<PAGE>
 
                    U.S. SECURITIES AND EXCHANGE COMMISSION

                            Washington, D.C. 20549

                                   FORM 10-K

     (Mark One)
      [X]  ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE 
           SECURITIES EXCHANGE ACT OF 1934
                  For the fiscal year ended December 31, 1998
                                        
      [_]  TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
           EXCHANGE ACT OF 1934 [No Fee Required]
                           For the transition period
               from...................to.................

                        Commission file number  0-21758

                       DIAGNOSTIC HEALTH SERVICES, INC.
                (Name of small business issuer in its charter)

  DELAWARE                                                            22-2960048
  (State or other jurisdiction of                               (I.R.S. Employer
  incorporation or organization)                             Identification No.)

            2777 STEMMONS FREEWAY, SUITE 1525, DALLAS, TEXAS 75207
                   (Address of principal executive offices)

                   Issuer's telephone number:  (214)634-0403

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

     Title of each class               Name of each exchange on which registered
     -------------------               -----------------------------------------
  Common Stock, $.001 par value                 NASDAQ National Market


  Securities registered pursuant to Section 12(g) of the Act:  Common Stock,
                                $.001 par value

     Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or 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 Regulation 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. [_]

     The aggregate market value of the Common voting stock based on a closing
price on the NASDAQ National Market on March 1, 1999 of $1.78 per share held by
non-affiliates of the registrant was $19,295,038.

     The number of shares outstanding of the registrant's Common Stock, $.001
par value, as of March 1, 1999 was 11,481,636.

  Documents Incorporated by Reference:  None
<PAGE>
 
                                    PART I
                                    ------                                

ITEM 1.   BUSINESS

THE COMPANY

Diagnostic Health Services, Inc. ("DHS" or the "Company") is a leading outsource
provider of medical support services to hospitals, physicians' offices and other
healthcare facilities in the Midwest, West and South Central United States.  DHS
primarily provides radiology and cardiology diagnostic  services and equipment,
as well as departmental management services, to healthcare facilities on an in-
house and shared basis.

The Company was incorporated in Texas in 1983 and was reincorporated in Delaware
in 1992.  The Company is headquartered in Dallas, Texas, and provides services
in Texas, Oklahoma, Illinois, Indiana, Louisiana, Mississippi, Missouri, Iowa,
Ohio, Michigan, Arkansas, Georgia, Alabama, Virginia, Kentucky, Tennessee, New
Mexico, Arizona, Nevada and California.  Until the sale of such operations in
December 1997, the Company also provided services in the greater Mexico City
area.

In addition to significant internal growth, the Company has expanded its
business through numerous acquisitions.  Information regarding acquisitions in
the past two fiscal years is included in the footnotes to the audited financial
statements appearing at Item 8 below.

The following chart sets forth the corporate structure of the Company and its
subsidiaries at March 1, 1999:

                             [CHART APPEARS HERE]

In addition, DHS and DHSMS have two inactive wholly-owned subsidiaries,
Diagnostic Health Services de Mexico, S.A. de  C.V. and HomeCare International,
Inc., and DHS has formed a new subsidiary (MAI Acquisition Corp.) for purposes
of a pending acquisition.  SoCal owns a 50% partnership interest in Scripps
Chula Vista Imaging Center, L.P., which is accounted for on the equity method.

                                       1
<PAGE>
 
BUSINESS OPERATIONS

In-House  Services  (also referred to as Fixed Site Services)
--------------------------------------------------------------
The Company provides diagnostic services within hospitals and clinical radiology
or cardiology departments. These services include the provision of the allied
healthcare professionals (technologists) who staff the equipment and are
responsible for image acquisition; the provision and management of diagnostic
equipment or other related instrumentation; the management and processing of
data for the procedures conducted within the respective department; and in some
instances the provision, via subcontracting, of the professional component
(interpretation) of the data by a physician.

These in-house services may include any or all of the aforementioned
responsibilities. The imaging modalities under management include, but are not
limited to, diagnostic ultrasound, computerized tomography, MRI, nuclear
medicine, and cardiac catherization services.

Generally, the Company is responsible for various quality assurance programs
related to the services it provides and assumes documentation responsibility and
management oversight of departmental compliance issues,  licenses, accreditation
and certification requirements.

At December 31, 1998, the Company provided in-house services at 138 hospitals
and other health care facilities throughout its operational markets.

Shared Services
---------------
The Company operates a fleet of specially equipped vehicles (vans and trucks) to
transport its imaging equipment to hospitals, clinics, long-term care facilities
and other healthcare settings. The services provided via the shared services
delivery mechanism are predominantly diagnostic ultrasound, for which the
equipment is portable and service is rendered on an "as needed" basis. This
includes a large number of regular and routed schedules as well as "on call"
services to customers in response to emergent demand.

At year-end 1998, the Company provided shared services to 290 of its
approximately 394 hospital customers and approximately 844 additional clients
across the healthcare spectrum, including physicians' offices, sub acute and
long-term care facilities, managed care systems, and government facilities.

Ancillary Services
-------------------
At various of its service sites, the Company provides temporary staffing and
cardiac monitoring services, such as Holter monitoring, pacemaker monitoring and
event recording for patients of the Company's customers. In addition, until the
sale of such operations in December 1997, the Company maintained an operating
unit providing contract occupational and physical therapists on a long or short
term basis to healthcare facilities throughout the United States, and provided
(through a separate subsidiary) therapists and nurses in a home healthcare
setting in the Mexico City and surrounding areas. The Company currently has no
plans to re-enter the therapist placement business or the Mexican market.

CUSTOMERS
Each of the Company's customers, irrespective of the method by which they are
served, has an agreement or contract specifying the terms of service, including
the nature of services, pricing, payment and other material terms.  The
Company's agreements for in-house services typically have a duration of three to
five years and specify equipment and personnel requirements, the scope and types
of services to be provided and the pricing and payment structure.  In addition
to certain longer term contracts, the Company performs a material portion of its
work under one-year contracts, or on a month-to-month basis.  Non-renewal of
such contracts, or renewal on less favorable terms, could have a material
adverse effect on the Company's revenues, operating margins, and net income.  If
the affected accounts were

                                       2
<PAGE>
 
obtained in one of the Company's business acquisitions, the goodwill related to
that acquisition could also become materially impaired. If such circumstances
arise, the Company records an impairment loss as the difference between the
estimate of the related after-tax income contribution, and the carrying value of
the goodwill. Any impairment loss would be reported as a component of income
from continuing operations before tax.

In 1997 and 1998, no single customer of the Company accounted for more than 10%
of the Company's total revenues and the three largest customers of the Company
accounted in the aggregate for approximately 3% of the Company's revenues in
1997 and approximately 4% of the Company's revenues in 1998. In most cases, the
hospital or healthcare facility (which is the Company's customer) is the
responsible payment party. Third party payors accounted for approximately 9% and
28% of the Company's revenues in 1997 and 1998, respectively. Although the
Company is not substantially reliant upon third-party payment mechanisms, many
of the Company's customers are reliant on third-party payment, and delays or
difficulties in third-party payments could thereby adversely affect the receipt
and timing of payments to the Company.

From 1991 to 1998, the Company's customer base increased from 323 (including
seven in-house agreements) to approximately 1,238.  Customers in 1998 included
394 hospitals (which included 138 in-house agreements) and 844 physicians'
offices, clinics and healthcare facilities in 20 states.

In 1998, the Company's revenues were attributable to shared services, in-house
services and ancillary services, in the following approximate proportions:

                  In-House/Fixed Site  50%
                  Shared               42%
                  Ancillary             8%

OPERATING STRUCTURE
Through the implementation of a deliberate acquisition strategy, the Company has
established a network of operational facilities throughout the country.  These
division offices, located in Arlington, TX, San Diego, CA, Phoenix, AZ, Tulsa,
OK, St. Louis, MO, Chicago, IL, Atlanta, GA, Monroe, LA and Huntsville, AL,
serve as an operations base for both clinical staff, local management and sales.
By keeping these functions local, the Company remains responsive to its customer
base as well as to opportunities for expansion and development within the
Company's markets.

The Company provides local personnel with a comprehensive range of support
services, including financial and administrative services, and employs a
mechanism, which carefully monitors local operations through an extensive system
of controls, including regular financial reporting, accounts receivable analysis
and customer tracking. The Company provides administrative functions at the
corporate level, including receivables management, purchasing, human resources
and accounting, thereby eliminating the duplicative expenses that would arise if
these services were provided locally.

MANAGEMENT INFORMATION SYSTEMS
The Company has configured an information technology system that provides real-
time monitoring of services, procedures and other business activities at all of
the Company's divisional offices. This enables the Company to monitor services,
revenues and costs on a Company-wide basis. The Company has made substantial
investments in the development of this system and all of the Company's business
offices are networked into the information technology system and integrated with
the Company's centralized processing system. This system also contributes to the
Company's sales and marketing efforts by enabling the sales force to formulate
quotations and pricing proposals to potential customers and to provide
management with information specific to existing customers. The Company made
significant additional investments in the upgrade and expansion of this system
in 1997, and believes that

                                       3
<PAGE>
 
its information technology system can support substantial growth without
requiring significant further capital expenditures.

SALES AND MARKETING
The Company directs its sales and marketing activities from its Dallas
headquarters, and out of each of its operating divisions. Each operating
division has at least one, and in some instances more than one, sales
representative devoted full-time to promotion of the Company's business and the
maintenance and expansion of existing relationships. Additionally, each division
manager as well as the regional vice presidents devotes portions of their time
to customer relations and marketing functions.

COMPETITION
Radiology and cardiology diagnostic services are characterized by a high degree
of competition. This competition comes from a number of independent local
operators specializing in one or two clinical applications, and from a few large
diversified healthcare companies (primarily larger hospitals having the
resources and capability to provide shared diagnostic services to other
healthcare facilities) which provide these services as part of their overall
business. Although the Company believes that it has a competitive advantage over
most of the small operators (primarily because most of them do not provide the
full range of services offered by the Company, and do not have the same volume
of revenues to absorb necessary fixed overhead costs), the Company may be
vulnerable to competition from the larger healthcare companies, at least one of
which can be found in each of the Company's geographic markets, and all of which
are substantially larger and possess greater financial resources than the
Company. There can be no assurance that the Company will be able to compete
successfully in its markets.

SEASONALITY
The Company's results of operations have, in some years, varied significantly
from quarter to quarter, for reasons particular to each quarter.  For instance,
hospital admissions and doctor visits (and, therefore, the Company's imaging
revenues) are typically lower during holiday periods, and at other times when
physicians traditionally take their own vacations.

SUPPLIERS
Although the Company has historically acquired most of its imaging and other
equipment through finance leases from a small number of suppliers, the Company
is not dependent upon any one supplier or group of suppliers.  While the Company
has a preference for the equipment manufactured by certain manufacturers, there
are a number of manufacturers of imaging equipment adequate for the Company's
purposes, and an even greater number of companies from whom such equipment can
be leased.  The Company believes that alternate sources for its equipment and
supply needs are readily available at comparable costs, and that its
relationships with its suppliers are satisfactory.

PATENTS OR TRADEMARKS
Although the Company relies upon sophisticated equipment, instrumentation and
technology, the Company does not own, license or otherwise rely upon any patents
or trademarks for the operation of its business.  Other than corporate names,
the Company does not own or utilize any trademarks in its business.

GOVERNMENT REGULATION
Many aspects of the healthcare industry in the United States are presently
subject to extensive federal and state government regulation. Certain of these
laws and regulations are applicable to the Company's business. The Company is
also subject to laws and regulations relating to business corporations in
general. The Company believes that its operations are in material compliance
with all applicable laws.

                                       4
<PAGE>
 
Federal Kickback Law
Federal law prohibits the offer, solicitation, payment or receipt of any
remuneration (direct or indirect, overt or covert, in cash or in kind) which is
intended to induce, or is in return for, the referral of patients for, or the
ordering of, items or services reimbursable by Medicare or Medicaid.  The law
also prohibits remuneration intended to induce the purchasing of, or arranging
for, or recommending the purchase or order of any item, good, facility or
service for which payment may be in whole or in part under those programs.
Under this statute, known as the "kickback law," an offense may be punished by
criminal prosecution or by excluding any of the parties to the transaction or
arrangement from participation in Medicare and Medicaid.  The law is very broad
and has been interpreted to apply to otherwise legitimate investment interests
if one purpose of the offer of an opportunity to invest is to induce referrals
from the investors.  Regulations implemented under the kickback law provide
certain "safe harbors" giving protection for certain categories of
relationships.

The breadth of the kickback law is such that virtually any financial
relationship between a practitioner and a healthcare provider, such as an
independent physiological laboratory (IPL) or an independent diagnostic testing
facility (IDTF), involving the offering of Medicare and Medicaid services may
trigger the application of the law.

A substantial portion of the Company's business arrangements involves the
management and staffing of in-house diagnostic laboratories at hospitals.  The
Company does not lease space from the hospitals or any other providers with whom
it contracts and does not bill Medicare or Medicaid for the technical services
provided at the hospitals' laboratories.  The Company believes that its
relationships with hospitals and other care providers are in compliance with the
Federal kickback law.

Federal Stark Laws
Federal law also prohibits physicians from ordering or prescribing certain
designated healthcare services or items if the service or item is reimbursable
by Medicare or Medicaid and is provided by an entity with which the physician
has a financial  relationship (including investment interests and compensation
arrangements).  Payment for a service provided in violation of these laws, known
as the "Stark Laws," may be denied, or money paid may be recouped.

The services specified by the Stark Laws include ultrasound procedures and other
designated services, which are provided by the Company as the result of
referrals from physicians who purchase the tests from the Company.  The Company
believes that its relationships with referring physicians are in compliance with
the Stark Laws.

State Law
A number of states, including states in which the Company does business, have
laws and regulations similar to the federal kickback laws and Stark Laws.  The
Company believes that it is in compliance with all of such laws, although, as is
the case with federal law, there can be no assurance that changes in such laws
or the interpretation or enforcement of such laws will not have a material
effect on the Company.

IDTFs
The Company must satisfy certain rules set forth by the Health Care Financing
Administration ("HCFA") relating to the payment of services to Medicare or
Medicaid beneficiaries.  These rules state that the carriers will pay for
services under the Medicare fee schedule only when performed by a physician, a
group practice of physicians, an approved supplier of portable x-ray services,
or an IDTF. The current effective date for IDTF status is March 15, 1999,
however this date is subject to change. The Company believes that its services
are provided according to the rules and specifications of an IDTF.

                                       5
<PAGE>
 
Potential National Healthcare Reform
Both the Clinton Administration and the Congress have periodically asserted a
need to overhaul or reform the nation's healthcare system. Such legislative
initiatives, if enacted, could impose pressures on the pricing structures
applicable to the Company's services. In particular, there is a possibility that
an even greater portion of healthcare services will be rendered and administered
through "managed care" systems, which could have the effect of forcing pricing
concessions and reductions on the part of service providers such as the Company.
Moreover, healthcare reform could also entail a greater analysis of each
patient's need for diagnostic testing, with the aim of reducing the total volume
of testing and the overall cost of medical care. The Company is unable to
predict whether, when or to what extent any new laws or regulations may be
enacted, or existing laws or regulations may be modified, any of which could
have a material adverse effect on the Company's revenues, operating margins and
profitability.

ENVIRONMENTAL MATTERS
With the exception of the nuclear imaging services performed by the Company, the
Company's operations do not entail the handling, storage, use, transport or
disposal of any hazardous substances or hazardous materials within the meaning
of any environmental laws. The Company is not aware of any asbestos abatement
activity required with respect to any of its facilities, or any underground
storage tanks on any of the properties on which the Company's facilities are
located.

The Company's nuclear imaging services require the handling of radioactive
materials, either in the form of FDA-approved single-dose prepackaged isotopes,
or small lots of bulk materials which the Company mixes with other
pharmaceuticals to prepare radiopharmaceuticals to facilitate imaging of various
body organs. These nuclear imaging operations are conducted in the States of
Illinois, Indiana, Ohio, Missouri, Kentucky, Texas, Louisiana and Oklahoma.  The
"Agreement States" (Illinois, Texas, Kentucky and Louisiana) require a separate
license from the State to handle these radioactive materials.  The Nuclear
Regulatory Commission controls the use of byproduct materials in the other
states (Indiana, Missouri, Oklahoma and Ohio) through the issuance of licenses.
The Company believes that it holds all necessary permits required by state and
federal law and that it is in compliance with all applicable laws and
regulations relating to the handling, storage, use, transport and disposal of
nuclear materials. Based on advice from its insurance carriers, the Company
believes that this limited handling of radioactive materials does not warrant
any special insurance.

The Company has not experienced any material environmental regulatory problems
in the past, and has not been subject to any fines, penalties or other
liabilities under any environmental laws or regulations. However, no assurance
can be given that future changes in such laws or regulations, or interpretations
thereof, or in the nature of the Company's operations, will not have a material
impact on the Company.

YEAR 2000 COMPLIANCE
The Company recognizes the need to ensure that its operations will not be
adversely impacted by Year 2000 computer and systems failures.  Year 2000
failures due to processing errors potentially arising from calculations using
the Year 2000 date are a known risk.  The Company is addressing this risk to the
availability and integrity of financial systems and the reliability of
operational systems, and has established processes for evaluating and managing
the risks and costs associated with this problem.  The computing portfolio was
identified and an initial assessment has been completed.  The cost of achieving
Year 2000 compliance is estimated to be approximately $40,000 over the cost of
normal upgrades and replacements, and will be incurred through fiscal 1999.

The Company believes that its financial reporting and billing systems are
substantially compliant with Year 2000 requirements.  The Company has consulted
with its diagnostic equipment vendors and has been advised that certain items
will be supported at no cost, and that older items will be supported on a fee
basis.  The cost of making the Company's diagnostic equipment Year 2000
compliant is estimated to

                                       6
<PAGE>
 
be within a range of approximately $100,000 to $150,000 over the cost of normal
upgrades and replacements, and will be incurred through fiscal 1999.

Certain of the Company's customers and vendors may be dependent on computer or
other embedded information systems to conduct business transactions, although
the Company has not yet undertaken any investigation, other than its diagnostic
equipment vendors, to determine the nature or extent of any Year 2000 issues
that may be posed by customer or vendor unpreparedness.  The Company expects to
discuss with its key customers and vendors the status of their Year 2000
readiness in the first and second quarters of 1999, and to promptly thereafter
identify possible alternative suppliers to the extent that such action may be
called for based on any relative lack of Year 2000 readiness by existing
suppliers.  The Company does not expect the costs of this investigation to be
material.

