITMENTS AND CONTINGENCIES                                                  -             -

                      Total liabilities                                1,424,832     1,485,227
                                                                      ----------    ----------
STOCKHOLDERS' EQUITY:
    Common stock, $.03 par value - shares authorized, 5,000,000;
        issued and outstanding, 1,207,574 and 1,171,042 shares            36,227        35,131
    Discount on common stock                                             (11,161)      (11,161)
    Additional paid-in capital                                         2,027,916     1,898,239
    Retained earnings                                                    988,649       266,568
                                                                      ----------    ----------
    Total stockholders' equity                                         3,041,631     2,188,777
                                                                      ----------    ----------
TOTAL LIABILITIES AND STOCKHOLDERS'  EQUITY                           $4,466,463    $3,674,004
                                                                      ==========    ==========
</TABLE>


                       See notes to financial statements.


                                       22


<PAGE>

OPTELECOM, INC.

STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31,1996, 1995 AND 1994
-------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                               1996         1995          1994
<S> <C>
REVENUE:
    Product sales                                          $ 8,317,282   $6,034,852    $6,481,527
    Engineering services                                       592,981      395,284       554,542
                                                           -----------   ----------    ----------
                      Total revenue                          8,910,263    6,430,136     7,036,069
                                                           -----------   ----------    ----------
COSTS AND EXPENSES:
    Direct labor                                               267,509      211,419       299,470
    Other direct costs                                       3,169,004    2,582,075     2,414,880
    Overhead                                                 1,433,410    1,538,015     1,608,522
    General and administrative                               2,965,002    2,526,054     2,300,507
                                                           -----------   ----------    ----------
                      Total costs and expenses               7,834,925    6,857,563     6,623,379
                                                           -----------   ----------    ----------
    Income (loss) from operations                            1,075,338     (427,427)      412,690
                                                           -----------   ----------    ----------
OTHER (EXPENSE) INCOME:
    Gain from claims settlement                                      -            -       209,012
    Loss on sale of investment                                       -            -       (20,000)
    Interest                                                   (19,460)      (3,763)      (22,643)
    Other                                                      (23,661)     (10,950)       (8,712)
                                                           -----------   ----------    ----------
                      Total other (expense) income             (43,121)     (14,713)      157,657
                                                           -----------   ----------    ----------
INCOME (LOSS) BEFORE PROVISION (BENEFIT)
    FOR INCOME TAXES                                         1,032,217     (442,140)      570,347

PROVISION (BENEFIT) FOR INCOME TAXES                           310,136     (233,756)      188,000
                                                           -----------   ----------    ----------
NET INCOME (LOSS)                                          $   722,081   $ (208,384)   $  382,347
                                                           ===========   ==========    ==========
EARNINGS (LOSS) PER COMMON
    AND COMMON EQUIVALENT SHARE                            $      0.59   $    (0.18)   $     0.33
                                                           ===========   ==========    ==========
WEIGHTED AVERAGE NUMBER OF
    COMMON SHARES AND COMMON SHARE
    EQUIVALENTS OUTSTANDING                                  1,218,893    1,177,048     1,163,012
                                                           ===========   ==========    ==========
</TABLE>

See notes to financial statements.


                                       23
<PAGE>


OPTELECOM, INC.

STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                                             Additional Capital
                                                                ------------------------------------------
                                     Number                       Discount                                           Total
                                       of          Common        on Common          Paid-in       Retained        Stockholders'
                                     Shares         Stock          Stock            Capital       Earnings           Equity
                                     ------        ------        ---------          -------       --------        -------------
<S> <C>
BALANCE, JANUARY 1, 1994           1,159,029     $   34,771     $  (11,161)     $   1,865,606   $    92,605      $   1,981,821

    Common stock issued                7,643            229              -             19,906             -             20,135

    Net income                             -              -              -                  -       382,347            382,347
                                   ---------     ----------     ----------      -------------   -----------      -------------
BALANCE, DECEMBER 31, 1994         1,166,672         35,000        (11,161)         1,885,512       474,952          2,384,303

    Common stock issued                4,370            131              -             12,727             -             12,858

    Net loss                               -              -              -                  -      (208,384)          (208,384)
                                   ---------     ----------     ----------      -------------   -----------      -------------
BALANCE, DECEMBER 31, 1995         1,171,042         35,131        (11,161)         1,898,239       266,568          2,188,777

    Common stock issued               36,532          1,096              -            129,677             -            130,773

    Net income                             -              -              -                  -       722,081            722,081
                                   ---------     ----------     ----------      -------------   -----------      -------------
BALANCE, DECEMBER 31, 1996         1,207,574     $   36,227     $  (11,161)     $   2,027,916   $   988,649      $   3,041,631
                                   =========     ==========     ==========      =============   ===========      =============
</TABLE>

See notes to financial statements.


                                       24
<PAGE>


OPTELECOM, INC.

STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31,1996, 1995 AND 1994
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                                              1996          1995           1994
                                                                              ----          ----           ----
<S> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
    Net income (loss)                                                      $ 722,081     $(208,384)      $ 382,347
    Adjustments to reconcile net income (loss) to net cash
        provided by (used in) operating activities:
        Depreciation and amortization                                        235,431       212,470         201,187
        Loss on sale of assets                                                     -         1,821               -
        Deferred taxes                                                      (145,821)       18,000          12,000
        Deferred rent                                                        (13,489)       (7,806)         39,817
        Common stock issued for services                                           -         9,497           8,113
        Provision for inventory obsolescence                                  92,494       105,722          83,803
        Reserve for HydraLite, Inc.                                                -             -         (71,000)
        Loss on sale of HydraLite, Inc.                                            -             -          20,000
    (Increase) decrease in assets:
        Contract receivables                                                 (52,217)      304,480         (99,777)
        Income tax refund receivable                                         215,693      (215,693)              -
        Inventories                                                         (517,121)     (409,066)       (129,630)
        Prepaid expenses and other assets                                   (197,660)      (40,331)        (16,888)
    Increase (decrease) in liabilities:
        Accounts payable                                                    (208,727)      424,904         134,591
        Accrued payroll                                                       31,216        (4,728)          8,569
        Accrued annual leave                                                  15,578       (17,394)         (1,449)
        Accrued income taxes                                                       -       (45,000)          5,038
        Other current liabilities                                            209,846      (238,989)        298,218
                                                                           ---------     ---------       ---------
                      Net cash provided by (used in) operating
                          activities                                         387,304      (110,497)        874,939
                                                                           ---------     ---------       ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
    Capital expenditures                                                    (219,119)     (287,854)       (207,025)
    Investment in and advances to HydraLite, Inc.                                  -             -         (21,000)
    Cash proceeds from sale of investment                                          -             -          30,000
                                                                           ---------     ---------       ---------
                      Net cash used in investing activities                 (219,119)     (287,854)       (198,025)
                                                                           ---------     ---------       ---------
</TABLE>
                                                                     (Continued)

                                       25
<PAGE>


OPTELECOM, INC.

STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31,1996, 1995 AND 1994 (continued)
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                                              1996          1995           1994
                                                                              ----          ----           ----
<S> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
    Borrowings on note payable to bank                                       340,000        60,000               -
    Payment on note payable to bank                                         (400,000)            -        (385,000)
    Proceeds from exercise of stock options                                  130,773         3,359          12,022
    Repayments of long-term debt                                             (34,819)      (23,212)              -
    Borrowings of long-term debt                                                   -       104,457               -
                                                                            --------     ---------        --------
      Net cash provided by (used in) financing activities                     35,954       144,604        (372,978)
                                                                            --------     ---------        --------
NET INCREASE (DECREASE) IN CASH AND
 CASH EQUIVALENTS                                                            204,139      (253,747)        303,936

CASH AND CASH EQUIVALENTS,
 BEGINNING OF YEAR                                                            62,436       316,183          12,247
                                                                            --------     ---------        --------
CASH AND CASH EQUIVALENTS,
 END OF YEAR                                                                $266,575     $  62,436        $316,183
                                                                            ========     =========        ========
SUPPLEMENTAL DISCLOSURES OF CASH
 FLOW INFORMATION:
 Cash paid for interest                                                     $ 24,731      $  6,497        $ 22,646
 Cash paid for income taxes (net of refunds)                                $276,477      $ 59,653        $170,962
</TABLE>
                                                                     (Concluded)

See notes to financial statements

                                       26
<PAGE>


OPTELECOM, INC.

NOTES TO FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1996, 1995, AND 1994
--------------------------------------------------------------------------------

1.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

    Nature of Business - Optelecom,  Inc.  (the  Company) is a Delaware
    corporation that was organized in 1972.  The Company's  business  consists
    primarily of the development,  manufacture,  and sale of fiber optic
    communications  products and laser systems for  commercial and military
    customers.

    The Company is organized into three operating  divisions:  the
    Communications  Products  Division (CPD), which develops,  manufactures,
    and sells optical fiber based data communication equipment to the commercial
    marketplace,  the Government Products Division (GPD) which  is  primarily
    focused  on  electro-optic   technology   development  for
    government-related defense business, and the Research and Development
    Division, which addresses technology development business  opportunities.
    GPD is composed of two operating groups,  Electro/Optics  (E/O) Technology
    and Laser Illuminator Technology.  This Division was formed in 1996 from two
    former divisions, R&D and GLINT.  These divisions were combined into one to
    provide a natural grouping of similar  operations  and  functions.
    Currently,  the business addressed by the individual  groups is  essentially
    the same as in prior years.  The  principal markets for the Companyis
    products and services are located in  California  and several   Southeastern
    and   Southwestern regions  of  the  United   States. Additionally,  the
    Company  generates  a portion of its  revenues  from  several countries in
    Europe.

    Use of Estimates - Certain estimates used by management are particularly
    susceptible  to significant  changes in the economic  environment. These
    include  estimates of  percentage-of-completion  on long-term  contracts,
    inventory  obsolescence,  and valuation  allowances for contract receivables
    and deferred tax assets.  Each of these  estimates,  as well as the related
    amounts reported in the financial statements,  are sensitive to near-term
    changes in the factors used to determine them. A significant change in any
    one of those factors could result in the  determination  of amounts
    different than those reported in the  accompanying   financial   statements.
    Management  believes  that  as  of December 31,  1996, the estimates used in
    the financial  statements are adequate based on the information  currently
    available.

    Revenue  Recognition - Revenues from  cost-plus-fixed-fee  contracts  are
    recognized  to the  extent  of  costs incurred  during  the  period  plus a
    proportionate  amount of the fee  earned. Revenues    from     fixed-price
    contracts    are    recognized    on    the percentage-of-completion  method
    based on costs  incurred  in relation to total estimated costs. Revenues
    from time-and-materials contracts and sales orders are recognized at the
    time completed units are delivered.

    Contract costs include all direct  labor and  material  costs,  all
    indirect costs  related  to  contract performance,  such as indirect  labor,
    rent, depreciation  and  supplies,  and selling,  general and
    administrative costs,  such as  officers'  salaries  and professional fees.
    Provisions for estimated losses on uncompleted contracts are made in the
    period in which such losses are determined.

    Inventories - Production materials  are  valued  at the  lower of cost or
    market  applied  on a  weighted average cost basis.  Work-in-process
    represents  direct labor,  materials,  and overhead incurred on products not
    delivered to date.  Finished goods inventories are valued at the lower of
    cost or market, cost being determined using standards that  approximate
    actual costs on a specific  identification  basis.

                                       27


<PAGE>

    Property, Equipment,  and  Depreciation - Property  and  equipment  is
    stated at cost and includes  additions and major  replacements  and
    betterments.  Depreciation  is computed using the  straight-line  method
    over the estimated useful lives of the assets,  which range from 5 to 10
    years. Leasehold  improvements  are amortized over the terms of the
    respective leases or the  service  lives of the  assets, whichever is
    shorter.

    Research and Development Costs - Research and development costs are expensed
    as incurred.  The Company  incurred  research and development costs of
    $517,654, $538,977, and $479,888 for the years ended December 31, 1996,
    1995, and 1994,  respectively.

    Earnings Per Share - The computation of earnings per share is based on the
    weighted  average number of outstanding  common shares during the period
    plus, when their effect is dilutive,  common stock equivalents consisting of
    certain stock  options.  The primary  weighted  average  number of common
    and equivalent shares outstanding was 1,218,893, 1,177,048, and 1,163,012 at
    December 31, 1996, 1995, and 1994,  respectively.  The fully diluted
    weighted average  number of common  and  equivalent  shares  outstanding
    was 1,223,429, 1,178,607,  and 1,163,012 at December 31, 1996,  1995,  and
    1994, respectively.