EMPLOYEES
As of March 1, 1999, the Company had 385 full-time employees and 126 part-time
employees for a total of 511 employees.  None of the Company's employees are
represented by any labor union or other collective bargaining unit.  The Company
has not experienced any significant degree of employee turnover and the Company
believes that its relations with its employees are satisfactory.

RECENT DEVELOPMENTS
On February 18, 1999, the Company entered into an Agreement and Plan of Merger
with Medical Alliance, Inc. ("MAI"), a Nasdaq National Market company, pursuant
to which MAI is to merge with and into a wholly-owned subsidiary of DHS.  Under
the terms of the agreement, holders of MAI common stock are to receive, upon
consummation of the transaction, 1.57 shares of DHS common stock for each
outstanding share of MAI common stock, and outstanding MAI stock options will be
converted into DHS stock options at that same exchange ratio.  The transaction
is subject to approval by the stockholders of both companies, and certain other
conditions.  Subject to obtaining such approvals and satisfying such conditions,
the transaction is expected to be completed by the end of the second quarter of
1999.  However, there can be no assurance as to whether or when the transaction
with MAI will be consummated.

On February 19, 1999, the Company received notification from Nasdaq that, due to
the write-offs for asset impairment described in Item 7 below, there was some
question as to whether the Company continued to be in compliance with the
minimum tangible net worth required for continued listing of the Company's
common stock on the Nasdaq National Market; such notification also questioned
whether the Company had the required minimum number of round lot stockholders.
In its response, the Company has indicated that, although the write-offs will
result in a temporary inability to meet the required $4,000,000 tangible net
worth requirement, the transaction with MAI would, upon consummation,
immediately restore the Company to compliance; in addition, with respect to the
number of stockholders, the Company advised Nasdaq that, when taking into
account all beneficial holders holding DHS shares in "street" name, there are
substantially in excess of 400 round lot stockholders.  The Company believes
that it has provided to Nasdaq a coherent and definitive plan for restoring the
Company's compliance with Nasdaq listing requirements, and the Company is
hopeful that Nasdaq will defer any further action regarding any delisting of the
Company's common stock pending the results of the proposed transaction with MAI
(although there can be no assurance as to whether or when Nasdaq will take any
further action).

ITEM 2.  PROPERTIES

PROPERTY
The Company maintains its headquarters in approximately 13,119 square feet of
leased office space  in Dallas, Texas.  Base rental at that facility is $16.40
per square foot per year, and the lease expires in January 2004.  The Company
also maintains divisional, satellite and other operating offices at 24 leased
locations, ranging in size from approximately 214 square feet to approximately
7,700 square feet, at rentals generally ranging from $4 to $32 per square foot
per year.  The Company believes that its existing premises will be adequate for
its current operations for the foreseeable future. The Company does not own any 
real property.

INVESTMENT POLICIES
The Company generally acquires its assets for the purpose of producing income
from the use of such assets in the Company's operations.  The Company invests
excess cash on hand primarily in short-term certificates of deposit and United
States Treasury instruments.

The Company does not have any real estate-related investments and does not
intend to make or acquire any such investments in the foreseeable future.

ITEM 3.  LEGAL PROCEEDINGS

The Company is a party to litigation arising in the normal course of its
business.  No pending litigation involving the Company (taken singly or in the
aggregate) is expected to have a material adverse effect on the Company or its
consolidated financial position.  The Company is not aware of any contemplated
legal proceedings that may be brought against the Company in the future and
which would, if adversely determined, have a material adverse effect on the
Company or its consolidated financial position.

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

No matters were submitted to a vote of security holders in the fourth quarter of
1998.

                                       7
<PAGE>
 
                                    PART II
                                    -------


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

MARKET INFORMATION
Since January 22, 1996, the Company's Common Stock has been listed on the NASDAQ
National Market.  From June 23, 1993 to January 19, 1996, the Common Stock was
listed on the SmallCap Market of the National Association of Securities Dealers
Automated Quotation System.  The range of reported high bid and low bid
quotations for the Common Stock on a quarterly basis from January 1, 1997
through December 31, 1998, is reflected in the table below.  These quotations
reflect inter-dealer prices without adjustment for retail mark-up, mark-down or
commission and may not represent actual transactions.

<TABLE>
<CAPTION>
                           High Bid  Low Bid
                           --------  -------
          1998
          <S>              <C>       <C>
            1st Quarter      $13.94   $10.06
            2nd Quarter      $12.50   $ 8.63
            3rd Quarter      $10.00   $ 3.75
            4th Quarter      $ 5.50   $ 1.97
 
          1997
            1st Quarter      $10.13   $ 7.44
            2nd Quarter      $ 9.13   $ 7.25
            3rd Quarter      $15.13   $ 9.00
            4th Quarter      $14.75   $10.38
</TABLE>

On March 1, 1999, the last reported sale price for the Common Stock was $1.78,
and the Company had 218 stockholders of record as of that date. The Company
believes that there are more than 1300 beneficial owners of Common Stock.

RECENT SALES OF UNREGISTERED SECURITIES
In the past three years, in addition to options granted under the Company's
various stock option plans (see Item 10 below) and securities issued in
connection with the Company's business acquisitions (see the notes to the
audited financial statements included in Item 7 below), the Company consummated
a private placement in April 1996 of unregistered promissory notes in an
aggregate amount of $1,000,000 (the "Bridge Notes"), and in connection
therewith, issued, to the purchasers of such Bridge Notes, warrants (the "Bridge
Warrants") entitling the holders thereof to purchase, at any time through April
15, 2001, up to an aggregate of 50,000 shares of Common Stock of the Company at
an exercise price of $6.25 per share, subject to adjustment upon the occurrence
of any stock dividends, stock splits, combinations of shares or
reclassifications of the Common Stock, or upon any consolidation or merger of
the Company with or into another corporation. Commencing October 15, 1997, the
Company had the right to call the Bridge Warrants for redemption at $.01 per
Bridge Warrant on 30 days' written notice if the average market price of the
Common Stock equals or exceed $9.00 per share (subject to adjustments in respect
of the aforedescribed events) for any 20 trading days within a period of 30
consecutive trading days ending on the fifth trading day prior to the date of
the notice of redemption. All of the Bridge Notes were repaid in full out of the
net proceeds of the Company's secondary public offering in June 1996, and as of
the date of this report, an aggregate of 40,000 Bridge Warrants have been
exercised (leaving 10,000 Bridge Warrants outstanding). The issuance of the
Bridge Notes and the Bridge Warrants was exempt from registration under
Regulation D promulgated under the Securities Act of

                                       8
<PAGE>
 
1933, as amended (the "Act"), based upon representations and warranties made by
the eighteen purchasers thereof as to their status as "accredited investors."

Simultaneously with the issuance of the Bridge Notes and the Bridge Warrants,
the Company borrowed an additional $1,000,000 from Chase Bank of Texas, N.A.,
formerly Texas Commerce Bank National Association ("Chase"), in conjunction with
which the Company issued to Chase warrants (the "Bank Warrants") entitling the
holders thereof to purchase up to 50,000 shares of Common Stock. The exercise
price, adjustment provisions, call provisions and other terms and conditions of
the Bank Warrants were identical to the terms and conditions of the Bridge
Warrants. The issuance of the Bank Warrants was exempt from registration
pursuant to Regulation D promulgated under the Act based upon Chase's
representations and warranties as to its status as an "accredited investor." All
of the Bank Warrants have been exercised.

In connection with the Company's acquisition of Advanced Clinical Technology,
Inc. and Horizon MDS Corporation (collectively, "ACT") in November 1996 (see
Note 13 to the audited financial statements included in Item 7 below), the
Company issued to ACT 642,857 shares of Series A Convertible Redeemable
Preferred Stock of the Company ("Series A Preferred Stock"), having an aggregate
liquidation preference of $4,500,000. The shares of Series A Preferred Stock
bear dividends at the rate of 7.25% per annum (payable in kind in additional
shares of Series A Preferred Stock), and all outstanding shares of Series A
Preferred Stock (including accrued dividends) are convertible, at the option of
the holder thereof, into Common Stock of the Company at the rate of one share of
Series A Preferred Stock for each share of Common Stock. In addition, in the
event that, commencing with the Company's fiscal quarter ended December 31,
1997, the mean average daily last reported sale price of the Common Stock (the
"Average Closing Price") in any fiscal quarter of the Company is less than $7.00
per share, then, at any time and from time to time during the next succeeding
fiscal quarter of the Company, each outstanding share of Series A Preferred
Stock will be convertible into a number of shares of Common Stock equal to $7.00
divided by the Average Closing Price during the preceding fiscal quarter. The
Company has reserved the right to limit ACT's holdings of conversion shares to
4.9% of the total outstanding common stock (or 9.9% in the event of and after
giving effect to any conversion at the reduced price under the immediately
preceding sentence). The issuance of the Series A Preferred Stock was exempt
from registration pursuant to Regulation D promulgated under the Act, and based
on ACT's warranty as to the acquisition of such shares for investment and not
for resale or distribution.

In connection with the Company's sale and issuance of $20,000,000 in principal
amount of subordinated notes to The Prudential Insurance Company of America
("Prudential") in April 1997, the Company also issued to Prudential five-year
redeemable common stock purchase warrants exercisable for up to 60,000 shares of
common stock of the Company at an exercise price of $12.25 per share. The
issuance of such subordinated notes and warrants was exempt from registration
under Regulation D promulgated under the Act, based upon Prudential's
representations and warranties as to its status as an "accredited investor." As
of December 31, 1998, none of such warrants had been exercised.

DIVIDEND POLICY
The Company has not previously paid any dividends on its common stock and for
the foreseeable future intends to continue its policy of retaining any earnings
to finance the development and expansion of its business.  In addition, the
Company's loan agreement with Chase and the Company's subordinated debt
agreements with Prudential prohibit the payment of dividends without such
lenders' prior consent.  In the future, the payment of dividends by the Company
on its Common Stock will also depend on the Company's financial condition,
results of operations and such other factors as the Board of Directors of the
Company may consider relevant.

                                      10
<PAGE>
 
ITEM 6. SELECTED FINANCIAL DATA

The following financial information for each of the five years ended December
31, 1998 has been derived from the Company's consolidated financial statements.
This information should be read in conjunction with the Consolidated Financial
Statements and related notes appearing at Item 8 below.  All 1994 and 1995
information has been restated to reflect the pooling-of-interest with Advanced
Diagnostic Imaging, Inc. ("ADI").

<TABLE>
<CAPTION>
                                                   YEARS ENDED DECEMBER 31,
                                        ----------------------------------------------
                                          1998       1997     1996     1995     1994
                                        ---------  --------  -------  -------  -------
                                            (In thousands, except per share data)
<S>                                     <C>        <C>       <C>      <C>      <C>
Gross revenues                          $ 44,844   $ 52,921  $24,171  $17,083  $11,508
Income (loss) from continuing
 operations before cumulative effect
 of change in accounting method (1)     $(30,459)  $  5,761  $ 2,459  $ 1,403  $   613
Net income (loss)                       $(41,292)  $  5,430  $ 2,459  $ 1,228  $   613
Net income (loss) per share - basic     $  (3.67)  $   0.57  $  0.37  $  0.25  $  0.14
Net income (loss) per share  diluted    $  (3.67)  $   0.48  $  0.29  $  0.22  $  0.13
Total assets                            $ 67,867   $107,854  $53,244  $19,292  $11,607
Long-term debt and lease obligations    $ 37,843   $ 35,310  $ 7,082  $10,527  $ 1,164
Stockholders' equity                    $ 15,081   $ 49,953  $29,901  $ 8,906  $ 7,748
</TABLE>

__________________

(1)  In 1998, the loss from continuing operations before cumulative effect of
     change in accounting method includes operating expenses relating to a non-
     recurring restructuring expense charge of approximately $6,597,000 and an
     impairment charge on acquired assets of approximately $24,672,000.

                                      10
<PAGE>
 
ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
         OF OPERATIONS

This information should be read in conjunction with the Consolidated Financial
Statements and related notes appearing at Item 8 below.

Results of Operations

In 1998, the Company's performance declined due to deterioration in the
ultrasound business it acquired from Advanced Clinical Technology, Inc. and
Horizon/MDS Corporation (collectively "ACT"), and to a lesser extent, the mobile
ultrasound business acquired from Diagnostic Imaging Services, Inc. ("DIS"). The
Company spent most of 1998 restructuring the acquired businesses, repricing or
resigning from unprofitable accounts, and adjusting its cost structure to
service the remaining business. As a result of the deterioration in the ACT and
DIS ultrasound businesses, the Company went through a period in which liquid
resources were depleted and the balance sheet became overleveraged. During 1998,
the Company wrote off $18.2 million in goodwill, $1.9 million in fixed assets,
and $2.4 million of acquired accounts receivable related primarily to these
acquisitions, as well as smaller additional write-offs related to other
acquisitions as described below. The Company has a high fixed-cost structure,
and as revenues from the acquired businesses declined, operating margins also
declined. Additionally, the margins related to portions of the replacement
revenues related to the business were too low. Many of the Company's
restructuring efforts during 1998 were directed towards reducing fixed costs,
eliminating marginal and unprofitable accounts, and establishing and improving
returns on new and existing business. Management began this process during the
second quarter of 1998 and substantially completed its restructuring efforts
during the fourth quarter. Although the net effect of these events in 1998 was
increased expenses on essentially flat revenues, management believes that its
efforts to restructure the business can result in a more stable and enduring
revenue stream with improved margins for 1999 and beyond.

In December 1998, the Company elected to change its method for accounting for
future payments relating to contract receivables due from long-term equipment
and service agreements. Under the previous method, expected profits or losses on
contracts were based on the contracts' guaranteed minimum values and total
estimated related contract costs upon installation. These estimates were
reviewed and revised periodically throughout the lives of the contracts, and
adjustments resulting from such revisions were recorded in the periods in which
the revisions were made. Losses on contracts were recorded in full as they were
identified. Accordingly, the Company's ability to accurately predict its
earnings was based in part on the timing, size, and estimated costs to be
incurred on new long-term contracts in any given period. As the Company's long-
term contracts increased in recent periods, both in length and dollar amount,
the impact of long-term contract revenue recognition became greater. Also,
because of uncertainties inherent in the estimation process as it relates to
long-term contracts, it was reasonably possible that actual earnings would
differ from the estimates. The Company changed its accounting method effective
January 1, 1998, in order to recognize revenue and expense on long-term
contracts ratably over the lives of the contracts. Although this change will
result in lower revenues and earnings (due to the deferral aspect of the new
method), the change will have no impact on cash flows. Management believes that
this change will make the Company's revenues, expenses and earnings more
predictable.

                                      11
<PAGE>
 
The following table sets forth pro forma operating results of the Company,
presented as if the change in accounting method had been in place for the years
ended 1997 and 1996, and to exclude nonrecurring charges. The discussion that
follows is based on a comparison of 1998 results of opertions as compared to the
pro forma presentation of the operating results for 1997 and 1996.

<TABLE>
<CAPTION>
                                                                               Pro forma
                                                                        Year Ended December 31,
                                                               ------------------------------------------
                                                                             (Unaudited)
                                                                 (In thousands, except per share data)
                                                                    1998           1997          1996
                                                               --------------  ------------  ------------
<S>                                                            <C>             <C>           <C>
Gross revenues                                                       $44,844        $43,897       $21,275
                                                                     -------        -------       -------
 
Expenses:
  General & administrative                                             3,279          2,232         1,385
  Salaries & employee benefits                                        25,880         23,658        11,899
  Legal & professional                                                   397            344           178
  Rent & utilities                                                     1,410          1,192           390
  Taxes & insurance                                                    1,208          1,104           420
  Technical operating expenses                                         5,948          5,994         3,158
  Provision for doubtful accounts                                      1,913            890            41
  Depreciation & amortization                                          7,040          5,843         2,797
                                                                     -------        -------       -------
     Total operating expenses                                         47,076         41,258        20,268
                                                                     -------        -------       -------
 
Income (loss) from continuing operations
                                                                     =======        =======       =======
  before income taxes                                                $(2,232)       $ 2,640       $ 1,007
                                                                     =======        =======       =======
 
Income (loss) from continuing operations
  before income taxes per share:                                     =======        =======       =======
    Basic
                                                                      $(0.20)         $0.28         $0.15
                                                                     =======        =======       =======
    Diluted                                                           $(0.20)         $0.24         $0.12
                                                                     =======        =======       =======
</TABLE>

NOTE:  Numbers may not add due to rounding.

Year Ended December 31, 1998 Compared With Year Ended December 31, 1997

Gross revenues increased by 2.16% to approximately $44,844,000 in 1998 from
approximately $43,897,000 in 1997. Excluding revenues attributable to acquired
businesses, gross revenues, decreased by 13.2% to approximately $38,094,000 for
1998 from approximately $43,897,000 for 1997. This decline in revenues was
primarily due to a loss of significant revenue contracts, which related to
acquisitions made prior to 1997, and is one of the factors associated with the
impairment of acquired assets.

The Company's operating expenses increased approximately 14.1% from
approximately $41,258,000 in 1997 to approximately $47,076,000 in 1998.  This
increase in ongoing operating expenses was, in part, related to the heightened
commitment the Company made in the last quarter of 1997 to its sales and
marketing efforts.  These efforts resulted in an increase in sales personnel and
an increase in general and administrative expenses associated with additional
travel expenses, as well as increased advertising expenses.  The Company also
experienced increases in legal and professional fees, rents, utilities, property
taxes, insurance, depreciation and amortization as a result of additional
expenses associated with the expansion of operations through prior
acquisitions. The provision for doubtful accounts also increased significantly
in 1998, due to the Company's reevaluation of the overall collectibility of its
outstanding accounts receivable.

In addition to recurring operating expenses, the Company incurred a non-
recurring restructuring expense charge of approximately $6,597,000 and an
impairment charge on acquired assets of approximately $24,672,000. The
restructuring charge relates to expenses for a reduction in staff and the
resulting severance payments and benefits amounting to approximately $1,198,000,
divisional office closings amounting to approximately $1,839,000, and other
expenses amounting to approximately $3,560,000.


                                      12
<PAGE>
 
The Company experienced an impairment charge on assets due to cash flow losses
by the acquired businesses, the loss of significant acquired revenue contracts,
and the doubtful realization of certain assets. The impaired assets consisted of
goodwill, non-compete agreements, accounts receivable and property and equipment
in connection with the acquisitions of ACT, Valley Diagnostic Services, Heart
Diagnostic Institutes Inc., Medmark Associates, Inc., Cardiac Concepts, Inc.,
DIS' ultrasound division, Mobil Diagnostics, Inc., and Sonomed, Inc. The amount
relating to the goodwill impairment was approximately $18,239,000. Impairment of
non-compete agreements amounted to approximately $213,000. Impairment of
acquired receivables due to uncollectibility amounted to approximately
$2,449,000. Impairment of property and equipment amounted to approximately
$3,771,000, arising from a significant decrease in the market value of the
property and equipment.