    Income Taxes - The Company recognizes income tax expense for financial
    statement purposes  following  the asset and  liability  approach for
    computing  deferred income  taxes.  Under this  method,  deferred  tax
    assets and  liabilities  are determined based on the difference between
    financial reporting and tax basis of assets and  liabilities  based on
    enacted  tax rates.  Deferred  tax assets are reduced by a valuation
    allowance when, in the opinion of management,  it is more likely than not
    that some  portion or all of the deferred tax assets will not be realized.

    Stock-Based  Compensation - In 1996, the Company adopted Statement of
    Financial  Accounting Standard No. 123 ("SFAS 123"),  Accounting for
    Stock-Based Compensation.  Upon  adoption  of SFAS 123,  the  Company
    continues  to measure compensation expense for its stock-based  employee
    compensation plans using the intrinsic value method  prescribed by APB No.
    25, Accounting for Stock Issued to Employees, and has provided in Note 7 pro
    forma disclosures of the effect on net income (loss) and earnings  (loss)
    per share as if the fair  value-based  method prescribed  by SFAS 123 had
    been applied  in  measuring  compensation  expense.

    Forward Exchange  Contracts - The Company enters into forward exchange
    contracts to hedge certain firm purchase  commitments  denominated in
    foreign currencies. The purpose of the Company's foreign currency hedging
    activity is to protect the Company from the risk that the eventual cash
    flows  resulting from the purchases from foreign suppliers will be adversely
    affected by changes in exchange rates. Gains and losses resulting from the
    forward exchange  contracts are deferred and accounted  for as part of the
    underlying  transactions.  In entering into these contracts,  the Company
    has assumed the risk that might arise from the  possible inability of
    counterparties to meet the terms of the contracts. The Company does not
    expect  any  losses as a result  of  counterparty  defaults.

    Cash and Cash Equivalents - For the purpose of  presentation  in the
    statements of cash flows, cash and cash  equivalents  are defined as cash
    and investments  with  original maturities of three months or less.

                                       28

<PAGE>

2.  CONTRACT RECEIVABLES

    Contract receivables at December 31, 1996 and 1995, consisted of the
    following:

                                                         1996           1995
                                                         ----           ----
Billed                                                $1,246,388     $1,378,424
Unbilled - net of cumulative progress billings of
    $283,746 for 1996 and $210,820 for 1995              217,038         32,785
                                                      ----------     ----------
                                                      $1,463,426     $1,411,209
                                                      ==========     ==========


    Approximately  40%, 26% and 26% of the  Company's  revenues in 1996,  1995,
    and 1994,  respectively,  were derived from  contracts  with  agencies of
    the United States Government and their prime contractors. The Company
    performs the services and ships equipment according to the specific contract
    terms. Contracts with the United  States  Department of Defense  allow the
    Defense Contract Audit Agency (DCAA) to audit the contract costs and the
    Company's compliance with the Federal Acquisition  Regulations.  The DCAA
    has audited the costs under  contracts  for years  through  1993.  The
    Company  believes that the ultimate  outcome of DCAA audits for  subsequent
    years will not have a material effect on the  financial statements.
    Generally,  the contract  terms for both government and commercial customers
    require payment of invoices in 30 days.

    On January  25,  1995,  the Company was notified  that a contract  with a
    prime  contractor in the amount of $1,020,232 was terminated for
    convenience. As a result of the termination,  the Company recorded an
    allowance for uncollectible costs of $34,711 in 1994. During 1995 the
    Company collected all amounts due under this contract,  and accordingly
    reversed  the  allowance for  uncollectible  costs.

    Included  in  the  billed receivables  at December 31, 1996, is a retainage
    receivable  of  approximately $62,000,  which is  expected to be received
    upon  completion  of the project in 1997.

3.  INVENTORIES

    Inventories at December 31, 1996 and 1995,  consist of the following:


                                               1996            1995
                                               ----            ----
Production materials                       $  765,783      $  549,277
Work in process                               397,123         153,203
Finished goods                                342,062         377,861
                                           ----------      ----------
                                           $1,504,968      $1,080,341
                                           ==========      ==========


                                       29

<PAGE>

4.  PROPERTY AND EQUIPMENT

    Property and equipment at December 31, 1996 and 1995, consist of the
    following:

                                                        1996           1995
                                                        ----           ----
Laboratory equipment                               $ 1,113,530     $ 1,034,058
Office equipment                                       695,490         576,675
Furniture and fixtures                                  26,366          26,366
Leasehold improvements                                 388,708         367,876
                                                   -----------     -----------
                                                     2,224,094       2,004,975

Less accumulated depreciation and amortization      (1,445,041)     (1,209,610)
                                                   -----------     -----------
Net property and equipment                         $   779,053     $   795,365
                                                   ===========     ===========



5.  DEMAND NOTE PAYABLE TO BANK

    The Company  has a credit  agreement  with a bank  whereby it may borrow up
    to $ 1,000,000  with  interest at the bank's prime rate plus 3/4% (9% at
    December 31, 1996).  The total amount of borrowings that may be outstanding
    at any given time is based upon a percentage of certain eligible
    receivables. The amount available under the credit  agreement as of December
    31,  1996, was $ 1,000,000.

6.  NOTE PAYABLE

    During 1995,  Optelecom  entered into a  promissory  note  agreement to
    finance the purchase of  equipment.  The  equipment  serves as collateral on
    the promissory note. The principal  amount of the note was $104,458,  and
    the amount outstanding at December 31, 1996, was $46,426. The promissory
    note is payable at $2,902 a month until April  1998.  Principal  amounts due
    under the note in 1997 and 1998 are $34,819  and  $11,607,  respectively.
    Interest is payable at prime plus 3/4%.  The fair value of this note
    payable is approximately  equal to its carrying value. The note can be
    prepaid without penalty.