Income from continuing operations before income taxes decreased by 184.5% to an
approximate loss of $2,232,000 in 1998 from an approximate income of $2,640,000
in 1997.  This decrease is due primarily to the increase in ongoing operating
expenses and deterioration of the acquired businesses as explained above.

Interest expense increased by 7.1% from approximately $4,056,000 in 1997 to
approximately $4,342,000 in 1998, primarily as a result of new debt obligations
assumed in connection with business acquisitions.

"Other income" is primarily interest earned on liquid investments in 1998 and 
1997.

The Company changed its accounting method effective January 1, 1998, in order to
recognize revenue and expense on long-term contracts ratably over the lives of
the contracts.  The cumulative effect of the change in accounting method at
December 31, 1998 was approximately $16,144,000 less tax benefit of
approximately $5,311,000.

Results for 1997 reflect a net loss (net of income taxes) of approximately
$327,000, arising from the dispositions of the Company's therapist placement
division and Mexican subsidiary.

Year Ended December 31, 1997 Compared With Year Ended December 31, 1996

Gross revenues increased by 106.3% to approximately $43,897,000 in 1997 from
approximately $21,275,000 in 1996. Excluding revenues attributable to acquired
businesses, gross revenues decreased by 11.4% to approximately $18,853,000 for
1997 from approximately $21,275,000 for 1996. This decline in revenues was
primarily due to a loss of significant revenue contracts, which related to
acquisitions made during 1996, and is one of the factors associated with the
impairment of acquired assets, as explained above.

The Company's operating expenses increased from approximately $20,268,000 in
1996 to approximately $41,258,000 in 1997.  As a percentage of gross revenues,
operating expenses decreased from 95.3% to 94.0%.  The decrease was due to
increased efficiencies realized through consolidation of various overhead and
administrative functions, and absorption of fixed costs over an increased
revenue base.

Income from continuing operations before income taxes increased by 162.0% to
approximately $2,640,000 in 1997 from approximately $1,007,000 in 1996. This
increase is primarily due to the DIS MRI division and other business
acquisitions, and continued consolidation of the Company's administrative
functions.

Interest expense increased by 366.5% from approximately $870,000 in 1996 to
approximately $4,056,000 in 1997, primarily as a result of the $20,000,000 in
subordinated debt obligations incurred  in connection with the Company's 1997
acquisitions from DIS, and new debt obligations assumed in connection with
those and other business acquisitions.  As a percentage of gross revenues,
interest expense increased from 3.6% in 1996 to 7.7% in 1997.

"Other income" is primarily interest earned on liquid investments in 1997 and 
1996.

Results for 1997 reflect a net loss (net of income taxes) of approximately
$327,000, arising from the dispositions of the Company's therapist placement
division and Mexican subsidiary.

LIQUIDITY AND CAPITAL RESOURCES
In May 1998, the Company and its subsidiaries entered in to an amendment of the
revolving credit and term loan facility with their senior lender, Chase Bank of
Texas, N.A. ("Chase"), providing for up to $2,500,000 in available revolving
credit (or, if less, 75% of the Company's and its subsidiaries' eligible
accounts receivable from time to time), and an acquisition term loan facility of
up to $17,500,000 in maximum principal amount. Pursuant to the amendment, the
Company rolled over the outstanding borrowings of $2,500,000 on the revolving
credit facility into the term loan facility. At December 31, 1998, the Company
had no outstanding borrowings under the revolving credit facility and $7,952,930
in principal amount of outstanding borrowings under the term loan facility.
These loans bear interest at varying rates, depending on the Company's relative
leverage from time to time.

In June 1998, the Company and its subsidiaries entered into a further amendment
of the revolving credit and term loan facility with Chase, whereby the revolving
credit facility was extended. In connection with the amendment, Chase waived
certain prior financial covenant defaults.

                                      13
<PAGE>
 
Effective as of December 31, 1998, the Company and its subsidiaries entered in
to an amendment of the revolving credit and term loan facility with Chase.  This
amendment provides for the implementation of a new financial covenant structure.
The Company has also entered in to an amendment of its subordinated loan
agreement with Prudential, containing amendments consistent with the Chase
amendment.

The new financial covenant structure temporarily suspend the Fixed Charge
Coverage Ratio, Funded Debt to EBITDA Ratio, and Senior Debt to EBITDA Ratio,
and requires the Company to maintain minimum EBITDA levels.  In addition, the
new structure limits unleveraged capital expenditures, and prohibits the Company
from incurring additional debt or selling assets.

Under the new amendment, the outstanding balance of the Company's term facility
begins a five-year amortization program to commence July 15, 1999, and the
remaining availability under that facility is cancelled. The revolving facility
was reduced to $1 million subject to certain advance restrictions with a
shortened maturity of January 31, 1999 (which was thereafter extended to June
30, 1999).

In April 1997, the Company issued and sold to Prudential $20,000,000 in
principal amount of senior subordinated promissory notes (the "Subordinated
Notes").  The Subordinated Notes bear interest at a fixed rate of 10.5% per
annum, and mature as to principal in equal one-third installments on April 17 of
each of 2003, 2004 and 2005.  The Subordinated Notes may be prepaid by the
Company under certain circumstances (including the requirement of certain "make-
whole" prepayment premiums), and the Company may be required (at the option of
the holders of the Subordinated Notes) to purchase the Subordinated Notes in the
event of a change in control of the Company.  The Subordinated Notes also
require the Company and its subsidiaries to comply with certain financial
covenants, including limitations on certain other indebtedness.

The Company's continuation as a going concern is dependent on its ability to
comply with the revised terms of its financing agreements, to obtain additional
financing or refinancing as may be required, and to increase cash flow from
operations. The Company's financial statements do not include any adjustments
relating to the recoverability of assets and classification of liabilities that
might be necessary should the Company be unable to continue as a going concern.

The Company and its subsidiaries have also entered into various financing
arrangements with commercial leasing companies and equipment suppliers, bearing
interest ranging from 7.7% to 12.1% per annum.

In 1997, the Company received net proceeds of approximately $8,423,993 from the
exercise of its previously outstanding publicly traded warrants (which were
called for redemption in the first quarter of 1997), $562,500 from the exercise
of other warrants, and $1,492,801 from the exercise of options under the
Company's various stock option plans.

In 1998, the Company received net proceeds of approximately, $1,801,858 from the
exercise of warrants, and $811,136 from the exercise of options under the
Company's various stock option plans.

Based on the Company's operating plan management believes that available
resources and funds generated from operations will be sufficient to meet the
Company's operating requirements through the close of the Company's fiscal year
ending December 31, 1999.

                                      14
<PAGE>
 
TRENDS AND UNCERTAINTIES
The Company's future revenues and results of operations may be substantially
affected by proposed reforms of the nation's healthcare system and by potential
reductions in reimbursement rates and policies imposed by Medicare and other
third-party reimbursement programs (from which the Company derives a material
portion of its receipts).  Continuing pressures on pricing structures applicable
to the Company's services, or inability to renew existing contracts, could have
the effect of reducing the Company's revenues and operating profit margins.  The
Company is unable to predict the nature or extent of any such changes and/or the
effects thereof on the Company.

Forward-Looking Statements

Certain statements contained in this Form 10-K, including, without limitation,
statements containing the words "believes," "anticipates," "intends," "expects"
and words of similar import, constitute "forward-looking statements" within the
meaning of the Private Securities Litigation Reform Act of 1995.  Such forward-
looking statements involve known and unknown risks, uncertainties and other
factors that may cause the actual results, performance or achievements of the
Company or industry results to be materially different from any future results,
performance or achievements expressed or implied by such forward-looking
statements.  Such factors include, among others, the regions in which the
Company operates; industry capacity; demographic changes; existing governmental
regulations; legislative proposals for health care reform; changes in Medicare
and Medicaid payment levels; liability and other claims asserted against the
Company; competition; the loss of any significant ability to attract and retain
qualified personnel; the availability and terms of capital to fund additional
acquisitions.  Given these uncertainties, prospective investors are cautioned
not to place undue reliance on such forward-looking statements.  The Company
disclaims any obligation to update any such factors or to publicly announce the
results of any revision to any of the forward-looking statements contained
herein to reflect future events or developments.

ITEM 7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Not Applicable

                                      15
<PAGE>
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA

<TABLE>
<CAPTION>
                                                        Page
                                                        Number
                                                        ------
     <S>                                                <C>    
     Consolidated Financial Statements:
 
     Independent Auditors' Report                       F - 2
 
     Consolidated Balance Sheet as
     of December 31, 1998 and 1997                      F - 3
 
     Consolidated Statement of Operations
     for the years ended
     December 31, 1998, 1997 and 1996                   F - 5
 
     Consolidated Statement of
     Stockholders' Equity for the
     years ended December 31, 1998, 1997 and 1996       F - 7
 
     Consolidated Statement of Cash Flows
     for the years ended December 31, 1998 and 1997     F - 8
 
     Notes to the Consolidated Financial Statements    F - 10
</TABLE>

                                      16
<PAGE>
 
                       DIAGNOSTIC HEALTH SERVICES, INC.
                               AND SUBSIDIARIES
                                        
                       CONSOLIDATED FINANCIAL STATEMENTS
                                        
                          DECEMBER 31, 1998 AND 1997
                                        
                                      AND
                                        
                         INDEPENDENT AUDITORS' REPORT



                                      F-1
<PAGE>
 
                         INDEPENDENT AUDITORS' REPORT
                         ----------------------------

February 19, 1999

The Board of Directors
Diagnostic Health Services, Inc.

We have audited the accompanying consolidated balance sheets of Diagnostic
Health Services, Inc. and Subsidiaries as of December 31, 1998 and 1997, and the
related consolidated statements of operations and comprehensive income,
stockholders' equity and cash flows for the years ended December 31, 1998, 1997
and 1996.  These consolidated financial statements are the responsibility of the
Company's management.  Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Diagnostic Health
Services, Inc. and Subsidiaries at December 31, 1998 and 1997, and the results
of their operations and cash flows for the years ended December 31, 1998, 1997
and 1996 in conformity with generally accepted accounting principles.



/S/ Simonton, Kutac & Barnidge, L.L.P.

Simonton, Kutac & Barnidge, L.L.P.
Houston, Texas

                                      F-2
<PAGE>
 
                DIAGNOSTIC HEALTH SERVICES, INC. & SUBSIDIARIES
                -----------------------------------------------

                          CONSOLIDATED BALANCE SHEETS
                          ---------------------------
                                        
                                    ASSETS

<TABLE>
<CAPTION>
                                                               December 31,
                                                       ----------------------------
                                                           1998           1997
                                                       -------------  -------------
<S>                                                    <C>            <C>
Current Assets:
  Cash and cash equivalents                            $  1,087,349   $  5,126,114
  Accounts receivable:
    Trade, net of allowance for doubtful accounts
     of $1,428,636 and $612,437, respectively            10,088,540     17,294,128
    Accrued interest and other                               96,176        793,369
  Contracts receivable - current                                 --      2,167,265
  Prepaid expenses                                          352,917      1,528,931
  Income tax refund receivable                              973,492             --
  Deferred tax asset                                      1,115,200         87,876
                                                       ------------   ------------
 
    Total Current Assets                                 13,713,674     26,997,683
                                                       ------------   ------------
 
Investment in unconsolidated affiliate                    1,933,477             --
 
Property & Equipment:
  Office furniture & equipment                            2,381,019      2,015,749
  Machinery & service equipment                          31,888,460     35,286,844
  Leasehold improvements                                  2,071,914        273,968
    Less: accumulated depreciation and amortization     (12,131,560)    (8,876,887)
                                                       ------------   ------------
 
    Total Property & Equipment                           24,209,833     28,699,674
                                                       ------------   ------------
 
Other Assets:
  Deposits and other                                        911,901      2,999,701
  Deferred acquisition costs                                 98,852        122,536
  Contracts receivable - long-term                               --     10,058,674
  Deferred tax asset                                      8,352,567             --
  Goodwill                                               19,043,582     38,793,903
  Noncompete agreements                                   2,698,533      3,428,270
    Less: accumulated amortization                       (3,095,764)    (3,246,266)
                                                       ------------   ------------
 
    Total Other Assets                                   28,009,671     52,156,818
                                                       ------------   ------------
 
Total Assets                                           $ 67,866,655   $107,854,175
                                                       ============   ============
</TABLE>

    The following notes are an integral part of these financial statements.

                                      F-3
<PAGE>
 
                DIAGNOSTIC HEALTH SERVICES, INC. & SUBSIDIARIES
                -----------------------------------------------

                    CONSOLIDATED BALANCE SHEETS (CONTINUED)
                    -------------------------------------- 
                                        
                      LIABILITIES & STOCKHOLDERS' EQUITY

<TABLE>
<CAPTION>
                                                                    December 31,
                                                            ----------------------------
                                                                1998           1997
                                                            -------------  -------------
<S>                                                         <C>            <C>
Current Liabilities:
  Accounts payable                                          $  3,503,268   $  2,626,978
  Accrued liabilities                                          2,221,795      3,774,969
  Current lease obligations                                    2,585,334      4,663,279
  Current portion of long-term debt                              814,106      1,485,113
  Notes payable                                                       --      2,362,554
  Accrued acquisition cost                                            --      1,500,000
  Deferred expenses                                            1,955,000             --
  Current income taxes                                                --      1,363,543
                                                            ------------   ------------
     Total Current Liabilities                                11,079,503     17,776,436
 
Long-term lease obligations                                   10,652,605     10,348,496
Long-term debt                                                27,190,030     24,961,570
Deferred rent                                                         --        149,253
Other liabilities                                              3,863,244      2,647,277
Deferred income taxes                                                 --      2,018,480
                                                            ------------   ------------
    Total Liabilities                                         52,785,382     57,901,512
                                                            ------------   ------------
 
Commitments and Contingencies
Stockholders' Equity:
  Common stock, $.001 par value; authorized 15,000,000
    shares; issued 11,713,895 shares in 1998 and
    10,718,867 shares in 1997; outstanding 11,480,636
    shares in 1998 and 10,485,608 shares in 1997                  11,714         10,719
  Preferred stock, $.001 par value; authorized 3,000,000
    shares; issued and outstanding 746,500 shares in
    1998 and 695,593 shares in 1997                                  747            696
  Additional paid-in capital                                  48,571,630     42,151,656
  Retained earnings (accumulated deficit)                    (33,291,667)     8,000,743
  Accumulated other comprehensive income                              --             --
  Stockholder receivable                                        (103,500)      (103,500)
  Treasury stock at cost; 233,259 common shares                 (107,651)      (107,651)
                                                            ------------   ------------
    Total Stockholders' Equity                                15,081,273     49,952,663
                                                            ------------   ------------
Total Liabilities and Stockholders' Equity                  $ 67,866,655   $107,854,175
                                                            ============   ============
</TABLE>

    The following notes are an integral part of these financial statements.

                                      F-4
<PAGE>
 
                DIAGNOSTIC HEALTH SERVICES, INC. & SUBSIDIARIES
                -----------------------------------------------

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     --------------------------------------
                           AND COMPREHENSIVE INCOME
                           ------------------------

<TABLE>
<CAPTION>
                                                            For the Years Ended
                                                                December 31
                                                 -----------------------------------------
                                                     1998           1997          1996
                                                 -------------  ------------  ------------
<S>                                              <C>            <C>           <C>
Gross revenues                                   $ 44,844,442   $52,920,804    24,171,286
                                                 ------------   -----------   -----------
 
Expenses:
  General & administrative                          3,279,109     2,232,032     1,385,305
  Salaries & employee benefits                     25,880,078    23,658,464    11,898,905
  Legal & professional                                397,245       344,029       177,756
  Rent & utilities                                  1,410,190     1,192,449       389,533
  Taxes & insurance                                 1,208,398     1,103,643       420,375
  Technical operating expenses                      5,947,721     5,994,195     3,158,037
  Provision for doubtful accounts                   1,913,004       890,161        40,970
  Depreciation and amortization                     7,040,277     5,842,678     2,796,865
  Restructure expense                               6,596,683            --            --
  Impairment of acquired assets                    24,672,291            --            --
                                                 ------------   -----------   -----------
    Total operating expenses                       78,344,996    41,257,651    20,267,746
                                                 ------------   -----------   -----------
Income (loss) from operations                     (33,500,554)   11,663,153     3,903,540
                                                 ------------   -----------   -----------
 
Other income (expense):
  Other income                                         83,778       369,403       486,704
  Interest expense                                 (4,341,991)   (4,056,301)     (869,601)
                                                 ------------   -----------   -----------
    Total other income (expense)                   (4,258,213)   (3,686,898)     (382,897)
                                                 ------------   -----------   -----------
 
Income (loss) from continuing operations
  before provision for income taxes, equity
  of net earnings of affiliate, discontinued
  operations and cumulative effect of
  change in accounting method                     (37,758,767)    7,976,255     3,520,643
 
  Provision for income tax expense (benefit)       (6,972,618)    2,215,726     1,061,560
                                                 ------------   -----------   -----------
 
Income (loss) from continuing operations
  before equity of net earnings of affiliate,
  discontinued operations and cumulative
  effect of change in accounting method           (30,786,149)    5,760,529     2,459,083
 
Equity of net earnings of affiliate                   326,946            --            --
                                                 ------------   -----------   -----------
 
Income (loss) before discontinued operations
  and cumulative effect of change
  in accounting method                           $(30,459,203)  $ 5,760,529   $ 2,459,083
                                                 ------------   -----------   -----------
</TABLE>

    The following notes are an integral part of these financial statements.

                                      F-5
<PAGE>
 
                DIAGNOSTIC HEALTH SERVICES, INC. & SUBSIDIARIES
                -----------------------------------------------

                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     -------------------------------------
                     AND COMPREHENSIVE INCOME (CONTINUED)
                     ------------------------------------

<TABLE>
<CAPTION>
                                                            For the Years Ended
                                                                December 31
                                               ---------------------------------------
                                                   1998           1997         1996
                                               -------------  ------------  ----------
<S>                                            <C>            <C>           <C>
Income (loss) before discontinued operations
  and cumulative effect of change
  in accounting method                         $(30,459,203)  $ 5,760,529   $2,459,083                                    
 
Loss from discontinued operations,
  net of income tax benefit of $160,952                  --      (326,934)          --
                                               ------------   -----------   ----------
 
Income (loss) before cumulative effect
  of change in accounting method                (30,459,203)    5,433,595    2,459,083
 
Cumulative effect of change in
  accounting method                              10,833,156            --           --
                                               ------------   -----------   ----------
 
Net income (loss)                              $(41,292,359)  $ 5,433,595   $2,459,083                                    
                                               ------------   -----------   ----------
 
Other comprehensive income (loss), net of
 tax:
  Foreign currency translation adjustment                --        (3,894)        (179)
                                               ------------   -----------   ----------
 
Comprehensive income (loss)                    $(41,292,359)  $ 5,429,701   $2,458,904                                    
                                               ============   ===========   ==========
 
Net income (loss) per share:
  Basic                                        $      (3.67)  $      0.57         0.37
                                               ============   ===========   ==========
  Diluted                                      $      (3.73)  $      0.48         0.29
                                               ============   ===========   ==========
Weighted average common
 shares outstanding:
  Basic                                          11,236,737     9,527,736    6,709,795
                                               ============   ===========   ========== 
  Diluted                                        11,063,197    11,221,358    8,446,335
                                               ============   ===========   ========== 
</TABLE>

    The following notes are an integral part of these financial statements.

                                      F-6
<PAGE>
 
                DIAGNOSTIC HEALTH SERVICES, INC. & SUBSIDIARIES
                -----------------------------------------------

                CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY 
                ----------------------------------------------

                FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997


<TABLE> 
<CAPTION> 
                                                                     Retained                                                     
                                                      Additional     Earnings      Foreign        Stock                             
                                   Common  Preferred   Paid-In      (Accumulated   Currency    Subscription  Stockholder Treasury   
                                    Stock    Stock     Capital       Deficit)     Translation  Receivable    Receivable    Stock  
                                   -----------------------------------------------------------------------------------------------
<S>                                <C>     <C>        <C>           <C>           <C>         <C>           <C>         <C>       
Balance, December 31, 1995         $ 5,206  $  --     $ 9,018,442   $    108,118  $(6,171)    $(8,250)      $(103,500)  $(107,651)
Shares issued in connection                                                                                                       
   with secondary offering           2,955             17,494,019                                                                 
Common shares issued in                                                                                                           
   connection with acquisitions        209                917,459                                                                 
Preferred shares issued in                                                                                                        
   connection with acquisitions               643                                                                                 
Stock options exercised                  1                  1,468                                                                 
MDI warrants exercised                   3                  9,231                                                                 
Foreign currency translations                                                         271                                         
Stock subscription collection                                                                   8,250                             
Shares issued in payment of debt        27                176,806                                                                 
Preferred stock dividend                        6                             (6)                                                 
Net income                                                             2,459,083                                                  
                                   -----------------------------------------------------------------------------------------------  
Balance, December 31, 1996           8,401    649      27,617,425      2,567,195   (5,900)         --        (103,500)   (107,651)
Common shares issued in                                                                                                           
   connection with acquisitions        350              3,548,946                                                                 
Stock options exercised                399              1,382,403                                                                 
Warrants exercised                   1,569              9,602,882                   5,900                                         
Disposition of Mexico Operations                                                                                
Preferred stock dividend                       47                            (47)                                                 
Net income                                                             5,433,595                                                  
                                   -----------------------------------------------------------------------------------------------  
Balance, December 31, 1997          10,719    696      42,151,656      8,000,743       --          --        (103,500)   (107,651)
Common shares issued in                                                                                                           
   connection with acquisitions        191              2,190,554                                                                 
Stock options exercised                269                810,867                                                                 
Warrants exercised                     278              1,801,580                                                                 
Shares issued in payment of debt       200              1,499,800                                                                 
Shares issued in settlement             57                117,173                                                                 
Preferred stock dividend                       51                            (51)                                               -
Net income                                                           (41,292,359)                                                 
                                   ----------------------------------------------------------------------------------------------- 
Balance, December 31, 1998         $11,714  $ 747     $48,571,630   $(33,291,667) $    --     $    --       $(103,500)  $(107,651)
                                   ===============================================================================================

<CAPTION> 
                                              Total        
                                         ------------  
<S>                                      <C>          
Balance, December 31, 1995               $  8,906,194 
Shares issued in connection                           
   with secondary offering                 17,496,974 
Common shares issued in                               
   connection with acquisitions               917,668 
Preferred shares issued in                            
   connection with acquisitions                   643 
Stock options exercised                         1,469 
MDI warrants exercised                          9,234 
Foreign currency translations                     271 
Stock subscription collection                   8,250 
Shares issued in payment of debt              176,833 
Preferred stock dividend                           -- 
Net income                                  2,459,083 
                                         ------------
Balance, December 31, 1996                 29,976,619 
Common shares issued in                               
   connection with acquisitions             3,549,296 
Stock options exercised                     1,382,802 
Warrants exercised                          9,604,451 
Disposition of Mexico Operations                5,900 
Preferred stock dividend                           -- 
Net income                                  5,433,595 
                                         ------------           
Balance, December 31, 1997                 49,952,663 
Common shares issued in                               
   connection with acquisitions             2,190,745 
Stock options exercised                       811,136
Warrants exercised                          1,801,858
Shares issued in payment of debt            1,500,000
Shares issued in settlement                   117,230
Preferred stock dividend                           --
Net income                                (41,292,359)
                                         ------------          
Balance, December 31, 1998               $ 15,081,273
                                         ============        
</TABLE> 

    The following notes are an integral part of these financial statements.

                                      F-7

<PAGE>
 
                DIAGNOSTIC HEALTH SERVICES, INC. & SUBSIDIARIES
                -----------------------------------------------

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                     -------------------------------------

<TABLE> 
<CAPTION> 
                                                                         For the Years Ended                              
                                                                             December 31,                                
                                                          -------------------------------------------------    
                                                                1998            1997            1996            
                                                          --------------   ---------------  ---------------    
<S>                                                         <C>            <C>              <C>              
Cash Flows from Operations:
Net income (loss)                                           $(41,292,359)  $  5,433,595        2,459,083  
Adjustments to Reconcile Net Income to                                                                    
  Net Cash (Used in) Provided by Operations:                                                              
  Restructure and impairment expense                          24,904,969             --               --  
  Effect of change in accounting method                       16,413,873             --               --  
  Equity earnings in unconsolidated affiliate                   (326,946)            --               --  
  Non-cash stock based compensation                              117,230             --               --  
  Loss on disposal of assets                                      36,009             --               --  
  Depreciation and amortization                                7,047,277      5,842,678        2,796,865  
  Deferred federal income taxes                              (11,398,371)       930,701          848,965  
  Deferred rent expense                                         (149,253)        (6,172)         155,426  
  Foreign currency translation                                        --          5,900              271  
  Provision for doubtful accounts                              1,913,004        890,161               --  
  Net chargeoffs for bad debt                                 (1,980,632)    (2,488,470)              --  
  Decrease (increase) in trade receivable                      3,021,696     (4,792,489)      (4,331,129) 
  Decrease (increase) in other receivable                        714,977             --               --  
  Increase in contracts receivable                                    --     (9,169,206)      (1,164,244) 
  Decrease (increase) in prepaid expenses                        605,312        (93,686)        (701,492) 
  Decrease (increase) in other assets                          1,986,535     (1,279,409)        (590,986) 
  Increase in accounts payable                                   835,775        336,490           14,404  
  Increase (decrease) in accrued liabilities                      12,412        716,231          655,716  
  Increase (decrease) in income taxes payable                 (2,337,035)     1,168,543          171,035  
  Increase in other liabilities                                       --      1,786,249          279,411  
                                                            ------------   ------------      -----------  
     Net Cash (Used in)                                                                                   
       Provided by Operations                                    124,473       (718,884)         593,325  
                                                            ------------   ------------      -----------  
                                                                                                          
Cash Flows from Investing Activities:                                                                     
  Purchase of investment securities                                   --             --       (5,000,000) 
  Sale of investment securities                                       --      5,000,000               --  
  Cash payments for property purchases                        (2,197,209)    (3,550,845)      (1,487,178) 
  Acquisition of businesses, net of cash acquired                (11,350)   (15,962,847)     (13,003,736) 
  Decrease in subsidiary acquisition costs                       (97,187)    (1,389,671)        (449,829) 
  Increase (decrease) in other receivables                      (139,470)        91,691         (524,384) 
  Increase (decrease) in employee receivables                    125,804         49,473          (87,587) 
  Increase in stockholder receivable                              (4,118)        (6,750)          (6,210) 
                                                            ------------   ------------      -----------  
     Net Cash Used in Investing Activities                    (2,323,530)   (15,768,949)     (20,558,924) 
                                                            ------------   ------------      -----------   
</TABLE>

    The following notes are an integral part of these financial statements

                                      F-8
<PAGE>
 
               CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
               ------------------------------------------------ 

                DIAGNOSTIC HEALTH SERVICES, INC. & SUBSIDIARIES
                -----------------------------------------------

<TABLE>
<CAPTION>
                                                               For the Years Ended
                                                                   December 31,
                                                 ----------------------------------------------   
                                                        1998             1997          1996       
                                                 -----------------   -------------  -----------   
<S>                                              <C>                 <C>            <C>           
Cash Flows from Financing Activities:                                                             
  Proceeds from issuance of common stock               2,612,994       10,987,254   17,751,177    
  Net borrowings on line of credit                       137,446          790,554      872,000    
  Proceeds from issuance of loans                             --        7,980,000    8,569,573    
  Proceeds from senior subordinated loan                      --       20,000,000           --    
  Proceeds from stock subscription receivable                 --                         8,250    
  Deferred finance charge                                     --         (800,000)          --    
  Principal payments on long-term debt                (1,156,654)     (13,902,001)  (6,315,642)   
  Principal payments on capital                                                                   
   lease obligations                                  (3,433,494)      (3,671,407)  (1,395,391)   
                                                     -----------     ------------   ----------    
    Net Cash Provided by                                                                          
       Financing Activities                           (1,839,708)      21,384,400   19,489,967    
                                                     -----------     ------------   ----------    
Net increase (decrease) in cash                                                                   
   and cash equivalents                               (4,038,765)       4,896,567     (475,632)   
Cash and cash equivalents, beginning of year           5,126,114          229,547      705,179    
                                                     -----------     ------------   ----------    
Cash and cash equivalents, end of year               $ 1,087,349     $  5,126,114      229,547    
                                                     ===========     ============   ==========    
</TABLE> 

    The following notes are an integral part of these financial statements

                                      F-9
<PAGE>
 
                DIAGNOSTIC HEALTH SERVICES, INC, & SUBSIDIARIES
                -----------------------------------------------

                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                  ------------------------------------------

NOTE 1 - ORGANIZATION
         
Organization - Diagnostic Health Services, Inc. ("DHS") and its subsidiaries
(collectively, with DHS, the "Company") is an outsource provider of medical
services to hospitals, physicians' offices and other healthcare facilities in
the Midwest, South Central and Western United States.  Headquartered in Dallas,
Texas, DHS primarily provides radiology and cardiology diagnostics services and
equipment, and related management services to a broad range of healthcare
providers.

Acquisitions are discussed in Note 11 of these Notes to Financial Statements.

The following chart sets forth the corporate structure of the Company and its
100% owned subsidiaries at December 31, 1998:
 
                             [CHART APPEARS HERE]

In addition to the above, DHS and DHSMS have two inactive wholly-owned
subsidiaries, Diagnostic Health Services de Mexico, S.A. de C.V. and HomeCare
International, Inc.

Principles of Consolidation - The consolidated financial statements include the
accounts of Diagnostic Health Services, Inc. and its subsidiaries.  All
intercompany accounts and transactions have been eliminated in the consolidated
financial statements.  Investment in unconsolidated affiliate is accounted for
on the equity method.  The equity in earnings of the unconsolidated affiliate is
reported in the consolidated statement of income.

                                     F-10
<PAGE>
 
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES


Revenue Recognition - Revenues are recognized when services are performed and
are recorded at published charges, net of discounts and contractual allowances.
Revenues received under the Medicare program are subject to audit and possible
adjustment by third party reimbursement agencies.

Cash Equivalents - For purposes of the statement of cash flows, the Company
considers any short-term cash investment with a maturity of three months or less
to be a cash equivalent.

Prepaid Expenses - Prepaid expenses represent advance payments made or
liabilities incurred on various contracts and agreements with initial terms of
one year or less.  The carrying amount of prepaid expenses is determined by
comparing the remaining period of the agreement to its initial cost.

Investment Securities - Investment securities consist of commercial paper with a
maturity of 180 days.  All of the Company's investments are carried at cost and
classified as held-to-maturity securities.  No realized gains or losses were
recognized during the years ended December 31, 1998, 1997 and 1996 since all
securities were held to maturity.

Contracts Receivable - In December 1998, the Company elected to change its
method for accounting for future payments relating to contract receivables due
on long-term equipment and service agreements. Under the previous method,
expected profits or losses on contracts were based on the Company's estimates of
total revenue values and related costs upon installation. These estimates were
reviewed and revised periodically throughout the lives of the contracts, and
adjustments resulting from such revisions were recorded in the periods in which
the revisions were made. Losses on contracts were recorded in full as they were
identified. The Company changed its accounting method effective January 1, 1998,
in order to recognize revenue and expense on long-term contracts ratably over
the lives of the contracts.

Property, Equipment and Leasehold Improvements - Property and equipment are
stated at cost and are depreciated using the straight-line method over the
estimated useful lives of the related assets, ranging from 3 to 10 years.
Depreciation expense amounted to $4,422,115 and $3,535,037 for the years ended
December 31, 1998 and 1997, respectively.

Deposits and Other Assets - Deposits and other assets include deferred finance
costs associated with the senior subordinated indebtedness, which is amortized
over the life of the indebtedness.

                                     F-11
<PAGE>
 
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Goodwill - The excess of the aggregate purchase price over the fair market value
of net assets of businesses acquired is included in the accompanying balance
sheet as goodwill, and is amortized over a twenty-year period using the
straight-line method.  The Company periodically evaluates whether changes have
occurred that would require revision of the remaining estimated useful life of
the assigned goodwill or impair the recoverability of the carrying value of the
goodwill.  If such circumstances arise, the Company records an impairment loss
as the difference between the estimate of the related after-tax income
contribution, on a discounted basis, and the carrying value of the goodwill.
Any impairment loss would be reported as a component of income from continuing
operations before tax.

Noncompete Agreements - Noncompete agreements are amortized over the life of the
agreements, which range from two to five years.

Long-Lived Assets - In accordance with SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,"
the Company records impairment losses on long-lived assets used in operations,
including goodwill and intangible assets, when events and circumstances indicate
that the assets might be impaired and the undiscounted cash flows estimated to
be generated by those assets are less than the carrying amounts of those assets.

Income Taxes - The Company accounts for income taxes in accordance with SFAS No.
109, "Accounting for Income Taxes," which requires the use of the "liability
method" of accounting for income taxes.  Deferred taxes are provided using the
liability method whereby deferred tax assets are recognized for deductible
temporary differences and deferred tax liabilities are recognized for taxable
temporary differences.  Temporary differences are the differences between the
reported amounts of assets and liabilities and their tax bases.  Deferred tax
assets and liabilities are adjusted for the effects of changes in tax laws and
rates on the date of enactment.  The Company files consolidated income tax
returns.

Earnings (Loss) Per Share - Basic earnings (loss) per share has been computed by
dividing net income by the weighted-average number of shares outstanding during
the period.  Diluted earnings per share has been computed by dividing net income
by the weighted average number of shares plus common stock equivalents
outstanding during the period, computed using the treasury stock method,
excluding anti-dilutive securities.

                                     F-12
<PAGE>
 
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)

Fair Value of Financial Instruments - The carrying value of cash, cash
equivalents, receivables and accounts payable approximates fair value due to the
short maturity of these instruments.  The carrying value of short and long-term
debt approximates fair value based on discounting the projected cash flows using
market rates available for similar maturities.  None of the financial
instruments are held for trading purposes.

Use of Estimates and Assumptions - Management uses estimates and assumptions in
preparing its financial statements.  Those estimates and assumptions affect the
reported amounts of assets and liabilities, the disclosure of contingent assets
and liabilities, and the reported amounts of revenues and expenses.  Actual
results may vary from the estimates that were used.

Stock-Based Compensation - In October 1995, SFAS No. 123, "Accounting for Stock-
based Compensation" was issued.  This statement requires the fair value of stock
options and other stock-based compensation issued to employees, to either be
included as compensation expense in the income statement or the pro forma effect
on net income and earnings per share of such compensation expense to be
disclosed in the footnotes to the Company's financial statements, commencing
with the Company's 1996 fiscal year.  The Company adopted SFAS 123 on January 1,
1996.  The Company will continue to measure compensation costs using the
"intrinsic value based method" of accounting for stock issued to employees.

New Accounting Standards  In June 1997, the Financial Accounting Standards Board
issued SFAS No. 130, "Reporting Comprehensive Income."  This statement, which is
effective for fiscal years beginning after December 15, 1997, establishes
standards for reporting and displaying comprehensive income and its components
in the financial statements.  Under this statement, the Company is required to
classify items of other comprehensive income by their nature in a financial
statement and display the accumulated balance of other comprehensive income
separately from retained earnings in the stockholders' equity section of the
balance sheet.

NOTE 3 - INVESTMENT IN UNCONSOLIDATED AFFILIATE

On February 26, 1998, SoCal acquired from Diagnostic Imaging Services, Inc., a
Delaware corporation ("DIS-Delaware"), one-half of the outstanding general
partnership interests and one-half of the outstanding limited partnership
interests in Scripps Chula Vista Imaging Center, L.P. ("SCVIC"), whose business
consists of the operations of a magnetic resonance imaging center on the campus
of Scripps Hospital in Chula Vista, California.  The consideration paid for such
partnership interests consisted of 127,250 shares of DHS common stock valued at
$1,606,531.

                                     F-13
<PAGE>
 
NOTE 4 - NOTES PAYABLE
-----------------------

At December 31, 1998 and 1997, notes payable consisted of the following
obligations:

<TABLE>
<CAPTION>
                                                          December 31,
                                                    -----------------------
                                                       1998         1997
                                                    ----------   ----------
    <S>                                             <C>          <C>
    $1,000,000 and $2,500,000 line of credit
    with bank at December 31, 1998 and 1997,
    respectively, with interest at varying rates
    (9.0 % at December 31, 1997),
    due June 30, 1999.  Secured by
    substantially all of the assets of
    the Company.                                    $       --   $2,362,554
                                                    ----------   ----------
                                                    $       --   $2,362,554
                                                    ==========   ==========
</TABLE>

In July 1996, the Company entered a two-year loan agreement with a bank whereby
the Company was permitted to borrow up to $2,500,000 under a revolving credit
note.  This revolving note replaced the existing credit facility in place at
that time. The loan agreement (as amended) also provided for a separate term
loan facility totaling $17,500,000 in original principal amount, whose terms are
discussed in Note 5.  In December 1998, the Company restructured the
aforementioned loan agreement by consolidating the outstanding revolving line
balance into a new term note agreement whose terms are discussed in Note 5.