                                       30

<PAGE>

7.  STOCK OPTIONS

    In May 1996,  the 1991  Stock  Option  Plan (the  "1991  Plan")  was
    amended to increase the number of options available to purchase shares of
    common stock from 133,333  shares to 533,333.  The  options may be granted
    to officers  (including officers who are  directors),  other key employees
    of, and  consultants  to, the Company.  The 1991 Plan  superseded and
    replaced the Incentive Stock Option Plan and the Non-Qualified  Stock Option
    Plan that the Company had in operation prior to the  adoption of the 1991
    Plan. Options  outstanding  in prior years for the previous plans are
    included in the 1991 Plan information as presented below.

    The exercise price of each option may not be less than 100% of the fair
    market value of the stock on the date of grant for  incentive  stock
    options or 85% of such fair market value for  nonqualified  stock options,
    as determined by the Board. Options  issued prior to April 1, 1996 are
    exercisable  in whole or in part any time  after one year from the date of
    grant.  As  amended  in May 1996,  options issued after April 1, 1996 are
    exercisable after one year from the date of grant and in equal  increments
    over four years.  Options issued prior to April 1, 1996 expire three years
    after the date of grant and, in most cases,  upon termination of
    employment. Options  issued  after April 1, 1996 expire five years from the
    date of grant and, in most cases, upon termination of employment.  The 1991
    Plan will terminate on May 31, 2001, unless terminated sooner by the Board.

    A summary of stock option  activity  during the years ended  December 31,
    1996, 1995, and 1994 is as follows:


<TABLE>
<CAPTION>
                                      1996                           1995                       1994
                            ----------------------------- ---------------------------  -------------------------
                                             Exercise                     Exercise                   Exercise
                              Number          Price           Number        Price        Number        Price
                             of Shares         Range        of Shares       Range      of Shares       Range
                             ---------       --------       ---------     ---------    ---------      --------
<S> <C>
Outstanding, January 1        42,500      $2.88 -  6.50       41,250    $2.88 - 6.50     37,300    $2.88 - 6.50
Granted                      100,723       2.88 - 10.88        7,500     3.00 - 3.63     38,750     2.88 - 3.38
Exercised                     17,000       2.88 -  3.81            -          -               -          -
Canceled                       9,250       3.81 -  6.50        6,250     3.13 - 6.50     34,800            6.50
                             -------      -------------       ------    ------------     ------    ------------
Outstanding, December 31     116,973      $2.88 - 10.88       42,500    $2.88 - 6.50     41,250    $2.88 - 6.50
                             =======      =============       ======    ============     ======    ============
Exercisable options           19,250      $3.00 -  3.81       34,500    $2.88 - 6.50     40,750    $2.88 - 6.50
                             =======      =============       ======    ============     ======    ============
</TABLE>



    On December 19, 1988, the Board of Directors approved the Directors Stock
    Option Plan (1988 Directors Plan) under which each  nonemployee  director
    who attends a meeting  of the Board of  Directors  is, at his  election,
    granted an option to purchase 333 shares of common stock in lieu of
    receiving a certain  dollar value of common  stock.  The options have an
    exercise  price equivalent to the market value  of the  stock  on the  date
    of  such  Board meeting.  The  options  are exercisable  upon  grant  and
    expire  three years  thereafter.  This  plan was terminated  as of December
    31, 1992,  and accordingly,  no more options will be granted under this
    plan.  All options granted under this plan either expired or were exercised
    in 1995. There were no outstanding options at December 31, 1995.

                                       31

<PAGE>

    A summary of stock option activity for 1995 and 1994 is as follows:


<TABLE>
<CAPTION>
                                        1995                          1994
                             ----------------------------  ----------------------------
                                             Exercise                        Exercise
                               Number          Price            Number        Price
                             of Shares         Range           of Shares      Range
                             ---------       --------          ---------     --------
<S> <C>
Outstanding, January 1        2,997         $1.59 - 3.88         9,657      $1.03 - 3.88
Granted                           -                    -             -
Exercised                     1,332          1.59 - 3.00         4,329       1.03 - 3.00
Canceled                      1,665          3.00 - 3.88         2,331       1.88 - 3.00
                              -----         ------------     ---------      ------------
Outstanding, December 31          -         $     -          $   2,997      $1.59 - 3.88
                              =====         ============     =========      ============
Exercisable options               -         $     -          $   2,997      $1.59 - 3.88
                              =====         ============     =========      ============
</TABLE>

    On December 7, 1992, the Board of Directors  approved the 1993 Directors'
    Stock Option Plan (1993  Directors'  Plan),  which replaces the 1988
    Directors'  Plan. Under this plan, each nonemployee director who attends a
    meeting of the Board of Directors is at his election, granted an option to
    purchase 450 shares of common stock at the fair market  value at the grant
    date in lieu of receiving a certain dollar  value of the stock on the date
    of such Board  meeting.  The  options are exercisable upon grant and expire
    three years thereafter.  In February 1995, the Board of  Directors
    terminated  this plan  effective  December  31,  1995,  and accordingly, no
    more options will be granted under this plan.

    A summary of stock option activity  during the years ended December 31,
    1996, 1995, and 1994 is as follows:

<TABLE>
<CAPTION>
                                       1996                       1995                      1994
                              -----------------------   --------------------------  ----------------------
                                            Exercise                   Exercise                  Exercise
                                Number        Price       Number        Price          Number     Price
                              of Shares       Range      of Shares       Range       of Shares     Range
                              ---------     --------     ---------     --------      ---------   --------
<S> <C>
Outstanding, January 1          27,450    $2.88 - 7.25     7,550     $2.88 - 7.25      4,500   $6.12 - 7.25
Granted                              -          -          9,900      2.75 - 4.50     13,050    2.88 - 4.63
Exercised                       16,200     2.88 - 7.25         -           -               -         -
Canceled                         1,800     5.25 - 6.13         -           -               -         -
                                ------    ------------    ------     ------------     ------   ------------
Outstanding, December 31         9,450    $2.75 - 4.63    27,450     $2.88 - 7.25     17,550   $2.88 - 7.25
                                ======    ============    ======     ============     ======   ============
Exercisable options              9,450    $2.75 - 4.62    27,450     $2.88 - 7.25     17,550   $2.88 - 7.25
                                ======    ============    ======     ============     ======   ============
</TABLE>






    In February  1996,  the Board of Directors  approved the 1996  Directors'
    Stock Option Plan (1996  Directors'  Plan),  which replaces the 1993
    Directors'  Plan. Under this plan, each nonemployee director who attends a
    meeting of the Board of Directors  is granted an option to purchase  500
    shares of common  stock at fair market value on the date of such Board
    meeting. The options are exercisable upon grant and expire five years
    thereafter. A total of 50,000 shares of common stock had been reserved at
    December 31, 1996.