Effective as of December 31, 1998, the Company and its subsidiaries entered in
to an amendment of the revolving credit and term loan facility with Chase.  This
commitment provides for permanent waiver of all defaults outstanding through and
including November 30, 1998, and implementation of a new covenant structure.
Under the new amendment, the outstanding balance of the Company's term facility
begins a five-year amortization program to commence July 15, 1999, and the
remaining availability under that facility is cancelled.  The revolving facility
was reduced to $2 million with a shortened maturity of January 31, 1999.  The
new financial covenant structure temporarily suspend the Fixed Charge Coverage
Ratio, Funded Debt to EBITDA Ratio, and Senior Debt to EBITDA Ratio, and
requires the Company to maintain minimum EBITDA levels.  In addition, the new
structure limits unleveraged capital expenditures, and prohibits the Company
from incurring additional debt or selling assets.

The Company's previous revolving credit and existing term note agreements
contain certain restrictive covenants which, among other things, (1) require the
maintenance of a minimum current ratio, (2) provide for a maximum funded debt
ratio (as defined in the loan agreement), (3) require the maintenance of a
minimum fixed charge coverage ratio (as defined in the loan agreement), and (4)
place certain restrictions on the Company's ability to declare or pay dividends,
make certain loans, advances or investments, or incur, create or assume
additional debt or other obligations.

                                     F-14
<PAGE>
 
NOTE 5 - LONG-TERM DEBT
-----------------------

Long-term debt at year-end consists of the following:

<TABLE> 
<CAPTION> 
                                                                           December 31,
                                                              ------------------------------------
                                                                  1998                   1997  
                                                              -------------         --------------
 <S>                                                          <C>                   <C>
  Restructured note payable to bank, maturing June 30,
  2001, due in quarterly installments of $400,000, plus
  interest due quarterly at varying rates (9.5% at
  December 31, 1998); secured by substantially all of
  the assets of the Company.                                    $ 7,952,930         $          --   
 
  Note payable to bank in connection with acquisitions
  representing outstanding portion of $17,500,000 credit
  facility, maturing June 1998, due in monthly installments
  of $142,826, plus interest at varying rates (9.0% at
  December 31, 1997); secured by substantially all of
  the assets of the Company.                                             --             6,121,094
 
  Senior subordinated promissory notes payable in
  connection with DIS acquisitions, maturing April 17,
  2005, interest at 10.50% due in quarterly installments
  and principal of $6,666,667 due on  April 17, 2003,
  2004, and 2005; unsecured.                                     20,000,000            20,000,000
 
  Notes payable to financial institutions, maturing through
  2000, due in monthly installments of $2,440 including
  principal and interest from 7.0% to 10.0%; secured by
  vehicles.                                                              --                31,200
 
  Note payable to corporation, maturing May 15, 2001,
  due in monthly installments of $1,825 including principal
  and interest at 7.25%; secured by equipment.                       51,208                66,132
 
  Noncompete agreements, maturing through 1998, due
  in monthly payments of $17,083 and $27,628   
  respectively, including principal and interest of
  6% to 9%, unsecured.                                                   --               228,257
                                                               ------------           -----------
                                                                 28,004,138            26,446,683
  Less current maturities                                          (814,107)           (1,485,113)
                                                               ------------           -----------
                                                               $ 27,190,031           $24,961,570
                                                               ============           ===========
</TABLE>
<PAGE>
 
NOTE 5 - LONG-TERM DEBT (CONTINUED)
---------------------------------- 

Scheduled maturities of long-term debt are as follows:

<TABLE>
<CAPTION>
   For the Years Ending
        December 31,
----------------------------
<S>                                    <C> 
            1999                       $   814,107
            2000                         1,611,242
            2001                         1,602,324
            2002                         1,590,586
            2003                         1,590,586
         Thereafter                     20,795,293
                                       -----------
                                       $28,004,138
                                       ===========
</TABLE>

NOTE 6 - LEASES
---------------

The Company, as lessee, has entered into and/or assumed various non-cancelable
leases for machinery, service equipment, vehicles, and office facilities.  The
following assets, subject to capital leases, are included in the balance sheet
under the corresponding asset categories at December 31:

<TABLE>
<CAPTION>
                                              December 31,
                                       --------------------------
                                           1998          1997
                                       ------------  ------------
    <S>                                <C>           <C>
 
    Office furniture & equipment       $    12,652   $    56,783
    Machinery & service equipment       14,614,874    20,089,761
                                       -----------   -----------
                                        14,627,526    20,146,544
     Less: accumulated amortization     (3,116,795)   (2,687,782)
                                       -----------   -----------
                                       $11,510,731   $17,458,762
                                       ===========   ===========
</TABLE>

Depreciation expense includes the amortization of assets acquired through
capital leases.

The Company leased its office space under operating lease agreements that
include a deferred rental period.  In accordance with generally accepted
accounting principles, rent expense was computed by the straight-line
amortization of the total lease payments.  As of December 31, 1998, there are no
deferred rental expenses.

                                     F-16
<PAGE>
 
NOTE 6  LEASES (Continued)
------------------------- 

Future minimum lease payments under non-cancelable leases at December 31, 1998
are as follows:

<TABLE>
<CAPTION>
          For the Years Ending                  Capital    Operating
               December 31,                     Leases       Leases
-------------------------------------------  ------------  ----------
<S>                                          <C>           <C>
                   1999                      $ 3,690,566   $1,189,329
                   2000                        3,561,302      996,546
                   2001                        3,242,950      756,472
                   2002                        2,385,665      596,277
                   2003                        2,385,665      372,373
                Thereafter                     1,210,371      227,152
                                             -----------   ----------
  Total minimum lease payments                16,476,519   $4,138,149
                                                           ==========
    Less: amount representing interest        (3,238,580)
                                             -----------
  Present value of minimum lease payments     13,237,939
    Less: current portion                     (2,585,334)
                                             -----------
 Long-term capital lease obligation          $10,652,605
                                             ===========
</TABLE>

Rent expense during the years ended December 31, 1998, 1997 and 1996 for all
operating leases was $1,255,144, $1,084,054 and $758,351, respectively, and is
included in operating expenses.

As of December 31, 1998, the Company is guarantor of a capitalized lease for
certain equipment owned by Scripps Chula Vista Imaging Center, L.P., in which
the Company is a partner with fifty-percent ownership.  The net present value of
the lease on the financial statements of the partnership at December 31, 1998
amounted to $807,040 with future minimum lease payments as follows:

<TABLE>
<CAPTION>
                                             Guaranteed
          For the Years Ending                 Capital
               December 31,                    Leases
-------------------------------------------  -----------
<S>                                          <C>
                   1999                      $  190,332
                   2000                         190,332
                   2001                         190,332
                   2002                         190,332
                   2003                         190,332
                Thereafter                       80,704
                                             ----------
  Total minimum lease payments                1,032,364
    Less: amount representing interest         (225,324)
                                             ----------
  Present value of minimum lease payments    $  807,040
                                             ==========
</TABLE>

                                     F-17
<PAGE>
 
NOTE 7  PREFERRED STOCK
-----------------------

The preferred stockholders are entitled to receive preferential and cumulative
annual preferred stock dividends at a rate of 7.25% of liquidation preference
value of $4,500,000, and are entitled to a preference, in liquidation, in the
amount of $7.00 per share plus accrued and unpaid dividends.  As of December 31,
1998, there were no cumulative preferred stock dividends in arrears.  Preferred
shares are not entitled to vote except in certain circumstances.  The holders of
outstanding preferred shares may convert outstanding shares at the rate of one
share for each share of common stock.  Additionally, in any fiscal quarter in
which the mean average daily last reported sale price of the common stock is
less than $7.00 per share, then, at any time during the next succeeding fiscal
quarter of the Company, the holders of the preferred stock shall have the right
to convert any or all of their shares into common stock, with each outstanding
share being convertible into a number of shares of common stock equal to the
liquidation value divided by the average closing price during the preceding
fiscal quarter.  Conversion has an aggregate limitation of 9.9% of the
outstanding common shares outstanding prior to conversion.

Additionally, the Company may at its sole discretion redeem all or any portion
of the preferred stock then outstanding. On any such redemption, the Company
will pay a price per share on a progressive scale specifically designated by the
certificate of stock designation agreement.  At December 31, 1998, the Company
would pay a price of no less than $8.10 per preferred share for any such
redemption.  Any such redemption would be subject to the consent of the
Company's lenders.

NOTE 8 - INCOME TAXES
----------------------

Net deferred tax assets and liabilities at December 31, 1998 and 1997 consisted
of the following:

<TABLE>
<CAPTION>
                                                                1998          1997
                                                            ------------  ------------
<S>                                                         <C>           <C>
Deferred tax assets:
  Allowance for doubtful accounts                           $   485,736   $    85,229
  Goodwill                                                    6,036,353            --
  NOL Carryforward                                            9,753,654            --
  Noncompete agreements                                         325,475       171,761
Accrued vacation                                                     --         2,647
                                                            -----------   -----------
    Total deferred tax assets before valuation allowance     16,601,218       259,637
Less: valuation allowance                                    (4,241,219)           --
                                                            -----------   -----------
    Total deferred tax asset                                $12,359,999   $   259,637
                                                            ===========   ===========
Deferred tax liabilities:
  Property and equipment                                     (2,892,232)   (2,013,838)
  Goodwill                                                           --      (176,403)
                                                            -----------   -----------
    Total deferred tax liabilities                           (2,892,232)   (2,190,241)
                                                            -----------   -----------
Net deferred tax asset (liability)                          $ 9,467,767   $(1,930,604)
                                                            ===========   ===========
</TABLE>

                                     F-18
<PAGE>
 
NOTE 8 - INCOME TAXES (CONTINUED)
---------------------------------

The Company has net operating loss carryforwards amounting to approximately
$28,700,000 which expire in the year 2013.

The consolidated provision for income taxes included in the statement of
operations for the years ended December 31, 1998 and 1997 consisted of the
following:

<TABLE>
<CAPTION>
                                                       1998         1997         1996
                                                   ------------  -----------  -----------
<S>                                                <C>           <C>          <C>
Current taxes (receivable) payable                 $  (973,492)  $1,363,543   $  195,000
Deferred taxes (receivable) payable:
  Long term (benefit)                               (4,971,802)     882,183      869,413
  Current (benefit)                                 (1,027,324)     (30,000)      (2,853)
                                                   -----------   ----------   ----------
Provision for income taxes                         $(6,972,618)  $2,215,726   $1,061,560
                                                   ===========   ==========   ==========
</TABLE>

The difference between the federal statutory tax rate and the effective tax rate
on continuing operations for the years ended December 31, 1998 and 1997 follows:

<TABLE>
<CAPTION>
                                                 1998              1997            1996       
                                                 --------        --------        --------     
<S>                                              <C>             <C>             <C>          
Federal Statutory Rate                              (35)%            35%              35%    
Property and equipment                                1               5               --           
Tax effect of loss on discontinued operations        --              (2)              --     
Intangible assets                                   (14)             (1)               2     
Net tax loss carryovers                              22              --               --           
Utilization of tax loss carryforwards                --              --              (12)         
Tax effect of change in accounting method            12              --               --     
Allowance for doubtful accounts                      (1)             (9)              --     
Valuation allowance                                   9              --               --     
Other, net                                           (8)              1                5     
                                                 --------        -------         --------     
Effective tax rate                                  (14)%            29%              30%    
                                                 ========        =======         ========      
</TABLE>

                                     F-19
<PAGE>
 
NOTE 9 -  OTHER COMPREHENSIVE INCOME
------------------------------------

The following is a summary of other comprehensive income:

<TABLE>
<CAPTION>
                                                 For the year ended December 31, 1996
                                                ---------------------------------------
                                                Before Tax   Tax (Expense)  Net-of-Tax
                                                  Amount        Benefit       Amount
                                                -----------  -------------  -----------
<S>                                             <C>          <C>            <C>
Foreign currency translation adjustments           $  (271)        $   92      $  (179)
                                                -----------   ------------  -----------
 
Total impact on other comprehensive income         $  (271)        $   92      $  (179)
                                                ===========   ============  ===========
</TABLE> 
  
<TABLE> 
<CAPTION> 
                                                   For the year ended December 31, 1997
                                             ----------------------------------------------
                                                Before Tax   Tax (Expense)  Net-of-Tax
                                                  Amount       Benefit        Amount
                                             -------------   ------------   ---------------
<S>                                          <C>             <C>            <C>  
Foreign currency translation adjustments           $(1,757)           597       (1,160)
 
Reclassification adjustment, net of tax, for
 previously recognized foreign currency
 translation adjustments                            (4,143)         1,409       (2,734)
                                             --------------  -------------   --------------
Total impact on other comprehensive income         $(5,900)        $2,006      $(3,894)
                                             ==============  =============   ============== 
</TABLE>

There are no other components of comprehensive income as of December 31, 1998.

                                     F-20
 
<PAGE>
 
NOTE 10 - SUPPLEMENTAL CASH FLOW INFORMATION
--------------------------------------------

Cash paid for the years ended December 31, 1998, 1997 and 1996 for interest was
approximately $4,209,686, $3,520,340 and $921,512, respectively.  Cash paid for
Federal income taxes for the years ended December 31, 1998, 1997 and 1996
amounted to $935,024, $23,022 and $0, respectively.

The Company acquired assets in exchange for the issuance of common stock and the
assumption of various liabilities in connection with certain acquisitions.  Cash
and noncash investing and financing activities related to acquisitions consisted
of the following for the years ended December 31, 1998, 1997 and 1996:

<TABLE>
<CAPTION>
                            1998         1997           1996
                         ----------  -------------  ------------
  <S>                    <C>         <C>            <C>
  Assets acquired        $ 958,594   $ 30,628,401   $19,904,468
  Liabilities assumed     (330,823)   (11,000,061)   (6,032,525)
  Common stock issued     (584,214)    (3,351,000)     (851,643)
                         ---------   ------------   -----------
  Total cash paid           43,557     16,277,340    13,020,300
  Less cash acquired       (32,207)      (314,493)      (16,564)
                         ---------   ------------   -----------
  Net cash paid          $  11,350   $ 15,962,847   $13,003,736
                         =========   ============   ===========
</TABLE>

Property and equipment acquired under capital leases for the years ended
December 31, 1998 and 1997 amounted to $1,567,293 and $14,642,967, respectively.

The Company issued 26,215 shares of common stock valued at $48,296 in 1997
pursuant to contingent stock issuance agreements relating to various
acquisitions.

The Company issued 56,553 shares of common stock valued at $117,230 in 1998
pursuant to an employee severance agreement.

In February 1998, the Company and DIS agreed to convert $1,500,000 deferred
liabilities owed to DIS in respect of the acquisition of the MRI centers into
200,000 shares of common stock (see Note 12); therefore, the deferred
liabilities recorded as current liabilities at December 31, 1997 were converted
to equity during the year ended December 31, 1998.

NOTE 11 - COMMITMENTS AND CONTINGENCIES
---------------------------------------

The Company is involved in certain lawsuits arising in the ordinary course of
business.  In the opinion of the Company's legal counsel and management, any
liability resulting from such litigation would not be material in relation to
the Company's financial position.

                                     F-21
<PAGE>
 
NOTE 12 - ACQUISITIONS 
----------------------

In January 1997, the Company, through its Heart Institute of Tulsa, Inc.
subsidiary ("HIT"), acquired Ultrasound Diagnostic Services, Ltd. ("UDS"), an
Arizona-based provider of non-invasive diagnostic ultrasound testing services.
The consideration paid for UDS consisted of 86,520 shares of DHS's common stock
and a $400,000 cash payment to the former stockholders of UDS.

On April 17, 1997 (effective March 1, 1997), SoCal acquired all of the issued
and outstanding capital stock of DIS (which, together with its wholly-owned
subsidiaries, Diagnostic Imaging Services, Inc. I and Santa Monica Imaging
Center Limited Partnership, are collectively referred to herein as the "DIS
Companies"), whose business consists primarily of the ownership and operation of
four (4) hospital-based magnetic resonance imaging (MRI) centers located in
southern California. The purchase price for the stock of DIS was $9,083,865
(subject to post-closing adjustment), of which $7,583,865 was paid in cash, and
the remaining $1,500,000 of which is payable either in cash or (at the seller's
option) in common stock of the Company (valued at $7.615 per share) in three
equal annual installments of $500,000 each on April 17 of each of 1998, 1999 and
2000. In addition, the DIS Companies were acquired subject to capital lease
obligations, financing agreements and other commitments in respect of fixed
assets of the business in the aggregate principal amount of $6,046,755.

The funds utilized to pay the cash portion of the purchase price in the second
DIS transaction were obtained through the simultaneous issuance and sale by the
Company to The Prudential Insurance Company of America ("Prudential") of
$20,000,000 in principal amount of senior subordinated promissory notes of the
Company (the "Notes").  The Notes bear interest at a fixed rate of 10.5% per
annum (payable quarterly), and mature as to principal in equal one-third
installments on April 17 of each of 2003, 2004 and 2005.  The Notes may be
prepaid at the Company's option (subject to certain "make-whole" prepayment
premiums in respect of the remaining stated term of the Notes), and the Company
may be required (at the Noteholders' option) to purchase the Notes in the event
of a change in control of the Company.  In addition to application to the
payment of the cash portion of the purchase price for the stock of DIS, the net
proceeds from the issuance and sale of the Notes were utilized to repay
$5,500,000 in borrowings obtained under the Company's senior credit facilities
with Texas Commerce Bank National Association (the "Bank") (utilized in
connection with the Company's March 1997 acquisition of the ultrasound business
of DIS), and for short-term investments pending other use of such net proceeds.

                                     F-22
<PAGE>
 
NOTE 12 - ACQUISITIONS (CONTINUED)
----------------------------------

In connection with the issuance of the Notes, the Company paid Prudential a fee
in the amount of $54,590, and issued to Prudential a five-year redeemable common
stock purchase warrant (with piggyback registration rights) for 60,000 shares of
common stock of the Company at an exercise price of $12.25 per share.  In
addition, the Company paid to Prudential Securities, Inc. (as placement agent) a
fee in the amount of $690,470.

Effect as of October 17, 1997, HIT acquired CardioVision, Inc. ("CVI"), a Las
Vegas, Nevada-based provider of non-invasive diagnostic ultrasound testing
services.  The consideration paid for CVI consisted of 29,728 shares of DHS
common stock and a $340,000 cash payment to the former stockholders of CVI.

On November 19, 1997, SoCal acquired the assets and business of Valley
Diagnostic Services ("Valley"); a proprietorship providing mobile diagnostic
ultrasound testing services in southern California.  The consideration paid by
SoCal in this transaction consisted of 13,309 shares of DHS common stock and a
$100,000 cash payment to the former owner of Valley.

Effective as of December 2, 1997, HIT acquired Medical Diagnostic Imaging, Inc.
("MDII"), a Huntsville, Alabama-based provider of non-invasive diagnostic
ultrasound testing services.  The consideration for MDII consisted of 100,524
shares of DHS common stock and a $900,000 cash payment to the former
stockholders of MDII.

Effective as of December 9, 1997, SoCal acquired Mobil Diagnostics, Inc.
("Mobil"), a southern California-based provider of mobile non-invasive
diagnostic ultrasound testing services.  The consideration for Mobil consisted
of 39,720 shares of DHS common stock and a cash payment of $150,000 to the
former stockholder of Mobil.  In addition, SoCal agreed to cause DHS to issue
certain additional shares of DHS common stock to the former stockholder within
15 days after the first anniversary of the closing date, and to make cash
payments to the former stockholder of $50,000 and $28,000, respectively, within
15 days after the first and second anniversaries of the closing date.

Effective as of December 30, 1997, the Company's second-tier wholly-owned
subsidiary Mobile Diagnostic Systems, Inc. ("MDS") acquired Medical Ancillary
Services, Inc. ("MASI"), a Fort Worth-based provider of non-invasive diagnostic
ultrasound and nuclear imaging testing services.  The consideration paid for
MASI consisted of 53,582 shares of DHS common stock and a cash payment of
$384,000 to the former stockholders of MASI.

                                     F-23
<PAGE>
 
NOTE 12 - ACQUISITIONS (CONTINUED)
---------------------------------- 

Effective as of January 30, 1998, MDS acquired International Cardiac Monitoring,
Inc. ("ICM"), a Houston-based provider of medical testing and monitoring
services.  The consideration paid for ICM consisted of 26,946 shares of DHS
common stock.

On February 26, 1998, SoCal acquired from Diagnostic Imaging Services, Inc., a
Delaware corporation ("DIS-Delaware"), one-half of the outstanding general
partnership interests and one-half of the outstanding limited partnership
interests in Scripps Chula Vista Imaging Center, L.P. ("SCVIC"), whose business
consists of the operations of a magnetic resonance imaging center on the campus
of Scripps Hospital in Chula Vista, California.  The consideration paid for such
partnership interests consisted of 127,250 shares of DHS common stock valued at
$1,606,531, which DHS committed to include in its next registration statement
filed with the Securities Exchange Commission (other than a registration
statement in respect of any acquisition, merger or consolidation relating to DHS
or any employee benefit plan of DHS.)  In conjunction with the acquisition, DIS-
Delaware agreed to convert $1,500,000 deferred liabilities owed in accordance
with the acquisition of the MRI centers to 200,000 shares of common stock;
therefore, the deferred liabilities were recorded as current liabilities at
December 31, 1997.

Effective as of March 2, 1998, the Company acquired Sonomed, Inc. ("Sonomed"), a
Birmingham, Alabama-based provider of medical testing and monitoring services.
The consideration paid for Sonomed consisted of 14,571 shares of DHS common
stock and a cash payment of $30,000 to the former stockholder of Sonomed.

On May 11, 1998, HIT acquired Diagnostic Radiology Mobile Ultrasound, Inc.
("DRMU"), an Edmond, Oklahoma-based provider of non-invasive diagnostic
ultrasound testing services.  The consideration paid to the former owners of
DRMU consisted of 13,484 shares of DHS common stock.

On May 22, 1998, MDS purchased the assets of the ultrasound business segment of
Advanced Respiratory Care Services, Inc. ("ARCS"), which provides non-invasive
diagnostic ultrasound testing services in Abilene, Texas and Nashville,
Tennessee.  The consideration paid to ARCS consisted of a cash payment of
$13,556.

NOTE 13 - RELATED PARTY TRANSACTIONS
------------------------------------

A stockholder of the Company is a principal in a firm that provides financial
consulting services to the Company.  Fees paid to the firm in 1998, 1997 and
1996 were $58,562, $49,652 and $63,740, respectively.

The accounts receivable from stockholders consist of $13,543 of other advances
made to three of the Company's stockholders as of December 31, 1998 and 1997,
and $37,778 and $33,660, respectively, of accrued interest on the stockholder
receivables.

                                     F-24
<PAGE>
 
NOTE 14 - STOCK OPTION PLANS
----------------------------

On April 15, 1992, DHS adopted a stock option plan (the "1992 Plan") that
authorizes the granting of options to officers, directors and selected key
employees and/or consultants to acquire shares of DHS common stock.  The
aggregate number of shares with respect to which qualified incentive options may
be granted shall not exceed 180,702 shares, with the exercise price being not
less than the fair market value at the date of grant.  The aggregate number of
shares with respect to which non-qualified options may be granted shall not
exceed 722,807 shares.  The exercise price for the non-qualified options shall
not be less than 85% of the fair market value at the date of grant.  As of
December 31, 1998, substantially all of the available options under the 1992
Plan have been granted at exercise prices ranging from $0.9375 to $8.625 per
common share, and approximately 94% of such awarded options contain optional
price reduction provisions in connection with any change in control of the
Company.  Stock options outstanding under the 1992 Plan amounted to 526,601,
639,308, and 793,585 as of the years ended December 31, 1998, 1997 and 1996,
respectively.

In April 1995, in response to the substantial increase in the size of the
Company and its labor force, the Board of Directors of the Company adopted and
approved the Company's 1995 Non-Qualified Stock Option Plan (the "1995 Non-
Qualified Plan"), pursuant to which officers, directors, and/or key employees
and/or consultants of the Company can receive non-qualified stock options to
purchase up to an aggregate of 500,000 shares of the Company's common stock.
The exercise price, expiration date and other terms of any options granted under
the 1995 Non-Qualified Plan are substantially similar to the requirements
applicable to non-qualified options under the 1992 Plan.  Through December 31,
1998, the Company's Board of Directors had awarded all of the available options
under the 1995 Non-Qualified Plan at exercise prices ranging from $1.9375 to
$10.25 per common share.  Stock options outstanding under the 1995 Non-Qualified
Plan amounted to 253,000, 350,200, and 454,625 as of the years ended December
31, 1998, 1997 and 1996, respectively.  At December 31, 1998, approximately 75%
of such awarded options contain optional price reduction provisions in
connection with any change in control of the Company.

In November 1995, the stockholders of DHS approved the Company's 1995 Incentive
Stock Option Plan (the "1995 Incentive Plan") as previously adopted by DHS'
Board of Directors.  A total of 500,000 incentive stock options may be issued
from time to time to key employees of the Company under the 1995 Incentive Plan,
on terms and conditions (including an exercise price not less than fair market
value on the date of grant) satisfying the requirements of the Internal Revenue
Code with respect to incentive stock options.  Through December 31, 1998, the
Company's Board of Directors had awarded 316,939 options under the 1995
Incentive Plan at exercise prices ranging from $6.25 to $10.6875 per common
share.  Stock options outstanding under the 1995 Incentive Plan amounted to
237,589, 159,789 and 127,250 as of the years ended December 31, 1998, 1997 and
1996, respectively.

                                     F-25
<PAGE>
 
NOTE 14 - STOCK OPTION PLANS (CONTINUED)
--------------------------------------- 

In January 1997, the Board of Directors of the Company adopted and approved the
Company's 1997 Non-Qualified Stock Option Plan (the "1997 Non-Qualified Plan"),
pursuant to which officers, directors, and/or key employees and/or consultants
of the Company can receive non-qualified stock options to purchase up to an
aggregate of 1,000,000 shares of the Company's common stock.  The exercise
price, expiration date and other terms of any options granted under the 1997
Non-Qualified Plan are substantially similar to the requirements applicable to
non-qualified options under the 1992 Plan.  Through December 31, 1998, the
Company's Board of Directors had awarded, under the 1997 Non-Qualified Plan,
stock options for an aggregate of 848,761 common shares at exercise prices
ranging from $7.4375 to $10.6875 per common share.  Stock options outstanding
under the 1997 Non-Qualified Plan amounted to 763,861 and 657,161 as of the
December 31, 1998 and 1997, respectively.  At December 31, 1998, approximately
one-third of such awarded options contains optional price reduction provisions
in connection with any change in control of the Company.


A summary of the status of stock options is set forth below:

<TABLE>
<CAPTION>
                                           Year ended             Year ended
                                        December 31, 1998      December 31, 1997
                                      ---------------------  ---------------------
                                                   Weighted               Weighted
                                                   Average                Average
                                                   Exercise               Exercise
Stock Options                           Shares      Price      Shares      Price
-------------                           ------     --------  -----------  --------
<S>                                   <C>          <C>       <C>          <C>
Outstanding, beginning of period       1,806,458      $7.53   1,375,460      $3.81
Granted                                  270,900      $8.64     897,890      $8.88
Exercised                               (219,457)     $3.67    (399,452)     $4.67
Forfeited/expired                        (76,850)     $6.27     (67,440)     $5.70
                                      ----------             ----------
 
Outstanding, end of period             1,781,051      $6.10   1,806,458      $7.53
                                      ==========             ==========
 
Options exercisable, end of period     1,532,151      $5.69   1,806,458      $7.53
                                      ==========             ==========
 
Weighted average fair value of
options granted during the year       $     8.64             $     8.88
                                      ==========             ==========
</TABLE>

                                     F-26
<PAGE>
 
NOTE 14 - STOCK OPTION PLANS (CONTINUED)
--------------------------------------- 

The following table summarizes information about stock options outstanding at
December 31, 1998:

<TABLE>
<CAPTION>
                                           Options Outstanding                                     Options Exercisable
                    ---------------------------------------------------------------------------------------------------------------
                                            Weighted Average
 Range of Exercise          Options             Remaining        Weighted Average      Options Exercisable at    Weighted Average
 Prices                 Outstanding at      Contractual Life      Exercise Price              12/31/98            Exercise Price
                           12/31/98
-----------------------------------------------------------------------------------------------------------------------------------
<S>                   <C>                  <C>                  <C>                    <C>                      <C>
$0.9375 to $3.00              598,601                  1.7               $ 1.90                    598,601               $ 1.90
$3.01 to $5.50                121,000                  4.9               $ 4.31                    121,000               $ 4.31
$5.51 to $7.50                306,350                  4.9               $ 7.24                    306,350               $ 7.24
$7.51 to $10.00               472,600                  5.2               $ 8.39                    223,700               $ 8.14
$10.01 to $13.00              282,500                  5.6               $10.68                    282,500               $10.68
                            ---------                                                            ---------
                            1,781,051                  4.0               $ 6.10                  1,532,151               $ 5.69
                            =========                                                            =========
</TABLE>

Vesting varies by agreement ranging from zero to three years.  Compensation
costs will be recognized as an expense over the periods of employment
attributable to the options at an amount equal to the excess of the fair market
value of the stock at the date of measurement over the amount the employee must
pay. The measurement date is generally the grant date. As of December 31, 1998,
1997 and 1996, no compensation cost was recognized as expense. Had compensation
cost for the Company's stock-based compensation been determined on the fair
value at the grant dates for awards with the method of FASB Statement 123, the
Company's net income (loss) would have been $(42,430,991), $4,545,538, and
$2,410,489 for the years ended December 31, 1998, 1997 and 1996, respectively.
Accordingly, basic and diluted loss per share would have amounted to $(3.78) per
share and $(3.84) per share, respectively, as of December 31, 1998. Basic and
diluted earnings per share would have amounted to $0.48 per share and $0.47 per
share, respectively, as of December 31, 1997. Basic and diluted earnings per
share would have amounted to $0.36 per share and $0.31 per share, respectively,
as of December 31, 1996.

Using the fair value method, the fair value of each option grant is estimated on
the date of grant using the Black-Scholes option pricing model with the
following weighted-average assumptions used for grants in 1998: dividend yield
of 0.0 percent; expected volatility of 81.94 percent; risk-free interest rates
of 5.5 percent; expected lives of three years.  Using the fair value method, the
fair value of each option grant is estimated on the date of grant using the
Black-Scholes option pricing model with the following weighted-average
assumptions used for grants in 1997: dividend yield of 0.0 percent; expected
volatility of 5.55 percent; risk-free interest rates of 5.0 percent; expected
lives of two years.  Using the fair value method, the fair value of each option
grant is estimated on the date of grant using the Black-Scholes option pricing
model with the following weighted-average assumptions used for grants in 1996:
dividend yield of 0.0 percent; expected volatility of 10.0 percent; risk-free
interest rates of 4.56 percent; expected lives of one year.

                                     F-27
<PAGE>
 
NOTE 15 - WARRANTS
------------------

On October 31, 1997, the Company filed an S-8 registration statement with the
Securities and Exchange Commission registering an aggregate of 2,867,509 shares
underlying the Company's stock option plans, for which options covering
1,789,660 shares were then outstanding.  Executive officers and directors, who
collectively hold approximately 71% of the outstanding options and option
shares, agreed to certain restrictions on the resale of their option shares
during the one-year period following the effective date of the registration.

On February 14, 1997, the SEC declared effective the Company's Form S-3
Registration Statement relating to an offering of 1,791,150 Warrant Shares,
which are issuable upon exercise, at prices ranging from $5.48 to $7.50 per
share, of (i) 1,375,000 Redeemable Common Stock Purchase Warrants (the "Public
Warrants") issued in connection with the company's 1993 initial public offering
(the "IPO"), (ii) 316,150 underwriter warrants issued in connection with the IPO
(the "Underwriters' Warrants"), and (iii) 100,000 warrants issued in connection
with DHS's equity private placement in April 1996 (the "Bridge Warrants") of
which 2,500 had been exercised prior to the effectiveness of the registration.
On February 18, 1997, the Company called all of the Public Warrants for
redemption.

On April 17, 1997, the Company issued 60,000 common stock purchase warrants to
Prudential Insurance Company of America in connection with the sale of
$20,000,000 in principal amount of senior subordinated promissory notes.  As of
December 31, 1998, no warrants under this agreement had been exercised.

At December 31, 1997, stock warrants outstanding amounted to 386,150, at
exercise prices ranging from $5.48 to $12.25 per common share.  At December 31,
1998, stock warrants outstanding amounted to 70,000, at exercise prices ranging
from $6.25 to $12.25 per common share.

                                     F-28
<PAGE>
 
NOTE 16 - EARNINGS PER SHARE
----------------------------

The following is a reconciliation of the numerators and denominators of the
basic and diluted earnings per share computations:

<TABLE>
<CAPTION>
                                           For the year ended December 31, 1998
                                         ----------------------------------------
                                            Income         Shares      Per Share
                                          (Numerator)   (Denominator)    Amount
                                         -------------  -------------  ----------
<S>                                      <C>            <C>            <C>
Loss before extraordinary item           $(41,292,359)
Less:  preferred stock dividends                  (51)
                                         ------------
BASIC EARNINGS PER SHARE
Loss available to common stockholders    $(41,292,410)    11,236,737      $(3.67)
                                                                          ======
EFFECT OF DILUTIVE SECURITIES
Convertible preferred stock                        51             --
Stock warrants                                     --        (34,126)
Employee stock options                             --       (139,414)
                                         ------------     ----------
DILUTED EARNINGS PER SHARE
Loss available to common stockholders
  plus assumed conversions               $(41,292,359)    11,063,197      $(3.73)
                                         ============     ==========      ======
</TABLE>

As of December 31, 1998, warrants to purchase 10,000 shares of common stock at
$6.25 per share and options to purchase 1,025,951 at prices ranging from $0.9375
to $7.4375 were outstanding but were not included in the computation of diluted
earnings per share because the options had an anti-dilutive effect on earnings
per share.  Additionally, preferred shares convertible into 1,136,583 shares of
common stock were not included in the computation of diluted earnings per share
because the options had an anti-dilutive effect on earnings per share.

<TABLE>
<CAPTION>
                                            For the year ended December 31, 1997
                                           --------------------------------------
                                              Income        Shares      Per Share
                                           (Numerator)   (Denominator)   Amount
                                           ------------  -------------  ---------
<S>                                        <C>           <C>            <C>
Income before extraordinary item            $5,433,595
Less: preferred stock dividend                     (47)
                                            ----------
BASIC EARNINGS PER SHARE
Income available to common stockholders     $5,433,548      9,527,736       $0.57
                                                                            =====
EFFECT OF DILUTIVE SECURITIES
Convertible preferred stock                         47        695,593
Stock warrants                                      --        156,993
Employee stock options                              --        841,036
                                            ----------     ----------
Diluted earnings per share
Income available to common stockholders
  plus assumed conversions                  $5,433,595     11,221,358       $0.48
                                            ==========     ==========       =====
</TABLE>

                                     F-29
<PAGE>
 
NOTE 16 - EARNINGS PER SHARE (CONTINUED)
---------------------------------------

As of December 31, 1997, warrants to purchase 60,000 shares of common stock at
$12.25 per share were outstanding but were not included in the computation of
diluted earnings per share because the options had an anti-dilutive effect on
earnings per share.

<TABLE>
<CAPTION>
                                            For the year ended December 31, 1996
                                           --------------------------------------
                                              Income        Shares      Per Share
                                           (Numerator)   (Denominator)   Amount
                                           ------------  -------------  ---------
<S>                                        <C>           <C>            <C>
Income before extraordinary item            $2,459,083
Less:  preferred stock dividends                    (6)
                                            ----------
BASIC EARNINGS PER SHARE
Income available to common stockholders     $2,459,077      6,709,795       $0.37
                                                                            =====
EFFECT OF DILUTIVE SECURITIES
Convertible preferred stock                          6        648,986
Stock warrants                                      --        126,463
Contingent stock options                            --         58,935
Employee stock options                              --        902,156
                                            ----------      ---------
DILUTED EARNINGS PER SHARE
Income available to common stockholders
  plus assumed conversions                  $2,459,083      8,446,335       $0.29
                                            ==========      =========       =====
</TABLE>

As of December 31, 1996, options to purchase 5,000 shares of common stock at
$7.50 per share were outstanding but were not included in the computation of
diluted earnings per share because the options had an anti-dilutive effect on
earnings per share.

NOTE 17 - EMPLOYEE BENEFIT PLAN
-------------------------------

Effective March 31, 1997, the Company adopted a profit sharing savings plan for
all eligible employees.  The plan provides for savings contributions by
employees of 1 to 15% of the their compensation, subject to limitations of the
Employee Retirement Income Security Act.  The Company may, at its discretion,
make a matching contribution and/or discretionary contribution to the plan, both
of which shall be determined by the Board of Directors.  Such contributions are
expenses and funded currently.  The Company made no discretionary contributions
during the year ended December 31, 1998 and 1997.