                                       32



<PAGE>

    A summary of stock option activity during the year ended December 31, 1996
    is as follows:

                                                                Exercise
                                                Number           Price
                                               of Shares         Range
                                               ---------    -------------
Outstanding, January 1                              -       $     -
Granted                                        16,000        3.25 - 11.25
Exercised                                           -             -
Canceled                                            -             -
                                               ------       -------------
Outstanding, December 31                       16,000       $3.25 - 11.25
                                               ======       =============
Exercisable options                            16,000       $3.25 - 11.25
                                               ======       =============



    In June 1990, the Board of Directors adopted a stock option plan (the
    Chairman's Plan) under which the  Chairman  of the Board is the sole
    participant.  On each January 1, the  Participant  is granted an option to
    purchase  1,666  shares of common stock at fair market value on the grant
    date.  Each option  granted under this plan  will  expire  three  years
    after  the date of grant.  On the date of adoption,  3,332  options were
    granted to the  participant  under the plan.  The total amount of shares
    available under this plan is 13,328. This plan terminated on December 31,
    1996,  and  accordingly,  no more options will be granted  under this plan.
    A total of 1,666 shares of common stock had been reserved at December 31,
    1996, under this plan.

    A summary of stock option  activity for 1996,  1995, and 1994 is as follows:

<TABLE>
<CAPTION>
                                    1996                      1995                     1994
                           ------------------------  ------------------------ -----------------------
                                        Exercise                  Exercise                Exercise
                              Number      Price         Number      Price       Number      Price
                            of Shares     Range       of Shares     Range     of Shares     Range
                            ---------  ----------     ----------  ---------   ----------  ----------
<S> <C>
Outstanding, January 1        4,998   $3.13 - 5.00       3,332   $4.88 - 5.00    3,332   $1.69 - 5.00
Granted                          -                       1,666           3.13    1,666           4.88
Exercised                     1,666           3.13           -         -         1,666           1.69
Canceled                      1,666           3.00           -         -            -
                              -----   --------------     -----   ------------    -----    -----------
Outstanding, December 31      1,666          $4.88       4,998   $3.13 - 5.00    3,332    4.88 - 5.00
                              =====   ==============     =====   ============    =====   ============
Exercisable options           1,666          $4.88       4,998   $3.13 - 5.00    3,332   $4.88 - 5.00
                              =====   ==============     =====   ============    =====   ============
</TABLE>


    In July 1991,  the Board of  Directors  approved a special  arrangement  for
    the granting  of a  total  of  30,000  stock  options  to  the  Companyis
    president (President's Plan). Under the arrangement, the president receives
    10,000 options each year at the market  price on the date of grant.  The
    options  expire  four years from the date of grant. All options under this
    plan were canceled in 1996.

                                       33
<PAGE>

    A summary of activity in 1996, 1995, and 1994 is as follows:

<TABLE>
<CAPTION>
                                      1996                          1995                          1994
                           ----------------------------- ----------------------------  ---------------------------
                                           Exercise                      Exercise                      Exercise
                             Number          Price         Number         Price          Number          Price
                           of Shares         Range       of Shares         Range        of Shares        Range
<S> <C>
Outstanding, January 1       20,000   $3.00  - 4.50        20,000      $3.00 - 4.50       20,000    $3.00 - 4.50
Granted                          -           -                  -            -                 -          -
Exercised                        -           -                  -            -                 -          -
Canceled                     20,000    3.00  - 4.50             -            -                 -          -
                             ------   -------------        ------      ------------       ------    ------------
Outstanding, December 31         -    $     -              20,000      $3.00 - 4.50       20,000    $3.00 - 4.50
                             ======   =============        ======      ============       ======    ============
Exercisable options              -    $     -              20,000      $3.00 - 4.50       20,000    $3.00 - 4.50
                             ======   =============        ======      ============       ======    ============
</TABLE>


    In 1996, the Company adopted the disclosure provisions of Statement of
    Financial Accounting   Standards  No.  123  ("SFAS  123"),   Accounting  for
    Stock  Based Compensation.  The required  disclosures include pro forma net
    income (loss) and earnings  (loss) per share as if the fair  value-based
    method of accounting had been used.

    If  compensation  cost for the  Company's  1996 and 1995  grants for
    stock-based   compensation   had  been  determined   consistent  with  the
    fair value-based  method of  accounting  per SFAS 123,  the  Company's  pro
    forma net income  (loss)  and pro forma  earnings  (loss)  per  share for
    the years  ended December 31, 1996 and 1995 would be as follows:


                                           1996           1995
                                           ----           ----
Net income (loss)
    As reported                           $722,081     $(208,384)
    Pro forma                             $538,647     $(256,467)

Primary earnings (loss) per share
    As reported                           $   0.59     $   (0.18)
    Pro forma                             $   0.44     $   (0.22)


    The fair value of the option  grant is  estimated on the date of grant using
    the Black-Scholes option pricing models with the following assumptions:


                                           1996             1995
                                           ----             ----
Expected dividend yield                     0 %              0 %
Expected stock price volatility            244 %            300 %
Risk-free interest rate                    6.37 %           5.10 %
Expected option term                   3 and 4 years       1 year


                                       34

<PAGE>

8.  INCOME TAXES

    The  components of the provision  (benefit) for income taxes for the years
    ended December 31, 1996, 1995, and 1994 are summarized as follows:


                                        1996           1995          1994
                                        ----           ----          ----
Current                               $455,957      $(251,756)     $176,000
Deferred                                 4,179         18,000        12,000
Change in valuation allowance         (150,000)             -             -
                                      --------      ---------      --------
                                      $310,136      $(233,756)     $188,000
                                      ========      =========      ========

    The Company's  1995 tax  provision  includes the benefit of the carryback
    of the current  year  loss  to the  prior  year.  Accordingly,  an  income
    tax refund receivable of $215,693 has been recorded as of December 31, 1995.

    The difference between  the  Federal  income tax  expense  (benefit)  and
    the amount  computed applying the statutory  Federal income tax rate for the
    years ended December 31, 1996, 1995, and 1994, are summarized as follows:

<TABLE>
<CAPTION>
                                                                 1996     1995     1994
                                                                 ----     ----     ----
<S> <C>
Federal income tax (benefit) at statutory rates                   34%     (34)%     34%

Increase (reduction) of taxes:
    State taxes, net of federal benefit                            4       (7)       5
    Utilization of tax credits                                     -        -       (6)
    Valuation allowance related to net deferred tax assets       (15)      (8)       -
    Other                                                          7       (4)       -
                                                                 ---      ---       --
Effective income tax rate                                         30%     (53)%     33%
                                                                 ===      ===       ==
</TABLE>




                                       35

<PAGE>

    Deferred  income  taxes  reflect  the net tax effects of  temporary
    differences between  the amount of assets  and  liabilities  for  income
    tax and  financial reporting purposes. The components of deferred income tax
    liabilities and assets as of December 31, 1996 and 1995, are as follows:


                                                          1996          1995
                                                          ----          ----
Deferred liabilities:
    Retainage receivable on long-term contracts       $  (36,831)   $  (67,275)
                                                      ----------    ----------
Gross deferred tax liabilities                           (36,831)      (67,275)
                                                      ----------    ----------
Deferred tax assets:
    Excess book depreciation                              17,482         5,389
    Capitalized overhead and inventory
        obsolescence reserve                              40,410        58,874
    Accrued vacation                                      38,592        27,386
    Deferral of rent expense                              77,742        77,309
    General business tax credits and capital losses            -        48,317
    Warranty reserve                                       8,426             -
                                                      ----------    ----------
Gross deferred tax assets                                182,652       217,275
                                                      ----------    ----------
Less:  Valuation allowance                                     -       150,000
                                                      ----------    ----------
Net deferred tax assets                               $  145,821    $        -
                                                      ==========    ==========


    A valuation  allowance  of $150,000  at December  31, 1995 was  reversed in
    1996 because it is more likely than not the deferred tax asset will be
    realized.

9.  EMPLOYEE BENEFIT PLANS

    The Company has a noncontributory Profit-Sharing Retirement Plan covering
    substantially all employees. Vesting occurs over a period of six years from
    the date of entry into the plan. Under the plan, the Company's  contribution
    is determined  annually by the Board of Directors and is funded as accrued.
    The expense for 1996, 1995, and 1994 was $113,329, $-0-, and $115,354,
    respectively.

    The Company has established a combined  tax-qualified  cash and deferred
    profit sharing plan under Section 401(k)  of  the  Internal  Revenue  Code
    for  all of the  Company's  full-time employees.  The  Company  matches
    employee contributions  to the  plan up to a maximum of 2.5%. Total
    contributions were $62,827,  $60,163 and $52,139 in 1996, 1995 and 1994,
    respectively.

10. COMMITMENTS AND CONTINGENCIES

    Operating Lease - During 1992, the Company moved its corporate office and
    manufacturing facilities and entered into a new 10-year noncancelable
    operating lease expiring August 31, 2002.  As an  inducement to enter the
    new lease,  the Company  received  certain incentives   such  as  a  rent
    abatement  and assumption  of  existing  lease obligations.  Additionally,
    the new lease provided for scheduled rent increases. These lease  incentives
    are being amortized  over the new lease  period.  Rent expense is being
    recognized on a straight-line  basis. In addition to the basic rentals,  the
    lease agreement  provides for  increases  based on payment by the Company of
    its share of real estate and  insurance  taxes.

                                       36


<PAGE>

    As of  December  31, 1996, future net minimum rental payments  required
    under operating  leases that have  initial  or  remaining  noncancelable
    terms in  excess of one year are as follows:

Year Ended December 31,

                1997                                $   200,980
                1998                                    207,009
                1999                                    213,220
                2000                                    219,616
                2001                                    226,205
                Later years                             153,789
                                                    -----------
                                                    $ 1,220,819
                                                    ===========





    Rental  expense was $221,651,  $216,566,  and $211,867 in 1996,  1995, and
    1994, respectively.

    Employment  Agreement - The Company has an employment agreement with an
    officer. In the event of his death while employed,  the officeris salary is
    to be paid to his beneficiaries for one year.  Through December 31, 1995,
    the officer earned a bonus of 1,666 shares of common stock for each
    twelve-month  period of the term of employment  (which began January 1,
    1984),  but no such stock shall be issued directly to him until  January 2,
    1999. A total of 13,329 shares has been issued in trust through  December
    31, 1996. All of the shares earned  through  December 31,  1995,  are to be
    transferred  to the  officer in the  future.  The Company recorded  expense
    of  $4,948  and  $4,998 in 1995 and  1994,  respectively,  in connection
    with this agreement.

    Employee  Cash/Stock  Bonus Plan - In 1980, the Company adopted an employee
    cash/stock bonus plan for which 8,333 shares of the Company's  common  stock
    have been set aside to be issued to  employees  at the discretion of
    management.  Through 1989, 1,533 shares had been issued. No shares were
    issued in 1996, 1995, and 1994.

11. INVESTMENT IN HYDRALITE, INC.

    In May, 1993, the Company agreed to make a 14% equity  investment in
    HydraLite, Inc., a start-up  telecommunications  company under a stock
    purchase agreement.  As of December  31,  1993,  the  Company had paid a
    total of $50,000 for the stock and provided an additional $75,345 in
    administrative, research and development, and marketing  support to
    HydraLite of which $21,000 was recorded as a  receivable. The Company had a
    commitment at December 31, 1993, to pay an additional  $21,000 for
    administrative assistance until HydraLite's first-round equity financing was
    completed. Due to delays in the completion of HydraLite's financing,
    management recorded a  valuation  reserve  for the entire  receivable  and
    investment  at December 31, 1993.

    In April 1994,  HydraLite  received its  first-round equity financing  and
    the  Company   reversed  the  reserve  for  the investment  and receivable.
    The Company also recorded a $42,000 receivable for repayment of the amounts
    advanced to HydraLite for administrative support. In December 1994, the
    Company sold its stock to the individual investors of HydraLite for $30,000
    and recorded a loss on the sale of $20,000.  In addition,  the Company and
    HydraLite settled  various  claims against  each  other  and,  as a result,
    the  Company recognized a gain of $209,012.