                                     F-30
<PAGE>
 
NOTE 18 - DISCONTINUED OPERATIONS
---------------------------------

In December 1997, the Company's Board of Directors adopted a plan to discontinue
the operations of HomeCare International de Mexico S.A. de C.V. ("HomeCare").
On December 30, 1997, the Company sold all of the outstanding stock of HomeCare
and terminated all operations within Mexico.  Accordingly, the loss of $392,674,
net of tax benefit, from the disposal of a business segment has been segregated
from continuing operations and reported as separate line item on the statement
of operations.  The net operating activity of HomeCare after the measurement
date through date of disposal on December 30, 1997 was not significant.

In November 1997, the Company's Board of Directors adopted a plan to discontinue
the operations of providing temporary placement with allied healthcare
professionals throughout the U.S. and Mexico.  Effective as of December 1, 1997,
the Company sold certain assets associated with this business segment.
Accordingly, the gain of $65,738, net of tax expense, from the disposal of a
business segment has been segregated from continuing operations and reported as
separate line item on the statement of operations.  The net operating activity
of this segment after the measurement date through date of disposal on December
1, 1997 was not significant.

NOTE 19 - YEAR 2000 EDP ISSUE
-----------------------------

The Company believes that its financial reporting and billing systems are
substantially compliant with Year 2000 requirements.  The Company has consulted
with its diagnostic equipment vendors and has been advised that certain items
will be supported at no cost, and that older items will be supported on a fee
basis.  The cost of making the Company's diagnostic equipment Year 2000
compliant is estimated within a range of approximately $100,000 to $150,000 over
the cost of normal upgrades and replacements, and will be incurred through
fiscal 1999.

NOTE 20 - IMPAIRMENT OF ACQUIRED ASSETS
---------------------------------------

For the year ended December 31, 1998, the Company recorded an impairment loss on
certain assets received in connection with several acquisitions.  The Company
experienced an impairment loss on assets due to a current period cash flow loss
by the acquired entities, loss of significant acquired revenue contracts and
projected future cash flow losses on the assets.  The impairment loss was
measured as the amount at which the carrying value of the asset exceeds the fair
value of the asset.  The fair value of the asset was determined using the
estimated undiscounted future cash flows of the assets.

                                     F-31
<PAGE>
 
NOTE 20 - IMPAIRMENT OF ACQUIRED ASSETS (CONTINUED)
-------------------------------------------------- 

The impaired assets consisted of goodwill, non-compete agreements, accounts
receivable and property & equipment in connection with the acquisitions of
Advanced Clinical Technology Inc., Valley Diagnostic Services, Heart Diagnostic
Institutes Inc., Medmark Associates, Inc., Cardiac Concepts, Inc., DIS'
ultrasound division, Mobil Diagnostics, Inc., and Sonomed, Inc.

The amount of the impairment loss included in loss from continuing operations
related to goodwill impairment amounted to $18,239,325 for the year ended
December 31, 1998. Impairment of non-compete agreements included in loss from
continuing operations for the year ended December 31, 1998 amounted to $212,763.
Impairment of acquired receivables due to uncollectibility included in loss from
continuing operations for the year ended December 31, 1998 amounted to
$2,448,946. Impairment of property and equipment included in loss from
continuing operations for the year ended December 31, 1998 amounted to
$3,771,257. A significant decrease in the market value of the property and
equipment created the impairment. Total impairment loss recognized for the year
ended December 31, 1998 amounted to $24,672,291.

NOTE 21 - RESTRUCTURE EXPENSE
-----------------------------

The Company restructured certain of its operations and recorded a restructuring
charge of approximately $6,596,683.  The restructuring charge relates to
expenses for a reduction in staff and the resulting severance payments amounting
to approximately $1,197,512, divisional office closings amounting to
approximately $1,839,175, and other expenses amounting to $3,559,996.  After the
related income tax benefit of approximately $2,243,000, this charge reduced
fiscal year 1998 earnings by approximately $4,353,683.

                                     F-32
<PAGE>
 
NOTE 22 - CHANGE IN ACCOUNTING METHOD
-------------------------------------

In December 1998, the Company elected to change its method for accounting for
future payments relating to contract receivables due on long-term equipment and
service agreements.  Under the previous method, expected profits or losses on
contracts were based on the Company's estimates of total revenue values and
related costs upon installation.  These estimates were reviewed and revised
periodically throughout the lives of the contracts, and adjustments resulting
from such revisions were recorded in the periods in which the revisions were
made.  Losses on contracts were recorded in full as they were identified.

The Company changed its accounting method effective January 1, 1998, in order to
recognize revenue and expense on long-term contracts ratably over the life of
the contracts.  The cumulative effect of the change in accounting method at
December 31, 1998 is $16,143,873 less tax benefit of $5,310,717.

The pro-forma effect of the change in accounting method relating to net income
follows:

<TABLE>
<CAPTION>
                                                      December 31,
                                                 ----------------------
                                                     1997        1996
                                                 ------------  --------
 <S>                                             <C>           <C>
 Income (loss) before discontinued operations    $  (691,224)  $412,208
 Loss from discontinued operations                  (326,934)        --
                                                 -----------   --------
 Net income (loss)                               $(1,018,158)  $412,208
                                                 ===========   ========
 
 Net income (loss) per common share:
   Basic                                         $     (0.11)  $   0.06
                                                 ===========   ========
   Diluted                                       $     (0.11)  $   0.05
                                                 ===========   ========
</TABLE>

                                     F-33
<PAGE>
 
NOTE 23 - QUARTERLY FINANCIAL DATA (UNAUDITED)
----------------------------------------------

Unaudited quarterly financial data for the year ended December 31, 1998 follows:

<TABLE> 
<CAPTION> 
                                                       For the Three Months Ended
                                                ----------------------------------------
                                                  (In thousands, except per share data)
                                                ----------------------------------------
                                                 Mar. 31   June 30   Sept. 30    Dec. 31                                     
                                                --------  --------  ---------  ---------                                    
<S>                                             <C>       <C>       <C>        <C>                                          
Net sales                                       $10,720   $11,415    $11,697   $ 11,012                                    
                                                -------   -------    -------   --------                                    
Gross profit (loss)                             $  (660)  $(5,852)   $   398   $(27,285)                                   
                                                -------   -------    -------   --------                                     
Income (loss) from continuing                                                                                              
 operations before cumulative effect                                                                                       
 of change in accounting method                 $(1,535)  $(6,879)   $  (711)  $(28,306)                                   
                                                -------   -------    -------   --------                                     
Net income (loss)                               $(1,535)  $(6,879)   $(1,038)  $(31,839)                                   
                                                =======   =======    =======   ========                                     
                                                                                                                           
Income (loss) from continuing                                                                                              
operations per common share:                                                                                               
  Basic                                         $ (0.14)  $ (0.61)   $ (0.06)  $  (2.52)                                   
                                                =======   =======    =======   ========                                     
  Diluted                                       $ (0.14)  $ (0.61)   $ (0.06)  $  (2.52)                                   
                                                =======   =======    =======   ========                                     
                                               
Net income (loss) per common share:
  Basic                                         $ (0.14)  $ (0.61)   $ (0.09)  $  (2.83)                                    
                                                =======   =======    =======   ========                                     
  Diluted                                       $ (0.14)  $ (0.61)   $ (0.09)  $  (2.83)                                    
                                                =======   =======    =======   ========                                      
</TABLE> 
 
Unaudited quarterly financial data for the year ended December 31, 1997 follows:
 
<TABLE> 
<CAPTION> 
                                                        For the Three Months Ended
                                             ---------------------------------------------------
                                                      (In thousands, except per share data)
                                             ---------------------------------------------------   
                                                Mar. 31        June 30         Sept. 30       Dec. 31     
                                             ------------    ------------    ------------   ------------ 
<S>                                          <C>               <C>             <C>            <C>           
Net sales                                    $    10,510     $     12,533    $     14,890   $     14,988                            
                                             ------------    ------------    ------------   ------------ 
Gross profit                                 $     1,864     $      2,927    $      3,349   $      3,523                         
                                             ------------    ------------    ------------   ------------ 
Income (loss) from continuing                                                                                               
 operations before cumulative effect                                                                                        
 of change in accounting method              $     1,546     $      2,064    $      2,283   $      1,756                         
                                             ------------    ------------    ------------   ------------ 
Net income (loss)                            $     1,021     $      1,362    $      1,505   $      1,546                         
                                             ============    ============    ============   ============                            
                                                                                                                            
Income (loss) from continuing                                                                                               
operations per common share:                                                                                                
  Basic                                      $      0.16     $       0.21    $       0.23   $       0.17                         
                                             ============    ============    ============   ============                            
  Diluted                                    $      0.15     $       0.17    $       0.19   $       0.15                         
                                             ============    ============    ============   ============                            
                                                                                                                            
Net income (loss) per common share:                                                                                         
  Basic                                      $      0.10     $       0.14    $       0.15   $       0.15                         
                                             ============    ============    ============   ============                            
  Diluted                                    $      0.10     $       0.12    $       0.13   $       0.13                         
                                             ============    ============    ============   ============                            
</TABLE>

                                     F-34
<PAGE>
 
NOTE 24 - SUBSEQUENT EVENTS
---------------------------

On February 18, 1999, the Board of Directors of the Company and Medical
Alliance, Inc. ("MAII") unanimously approved and entered into a definitive
agreement pursuant to which Medical Alliance, Inc. will merge with and into a
wholly-owned subsidiary of the Company.  Once the transaction is finalized, the
combined entity will be called Medical Alliance, Inc., and its common stock will
trade on the NASDAQ National Market under the symbol MAII.  Under the terms of
the agreement, holders of the Medical Alliance common stock will receive a fixed
ratio of 1.57 shares of the Company's common stock for each share of Medical
Alliance common stock.  The transaction, which is expected to be accounted for
as a pooling-of-interests, is subject to approval by the shareholders of both
companies, various state and federal regulatory agencies, and certain other
conditions.  Closing of the transaction is expected to occur by the end of the
second quarter of 1999.

                                     F-35
<PAGE>
 
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
         ON ACCOUNTING AND FINANCIAL DISCLOSURE

         None

                                   PART III
                                   --------
                                        
ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

EXECUTIVE OFFICERS, DIRECTORS AND KEY EMPLOYEES

The executive officers, directors, and key employees of the Company are as
follows:

<TABLE> 
<CAPTION> 
Name                            Age                    Position
----                            ---                    --------
<S>                             <C>                    <C>      
Max W. Batzer (1)                55                    Chairman of the Board of Directors
 
Brad A. Hummel (2)               42                    Director, President, Chief Executive Officer
                                                       and Chief Operating Officer

Thomas M. Sestak (1)(2)          56                    Director
 
Bo W. Lycke (1)(2)               53                    Director
 
James R. Angelica                51                    Director and Senior Vice President
 
Bonnie G. Lankford               43                    Sr. Vice President - Operations
 
Don W. Caughron                  43                    Vice President - Finance
 
Christopher L. Turner            38                    Chief Financial Officer
 
Mark J. Foley                    36                    Vice President - Sales and Marketing
</TABLE>

_____________
(1)  Member of the compensation committee
(2)  Member of the audit committee

The Board of Directors of the Company is divided into three classes of an equal
(or as nearly equal as possible) number of Directors, with each Director serving
for a term of three years, and with elections for only one class of directors to
be held in each year.  Mr. Sestak's and Mr. Lycke's seats next come up for
election on or about May 31, 1999, Mr. Hummel's seat next comes up for election
on or about May 31, 2000, and Mr. Batzer's and Mr. Angelica's seats next come up
for election on or about May 31, 2001.

The following is a summary of the business experience of each executive officer,
director and key employee.

Max W. Batzer has been Chairman of the Board and of the Company since 1987, was
Chief Executive Officer from 1987 to January 1999, and a stockholder and
Director of the Company since its inception in 1983.  From 1981 to 1991, Mr.
Batzer was also President of General Hide & Skin Corporation, a worldwide
commodity trading organization headquartered in New York City.  In addition, Mr.
Batzer has also, at various times during the past 20 years, worked as an analyst
for Pan American World Airways, served as Vice President for Marketing for World
Courier Inc., and served as a director and

                                      17
<PAGE>
 
executive committee member of Simmons Airlines, Inc. (which was a publicly
traded company that was purchased by and is now a subsidiary of American
Airlines). Mr. Batzer holds a B.S.E. degree from The Wharton School at the
University of Pennsylvania, and a M.B.A. degree from the University of Arizona.

Brad A. Hummel was named Chief Executive Officer in January 1999, and has been
President and Chief Operating Officer of the Company since January 1987.  Mr.
Hummel was also Chief Financial Officer of the Company from February 1994 to
April 1997, and was employed by the Company in other capacities from 1984 to
1986.  From 1981 to 1984, Mr. Hummel was an associate with Covert, Crispin and
Murray (a Washington, D.C. and London-based management consulting firm), and
from 1979 to 1981, Mr. Hummel served as an executive assistant to United States
Senator John C. Culver.  Mr. Hummel holds a bachelor's degree (with honors) from
the University of Iowa.

Thomas M. Sestak has been a Director of the Company since its inception in 1983,
and was the Secretary of the Company from November 1987 to March 1993.  Mr.
Sestak has also been employed since 1972 as the Chairman and Chief Executive
Officer of Standard Construction of San Francisco, Inc. (a general construction
contractor operating in the greater San Francisco area). Mr. Sestak holds a
B.S.E. degree from The Wharton School at the University of Pennsylvania.

Bo W. Lycke has been a Director of the Company since April 1993.  Since February
1991, Mr. Lycke has been employed as Chairman of the Board and Chief Executive
Officer of Claimsnet.com and its affiliate, National Financial Corporation, each
of which is engaged in providing financial services to various medical
businesses.  Mr. Lycke holds a M.B.A. degree from the University of Goteborg,
Sweden.

James R. Angelica was appointed a Director and Vice President-Sales of the
Company in September 1994, upon the consummation of the Company's acquisition of
Mobile Diagnostic Imaging, Inc. ("MDI"), and was promoted to Senior Vice
President in January 1996.  From June 1991 through September 1994, Mr. Angelica
was the President and Chief Operating Officer of MDI.  From June 1990 through
June 1991, Mr. Angelica was an Executive Vice President of Cost Management
Technologies, a third-party insurance claims administrator headquartered in St.
Louis.  From May 1981 through January 1990, Mr. Angelica was an Executive Vice
President of Group Health Plan, a health insurance administrator headquartered
in St. Louis.  Mr. Angelica holds a bachelor's degree in business administration
from Pacific University.

Bonnie G. Lankford has been Senior Vice President-Operations of the Company
since January 1996, and has been employed  in other management capacities by the
Company at all times since 1985.  Ms. Lankford has received a certification in
echocardiography from Grossmont College,  and is a registered diagnostic medical
sonographer in both echocardiology and obstetrics/gynecology.

Don W. Caughron has been Vice President-Finance of the Company since January
1996, and has been employed in other financial capacities with the Company at
all times since April 1994.  From May 1993 to April 1994, Mr. Caughron was a
self-employed accountant.  From 1990 to 1993, Mr. Caughron was Corporate
Controller for Actuarial Computer Technology, Inc., a privately held Dallas-
based actuarial computer software company.  Mr. Caughron is a Certified Public
Accountant in the State of Texas,  and a member of the Texas Society of CPA's as
well as the American Institute of CPA's.  Mr. Caughron holds a B.B.A. degree
from Texas Tech University.

Christopher L. Turner has been Chief Financial Officer of the Company since
April 1997. Prior to joining the Company, from 1992 to April 1997, Mr. Turner
was a self-employed certified public accountant and a shareholder in the Dallas,
Texas firm of Turner & Turner, P.C. Mr. Turner began his career as an internal
auditor for Interfirst Bank, and also worked for the Texas firm of Philip Vogel
& Co., and the national public accounting firm Grant Thornton. He is a member of
the American Institute of Certified Public Accountants (AICPA) and the Texas
Society of Certified Public Accountants (TSCPA) where he

                                      18
<PAGE>
 
has been active on various committees. Mr. Turner received his BSBA from
Missouri Southern State College in 1983, and Master of Accountancy from the
University of Missouri in 1984, and was granted his CPA license in 1985.

Mark J. Foley has been Vice President - Sales and Marketing of the Company since
April 1997.  Prior to joining the Company, Mr. Foley was General Manager
(Midwest Region) of the Diagnostic Services Division of National Medical Care,
Inc. (and its predecessor company, Mediq Imaging Services) from 1989 to 1997,
where he was responsible for one of that company's largest geographic
territories.  He received a B.S. in Business Administration from Fitchburg State
College in 1984, and a M.B.A., Concentration in Marketing from the University of
Massachusetts, Boston, in 1994.

The Company is not aware of any person who, at any time during the fiscal year
ended December 31, 1998, was a director, officer, or beneficial owner of more
than 10% of the Company's common stock that failed to timely file any reports
required by Section 16(a) of the Exchange Act during the most recent fiscal
year, or prior years, except that (a) following the consummation of the
Company's initial public offering in June 1993, each of the directors and
officers of the Company was late in filing his or her Form 3 (all of which
filings have since been made), and (b) Christopher L. Turner and Mark J. Foley
were late in filing their respective Form 3s upon their becoming executive
officers of the Company (both of which filings have since been made).


ITEM 11.  EXECUTIVE COMPENSATION

The following table sets forth the amount of all compensation paid by the
Company to its Chief Executive Officer and all executive officers who earned
greater than $100,000 in 1998 (the "Named Officers"):

<TABLE>
<CAPTION>
                                                        Other       Restricted
                                                        Annual         Stock     Options/    LTIP       All Other
Name & Principal Position    Year  Salary   Bonus   Compensation(1)    Awards    SAR's (#)  Payouts  Compensation(2)
-------------------------------------------------------------------------------------------------------------------
<S>                          <C>   <C>      <C>     <C>              <C>         <C>        <C>      <C>
Max W. Batzer                1998  380,117  36,000         0              0        15,000       0         253,138
Chairman and CEO             1997  345,000  15,000         0              0       210,000       0               0
                             1996  305,900  20,000         0              0             0       0               0
                                                                                                    
Brad A. Hummel               1998  288,840  27,000         0              0        15,000       0         234,388
President and COO            1997  260,000  10,000         0              0       183,000       0         269,389
                             1996  225,570  15,000         0              0             0       0               0
                                                                                                    
Christopher L. Turner (3)    1998  153,172       0         0              0         1,000       0               0
Chief Financial Officer      1997  103,125       0         0              0       150,000       0          24,640
                             1996       --      --         0              0             0       0               0
                                                                                                    
Bonnie G. Lankford           1998  145,020       0         0              0         2,000       0         135,841
Sr. V.P. - Operations        1997  135,000  16,000         0              0        45,000       0         121,585
                             1996   99,420       0         0              0             0       0               0
</TABLE>

___________________

(1)  Does not include benefits or perquisites in an aggregate amount, as to each
person, which is less than the lesser of $50,000 or 10% of the total salary and
bonus for the subject year.