                                       37


<PAGE>

12. SEGMENT INFORMATION

    Segment information by major business segment is presented below:

<TABLE>
<CAPTION>
                                                              Year Ended December 31, 1996
                                            ------------------------------------------------------------------
                                                               Government Products Division
                                                                 Electro/         Laser
                                              Communication       Optics       Illuminator
                                                Products        Technology     Technology
                                                Division           Group          Group         Total
                                              -------------    -----------    ------------   ----------
<S> <C>
Revenues                                      $6,453,686         $592,981      $1,863,596    $8,910,263
Operating income (loss)                           60,664          (31,903)      1,046,577     1,075,338

Identifiable assets                            3,186,605          262,915         247,363     3,696,883
Corporate assets                                       -                -               -       769,580
                                              ----------         --------      ----------    ----------
Total assets                                  $3,186,605         $262,915      $  247,363    $4,466,463
                                              ==========         ========      ==========    ==========
Gross additions to property and equipment:
    Identifiable                              $  219,119         $      -      $        -    $  219,119
    Corporate                                          -                -               -             -
                                              ----------         --------      ----------    ----------
Total                                         $  219,119         $      -      $        -    $  219,119
                                              ==========         ========      ==========    ==========
Depreciation and amortization:
    Identifiable                              $  235,431         $       -     $        -    $  235,431
    Corporate                                          -                 -              -             -
                                              ----------         --------      ----------    ----------
Total                                         $  235,431         $       -     $        -    $  235,431
                                              ==========         ========      ==========    ==========
</TABLE>


                                       38

<PAGE>

<TABLE>
<CAPTION>
                                                           Year Ended December 31, 1995
                                        ------------------------------------------------------------------
                                                            Government Products Division
                                                              Electro/         Laser
                                          Communication        Optics       Illuminator
                                            Products         Technology      Technology
                                            Division            Group          Group           Total
<S> <C>
Revenues                                     $5,319,556       $ 395,284       $715,296     $6,430,136
Operating income (loss)                        (470,866)       (263,930)       307,369       (427,427)

Identifiable assets                           3,117,177         101,103         68,635      3,286,915
Corporate assets                                      -               -              -        387,089
                                             ----------       ---------       --------     ----------
Total assets                                 $3,117,177       $ 101,103       $ 68,635     $3,674,004
                                             ==========       =========       ========     ==========
Gross additions to property and equipment:
    Identifiable                             $  287,854       $       -       $      -     $  287,854
    Corporate                                         -               -              -              -
                                             ----------       ---------       --------     ----------
Total                                        $  287,854       $       -       $      -     $  287,854
                                             ==========       =========       ========     ==========
Depreciation and amortization:
    Identifiable                             $  212,470       $       -       $      -     $  212,470
    Corporate                                         -               -              -              -
                                             ----------       ---------       --------     ----------
Total                                        $  212,470       $       -       $      -     $  212,470
                                             ==========       =========       ========     ==========
</TABLE>


                                       39
<PAGE>

<TABLE>
<CAPTION>
                                            Year Ended December 31, 1994
                               ------------------------------------------------------
                                             Government Products Division
                                                Electro/      Laser
                               Communication     Optics     Illuminator
                                  Products     Technology   Technology
                                  Division        Group        Group         Total
                               -------------   ----------   -----------      -----
<S> <C>
Revenues                         $5,562,130     $ 554,542     $919,397     $7,036,069
Operating income (loss)             174,084      (175,589)     414,195        412,690
Identifiable assets               2,538,970       488,915      189,501      3,217,386
Corporate assets                          -             -            -        399,912
                                 ----------     ---------     --------     ----------
Total assets                     $2,538,970     $ 488,915     $189,501     $3,617,298
                                 ==========     =========     ========     ==========
Gross additions to property
 and equipment:
 Identifiable                    $  124,215     $  82,810     $      -     $  207,025
 Corporate                                -             -            -              -
                                 ----------     ---------     --------     ----------
Total                               124,215        82,810            -        207,025
                                 ==========     =========     ========     ==========
Depreciation and amortization:
 Identifiable                    $  120,712     $  80,475     $      -     $  201,187
 Corporate                                -             -            -              -
                                 ----------     ---------     --------     ----------
Total                            $  120,712     $  80,475     $      -     $  201,187
                                 ==========     =========     ========     ==========
</TABLE>

    All of the revenues from Research and  Development  and GLINT divisions are
    from U.S.  Government  agencies and their prime  contractors.

    The Company is engaged primarily in the development,  manufacture,  and sale
    of optical  communications products and laser systems.  Revenue represents
    shipments and services provided to third parties.  Contract costs and
    operating  expenses directly  traceable to individual  segments were
    deducted from revenue to arrive at operating  income. Identifiable  assets
    by segment are those assets that are used in the  Companyis operations in
    each segment.  Corporate assets consist primarily of cash, prepaid expenses,
    deferred taxes, and long-term assets.

13. SIGNIFICANT CUSTOMERS AND FOREIGN EXPORTS

    The Companyis primary business activity is with the U.S. Government and its
    prime contractors and commercial customers providing communications products
    and services.  In 1996, three customers accounted for 21%, 8%, and 8% of
    sales. During 1995, the Company made sales to two commercial customers that
    accounted for approximately 10% and 9% of revenues, respectively.  During
    1994, the Company made sales to individual commercial customers that
    accounted for approximately 12% and 10% of revenues, respectively.  In 1996,
    1995, and 1994, the Company had export sales to foreign customers totaling
    approximately $1,159,000, $860,000 and $923,000, respectively.  At December
    31, 1996, contract  receivables from three customers  represented 17%, 13%
    and 4%, respectively, of total contract receivables outstanding.

                                  * * * * * *

                                       40

<PAGE>
                                                                     SCHEDULE II


OPTELECOM, INC.

SCHEDULE OF VALUATION AND QUALIFYING ACCOUNTS
YEAR ENDED DECEMBER 31, 1996, 1995 AND 1994
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                          Balance       Charged to                               Balance
                                        at Beginning    Costs and     Other                       at End
Description                              of Period       Expenses    Changes     Deductions     of Period
-----------                             ------------    -----------  -------     ----------     ---------
<S> <C>
Year Ended December 31, 1994

Reserves and allowances deducted
 from asset accounts
 Obsolescence reserve for
  inventory                               $42,469       $ 83,803     $   -     $ (42,870)(1)     $83,402
 Allowance for uncollectible
  contract costs                                -         34,711         -                        34,711
 Reserve for investment                    71,000        (71,000)        -                             -


Year Ended December 31, 1995

Reserves and allowances deducted
 from assets/accounts:
 Obsolescence reserve for
  inventory                               $83,402       $105,722     $   -     $ (92,119)        $97,005
 Allowance for uncollectible
  contract costs                           34,711        (34,711)        -             -               -

Year Ended December 31, 1996

Reserves and allowances deducted
 from asset accounts:
 Obsolescence reserve for
  inventory                               $97,005       $ 92,494     $   -     $(113,250)        $76,249
 Allowance for uncollectible
  contract costs                                -         78,186         -             -          78,186
</TABLE>

(1) Scrap inventory


                                       41

<PAGE>

                                                                      EXHIBIT 11

OPTELECOM, INC.

EARNINGS PER SHARE
YEAR ENDED DECEMBER 31, 1996, 1995 AND 1994
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
                                                 1996          1995          1994
                                                 ----          ----          ----
<S> <C>
Primary Earnings Per Share:
      Net earnings (loss)                     $  722,081    $ (208,384)   $  382,347
                                              ==========    ==========    ==========
Weighted average common and common
 equivalent shares                            $1,183,253    $1,170,393    $1,162,660
Adjustment to options using average year
 price when dilutive                              35,640         6,655           352
                                              ----------    ----------    ----------
Primary shares                                 1,218,893     1,177,048     1,163,012
                                              ==========    ==========    ==========
Earnings (loss) per share                     $      .59    $    (0.18)   $     0.33
                                              ==========    ==========    ==========
Fully Diluted Earnings Per Share:
      Net earnings (loss)                     $  722,081    $ (208,384)   $  382,347
                                              ==========    ==========    ==========
Weighted average common and common
 equivalent shares                             1,183,253     1,170,393     1,162,660
Adjustment to options using year
 end price when dilutive                          40,176         8,214           352
                                              ----------    ----------    ----------
Fully diluted shares                           1,223,429     1,178,607     1,163,012
                                              ==========    ==========    ==========
Earnings (loss) per share                     $     0.59    $    (0.18)   $     0.33
                                              ==========    ==========    ==========
</TABLE>



                                       42
<PAGE>


Item 9.  CHANGES IN AND DISAGREEMENT WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

         None

                                    PART III

Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

1.       Directors of the Company

         See the Company's  Proxy  Statement,  incorporated by Reference as Part
         III of this Form 10-K, under the heading "Proposal 1 and
         Miscellaneous."

2.       Executive Officers of the Company

         See the Company's  Proxy  Statement,  incorporated by Reference as Part
         III of this Form 10-K, under the heading "Proposal 1 and
         Miscellaneous."

Item 11. EXECUTIVE COMPENSATION

         See the Company's  Proxy  Statement,  incorporated by Reference as Part
         III of this Form 10-K, under the heading "Summary Compensation Table."

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

         See the Company's  Proxy  Statement,  incorporated by Reference as Part
         III of this Form 10-K, under the heading "Proposal 1."

Item 13. CERTAIN RELATIONSHIPS AND RELATED PARTIES

         See the Company's  Proxy  Statement,  incorporated by Reference as Part
         III of this Form 10-K, under the heading "Miscellaneous."

                                       43

<PAGE>

                                    PART IV

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

1.       Financial Statements and Financial Statement Schedules
         Report of Independent Certified Public Accountants

Statements
----------

Balance Sheets as of December 31, 1996 and 1995

Statements of Operations for the Years Ended December 31, 1996, 1995, and 1994

Statements of Stockholders' Equity for the Years Ended December 31, 1996, 1995,
and 1994

Statements of Cash Flows for the Years Ended December 31, 1996, 1995, and 1994

Summary of Accounting Policies

Notes to Financial Statements

2.       Financial Statement Schedules

         Schedule II       Valuation and Qualifying Accounts, Years Ended
                           December 31, 1996, 1995, and 1994

         Other  schedules  are  omitted  because  they  are  not  applicable  or
         information is shown elsewhere in the financial statements or notes
         thereto.

3.       Exhibits

         Item 3(i)(1) Restated Certificate of Articles of Incorporation of
         Optelecom, Inc. as in effect March 14, 1994.

         Item 3(i)(2) Certificate of Amendment of Articles of Incorporation

         Item 11 - Statement Regarding Computations of Per Share Earnings

         Item 21 - The significant subsidiaries of the Registrant, as defined in
         Section 1-02(w) of regulations S-X are:

                  Optelecom FSC, Inc., a U.S. Virgin Island Corporation

4.       Reports on Form 8-K

         No 8-Ks were filed during 1996.

                                       44

<PAGE>

                                   SIGNATURES

Pursuant to the  requirements of Section 13 or 15(d) of the Securities  Exchange
Act of 1934,  the  registrant  has duly  caused  this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

                                      OPTELECOM, INC.


Date: March 27, 1997               By   /s/ William H. Culver
                                      __________________________________________
                                            William H. Culver
                                            Chairman and Treasurer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following  persons on behalf of the  registrant and
in the capacities and on the dates indicated.

                                            OPTELECOM, INC.


Date: March 27, 1997               By   /s/ William H. Culver
                                      __________________________________________
                                            William H. Culver
                                            Chairman and Treasurer


Date: March 27, 1997               By   /s/ Edmund D. Ludwig
                                      __________________________________________
                                            Edmund D. Ludwig
                                            Director and President

Date: March 27, 1997               By   /s/ John A. Jamieson
                                      __________________________________________
                                            John A. Jamieson
                                            Director

Date: March 27, 1997               By   /s/ Gordon A. Smith
                                      __________________________________________
                                            Gordon A. Smith
                                            Director


Date: March 27, 1997               By   /s/ Alexander L. Karpinski
                                      __________________________________________
                                            Alexander L. Karpinski
                                            Director


Date: March 27, 1997               By   /s/ Calvin T. Mathews
                                      __________________________________________
                                            Calvin T. Mathews
                                            Director

                                       45