(2)  Represents compensation arising from the exercise of non-qualified stock
options.

(3)  Represents compensation from commencement of such individual's employment
in 1997.

                                      19
<PAGE>
 
A table detailing the stock options granted to Named Officers and directors is
included under the heading "Stock Option Plans" below.

The Company does not pay directors' fees.  Rather, the Compensation Committee of
the Company's Board of Directors is authorized to consider the grant of non-
qualified stock options to members of the Board, consistent with the Company's
philosophy of incentivizing directors to foster, contribute to and participate
in the Company's growth.

EMPLOYMENT AGREEMENTS
The Company has an employment agreement with Max W. Batzer, pursuant to which
Mr. Batzer is to serve as Chairman of the Company through December 31, 2001.
The agreement provides for payments to Mr. Batzer at the rate of $250,000 per
annum (of which $50,000 per annum is designated as compensation for ongoing
services, and the balance of which is treated as consideration for the
restructuring of his prior employment arrangements with the Company), and
benefits comparable to those provided to other Company employees.  Although Mr.
Batzer presently devotes the majority of his business time to the Company, his
employment agreement permits him to engage in other business activities that are
not competitive with the business of the Company and that do not materially
interfere with his performance of his duties and responsibilities to the
Company.

The Company has an employment agreement with Brad A. Hummel, pursuant to which
Mr. Hummel is to serve as Chief Executive Officer, President and Chief Operating
Officer of the Company through December 31, 2002.  The employment agreement
provides for a minimum base salary of $310,500 per annum, and benefits
comparable to those provided to other Company employees.  The agreement further
provides for Mr. Hummel to devote substantially all of his business time to the
performance of his duties and responsibilities to the Company.  Mr. Hummel's
employment agreement grants him the right to elect, within one year after any
change in control of the Company, to terminate his employment on not less than
90 days' prior written notice, and thereafter receive his salary and benefits
for a period of 24 months or to the scheduled expiration date of such employment
agreement (whichever is later).  Such salary continuation is also applicable in
the event that the Company terminates such individual's employment (other than
"for cause") within one year after any change in control of the Company.  For
purposes of such agreements, a "change in control" is deemed to occur at such
time as 20% of the total outstanding votes eligible to vote for directors of the
Company are owned (legally or beneficially) by any person (or group of persons
acting in concert) who was not a stockholder of the Company as of March 13,
1996.

The Company also has employment agreements with Bonnie G. Lankford, Christopher
L. Turner and Mark J. Foley.  Ms. Lankford's employment agreement (as amended)
calls for her to serve as Senior Vice President-Operations of the Company
through December 31, 1999, at a minimum base salary of $150,000 per annum, and
benefits comparable to those provided to other Company employees.  Mr. Turner's
employment agreement calls for him to serve as Chief Financial Officer of the
Company through March 31, 1999, and provides for a fixed annual salary of
$165,000 per annum and benefits comparable to those provided to other Company
employees.  Mr. Foley's employment agreement calls for him to serve as Vice
President - Sales and Marketing of the Company through May 31, 1999, and
provides for a fixed annual salary of $135,000 per annum, commissions on certain
new account revenues in excess of business development budgets, and benefits
comparable to those provided to other Company employees.

Any increases in the annual rates of compensation of Messrs. Batzer and Hummel
under their employment agreements must be approved by a majority of both the
disinterested directors and the Compensation Committee of the Company's Board of
Directors.

STOCK OPTION PLANS
On April 15, 1992, the stockholders of the Company approved the Company's 1992
Stock Option Plan, as previously adopted by the Company's Board of Directors
(the "1992 Plan"), pursuant to which

                                      20
<PAGE>
 
officers, directors, and/or key employees and/or consultants of the Company can
receive incentive stock options and non-qualified stock options to purchase up
to an aggregate of 903,509 shares of the Company's Common Stock (of which no
more than 180,702 shares may be pursuant to qualified incentive stock options,
and no more than 722,807 shares may be pursuant to non-qualified stock options).
As of March 1, 1999, there are outstanding, under the 1992 Plan, stock options
for an aggregate of 526,601 shares of common stock at exercise prices ranging
from $.93 to $8.625 per share, and expiring at various times from January 1999
through April 2005. The weighted average exercise price under such options is
approximately $1.97 per share. The exercise prices applicable under such
outstanding stock options represent not less than 100% of the fair market value
of the underlying Common Stock as of the date that such options were granted, as
determined from the closing bid price most recently quoted in the over-the-
counter "pink sheets" or on the National Association of Securities Dealers, Inc.
Automated Quotation System ("NASDAQ") prior to the date that such options were
granted.

With respect to incentive stock options, the 1992 Plan provides that the
exercise price of each such option must be at least equal to 100% of the fair
market value of the Common Stock on the date that such option is granted (and
110% of fair market value in the case of stockholders who, at the time the
option is granted, own more than 10% of the total outstanding Common Stock), and
requires that all such options have an expiration date not later than that date
which is one day before the tenth anniversary of the date of the grant of such
options (or the fifth anniversary of the date of grant in the case of 10%
stockholders).  However, with certain limited exceptions, in the event that the
option holder ceases to be associated with the Company, or engages in or is
involved with any business similar to that of the Company, such option holder's
incentive options immediately terminate.  Pursuant to the 1992 Plan, the
aggregate fair market value, determined as of the date(s) of grant, for which
incentive stock options are first exercisable by an option holder during any one
calendar year cannot exceed $100,000.

With respect to non-qualified stock options, the 1992 Plan requires that the
exercise price of all such options be at least equal to 100% of the fair market
value of the Common Stock on the date such option is granted, provided that non-
qualified options may be issued at a lower exercise price (but in no event less
than 85% of fair market value) if the net pre-tax income of the Company in the
full fiscal year immediately preceding the date of the grant of such option (the
"Prior Year") exceeded 125% of the mean annual average net pre-tax income of the
Company for the three fiscal years immediately preceding such Prior Year.  Non-
qualified options must have an expiration date not later than that date which is
the day before the eighth anniversary of the date of the grant of the subject
option.  However, with certain limited exceptions, in the event that the option
holder ceases to be associated with the Company, or engages in or becomes
involved with any business similar to that of the Company, such option holder's
non-qualified options immediately terminate.

The 1992 Plan further provides that non-qualified options may (but need not)
include a provision that, in the event of any change in control and management
of the Company or any sale of the business of the Company, except to the extent
that the subject option holder affirmatively elects, during a limited period of
time following such event, to permanently revoke and terminate the subject non-
qualified option (in whole or in part) and/or to reaffirm all or any portion of
such non-qualified option without giving effect to the reduction in exercise
price herein described, then the otherwise applicable exercise price in respect
of such option may thereafter be reduced (but not by more than 50%) in the event
that, and at such time(s) as, the subject option holder thereafter exercises
such option (or the non-revoked and non-reaffirmed portion thereof, as the case
may be).  As of March 1, 1999, substantially all of the 526,601 outstanding non-
qualified options under the 1992 Plan contain such provision, and this could
have the effect of delaying or hindering potential change in control or sale
transactions, and/or providing additional compensation or consideration to the
subject option holders in connection with any such transaction that may be
consummated.

In April 1995, in response to the substantial increase in the size of the
Company and its labor force, the Board of Directors of the Company adopted and
approved the Company's 1995 Non-Qualified Stock

                                      21
<PAGE>
 
Option Plan (the "1995 Non-Qualified Plan"), pursuant to which officers,
directors, and/or key employees and/or consultants of the Company can receive
non-qualified stock options to purchase up to an aggregate of 500,000 shares of
the Company's common stock. The exercise price, expiration date and other terms
of any options granted under the 1995 Non-Qualified Plan are substantially
similar to the requirements applicable to non-qualified options under the 1992
Plan. As of March 1, 1999, there were outstanding, under the 1995 Non-Qualified
Plan, stock options for an aggregate of 235,000 shares of common stock at
exercise prices ranging from $1.93 to $10.25 per share, and expiring at various
times from December 2000 through January 2006. The weighted average exercise
price under such options is $4.11 per share. Approximately 75% of the
outstanding options under the 1995 Non-Qualified Plan contain price reduction
provisions similar to those described in the immediately preceding paragraph.

The Company also maintains a 1995 Incentive Stock Option Plan ("the 1995
Incentive Plan"), as approved by the Company's stockholders on November 22,
1995, pursuant to which key employees of the Company can receive incentive stock
options to purchase up to an aggregate of 500,000 shares of common stock of the
Company.  The requirements of the 1995 Incentive Plan are substantially
identical to the provisions of the 1992 Plan which are specifically applicable
to incentive stock options, except that the 1995 Incentive Plan will expire on
August 31, 2005 (after which date no further options may be granted under the
1995 Incentive Plan).  As of March 1, 1999, there were outstanding, under the
1995 Incentive Plan, stock options for an aggregate of 237,589 shares of common
stock at exercise prices ranging from $6.25 to $10.69 per share, and expiring at
various times from July 2001 through December 2002.  The weighted average
exercise price under such options is $8.72 per share.

In January 1997, the Board of Directors of the Company adopted the Company's
1997 Non-Qualified Stock Option Plan (the "1997 Non-Qualified Plan"), pursuant
to which officers, directors and/or key employees and/or consultants of the
Company can receive non-qualified stock options to purchase up to an aggregate
of 1,000,000 shares of the Company's Common Stock.  The exercise price,
expiration date and other terms of any options granted under the 1997 Non-
Qualified Plan are substantially similar to the requirements applicable to non-
qualified options under the 1992 Plan.  As of March 1, 1999, there were
outstanding, under the 1997 Non-Qualified Plan, options for an aggregate of
763,861 shares of Common Stock at exercise prices ranging from $7.44 to $10.69
per share and expiring at various times from January 2005 through December 2005.
The weighted average exercise price under such options is $8.71 per share.
Approximately one-third of such options contain price reduction provisions
similar to those described above.

                                      22
<PAGE>
 
The table set forth below lists information on stock options granted to each of
the Company's Named Officers and directors during the year ended December 31,
1998.

<TABLE>
<CAPTION>
 
                                                     Percent of
                                                   Total Options
                                                     Granted to    Exercise
                            Type of      Number     Employees In     Price     Expiration
Name                        Option      of Shares   Fiscal Year    Per Share      Date
-------------------------------------------------------------------------------------------
<S>                      <C>            <C>        <C>             <C>        <C>
Max W. Batzer            Non-qualified     15,000            9.8%      $8.63  June 14, 2005
 
Brad A. Hummel           Non-qualified     15,000            9.8%      $8.63  June 14, 2005
 
James R. Angelica            Qualified      2,000            1.3%      $8.63  June 14, 2003
 
Christopher L. Turner        Qualified      1,000            0.7%      $8.63  June 14, 2003
 
Bonnie G. Lankford           Qualified      2,000            1.3%      $8.63  June 14, 2003
</TABLE>

Through December 31, 1998, a total of 621,534 stock options granted under the
Plans had been exercised (261,415 by executive officers and directors).

The following table sets forth all stock option exercises by Named Officers and
directors of the Company during the fiscal year ended December 31, 1998, the
"value" (i.e., the amount by which the fair market value of the underlying
common stock exceeded the option exercise price on the date of exercise)
realized upon such exercises, the number of remaining options held by Named
Officers and directors of the Company as of December 31, 1998, and the "value"
(i.e., the amount by which the fair market value of the underlying common stock
exceeded the option exercise price) as of December 31, 1998 of all unexercised
stock options then held by Named Officers and directors of the Company.

<TABLE>
<CAPTION>
                           Shares                               Number of                   Value of Unexercised      
                          Acquired          Value              Unexercised                      In-The-Money         
Name                     on Exercise       Realized      Options at Fiscal Year End       Options at Fiscal Year End 
----                     -----------       --------      --------------------------       -------------------------- 
<S>                      <C>               <C>           <C>                              <C>                        
Max W. Batzer             25,000           $253,138                480,505                           $198,068          

Brad A. Hummel            25,000           $234,388                327,645                           $ 50,793          

Thomas M. Sestak              --           $     --                181,645                           $ 93,414          

Bo W. Lycke                   --           $     --                 83,800                           $ 46,259          

James R. Angelica             --           $     --                 20,000                           $     --        

Christopher L. Turner         --           $     --                150,000                           $     --        

Bonnie G. Lankford        17,209           $198,281                 72,000                           $  7,219         
</TABLE>

                                      23
<PAGE>
 
Prior to April 16, 1993, the 1992 Plan was administered by the Company's Board
of Directors. Beginning on April 16, 1993, administration of the 1992 Plan was
delegated to the Compensation Committee of the Company's Board of Directors,
which has wide discretion in determining the recipients of options, the amounts
of options awarded, and various other terms and conditions applicable to options
granted under the 1992 Plan. The 1995 Non-Qualified Plan, the 1995 Incentive
Plan and the 1997 Non-Qualified Plan have at all times been administered by the
Compensation Committee, which has similar wide discretion in the administration
thereof. In determining whether and to what extent specific employees or
consultants will be awarded options, the Compensation Committee takes into
account the value of the specific individual's services to the Company, the
individual's time in service, the long-term prospects for the individual to
handle additional responsibilities within the Company, and such other factors as
the Compensation Committee may deem relevant in order to reward and motivate the
Company's employees and consultants.

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The following table sets forth, as of March 1, 1999, the number of shares of the
Company's Common Stock owned by each person (including any "group" as used in
Section 13(d)(3) of the Exchange Act) known to the Company to be the beneficial
owner of more than five percent of the Company's common stock, each director of
the Company, and all directors and executive officers of the Company as a group.

<TABLE>
<CAPTION>
                                        Beneficially
Name and Address of Beneficial Owner        Owned      Percentage
------------------------------------    ------------   ----------
<S>                                    <C>             <C>
Max W. Batzer                            635,255 (1)          5.3%
 2777 Stemmons                                       
 Dallas, Texas 75207                                 
Thomas M. Sestak                         308,066 (2)          2.6%
 1226 Ninth Avenue                                   
 San Francisco, California 94122                     
Brad A. Hummel                           336,238 (3)          2.8%
 2777 Stemmons                                       
 Dallas, Texas 75207                                 
Bo W. Lycke                               84,800 (4)          0.7%
 2777 Stemmons                                       
 Dallas, Texas 75207                                 
James R. Angelica                        335,052 (5)          2.7%
 9717 Landmark Parkway Drive
 St. Louis, Missouri 63127
All directors and executive officers
 as a group (ten persons)              1,987,322 (6)         15.5%
</TABLE>

__________________

(1) Includes 480,505 shares which are subject to stock options exercisable
    within 60 days.
(2) Includes 452 shares held by Mr. Sestak as custodian for his minor children,
    and 181,645 shares which are subject to stock options exercisable within 60
    days.
(3) Includes 327,645 shares which are subject to stock options exercisable
    within 60 days.
(4) Includes 83,800 shares which are subject to stock options exercisable within
    60 days.
(5) Includes 20,000 shares which are subject to stock options exercisable
    within 60 days. Of the 335,052 outstanding shares, 116,800 are held jointly
    by Mr. Angelica and his spouse.
(6) Includes 1,345,595 stock options exercisable within 60 days.

                                      24
<PAGE>
 
ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
In October 1989, Max W. Batzer, Thomas M. Sestak and Brad A. Hummel borrowed
$66,000, $10,000 and $33,000, respectively, from the Company. The proceeds of
these loans were utilized by Messrs. Batzer, Sestak and Hummel to purchase
shares of common stock. The loans were amended and restated as of January 1,
1993, such that the loans now bear simple interest at a certain bank's prime
rate (adjusted annually for purposes of the loans), with payment of all
principal and accrued interest due on December 31, 2000. Mr. Sestak's loan was
repaid in full in October 1993. Mr. Batzer's and Mr. Hummel's loans are non-
recourse, and are secured solely by shares of common stock of the Company having
an aggregate market value equal to 50% of the outstanding loan obligations
(provided that the number of shares pledged as collateral will never exceed the
number of shares (185,265 in the case of Mr. Batzer, and 92,633 in the case of
Mr. Hummel) purchased with the proceeds of the loans. The Company has retained a
right of first refusal in connection with any proposed sale of the pledged
shares while they remain subject to such pledge, although the Company is
prohibited, under its loan agreement with Chase Bank of Texas, N.A. ("Chase"),
to redeem or purchase any shares of its common stock without Chase's prior
consent.

In April 1996, in connection with the Company's private placement of the Bridge
Notes and Bridge Warrants, an aggregate of $50,000 of Bridge Notes and 2,500
Bridge Warrants were purchased by James R. Angelica, and $100,000 of Bridge
Notes and 5,000 Bridge Warrants were purchased by Thomas M. Sestak. All of such
Bridge Notes have since been repaid, and all of such Bridge Warrants have since
been exercised.

                                      25
<PAGE>
 
                                    PART IV
                                    -------

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

Item 14(a) (1), 14(a) (2) and 14(d):

The following financial statement schedule is filed as a part of this Report at
page 29 hereof:

  Schedule II - Valuation and Qualifying Accounts

All other schedules are omitted because they are not required, not applicable or
the information is included in the consolidated financial statements and notes
thereto.

Item 14(a) (3) and 14(c)


Exhibits          Description of Exhibit
--------          ----------------------
3.1               Certificate of Incorporation of the Company, as amended. (1)

3.2               By-Laws of the Company. (1)

3.3               Certificate of Amendment of Certificate of Incorporation of
                  the Company, authorizing preferred stock of the Company. (2)

3.4               Certificate of Stock Designation, creating Series A Preferred
                  Stock. (4)

4.1               1992 Stock Option Plan, including forms of qualified incentive
                  stock option agreement and non-qualified stock option
                  agreement. (1)

4.2               Form of Underwriter's Warrant. (1)

4.3               Specimen Form of Share Certificate. (1)

4.4               1995 Nonqualified Stock Option Plan.  (2)

4.5               1995 Incentive Stock Option Plan. (2)

4.6               Form of Bridge Warrant and Bank Warrant. (3)

4.7               1997 Non-Qualified Stock Option Plan. (5)

10.1              Employment Agreement, dated November 1, 1991 between the
                  Company and Max W. Batzer. (1)

10.2              Amendment, dated March 13, 1996, to Employment Agreement
                  between the Company and Max W. Batzer. (3)

10.3              Amendment, dated January 1, 1998, to Employment Agreement
                  between the Company and Max W. Batzer. (8)

10.4              Employment Agreement, dated November 1, 1991, between the
                  Company and Brad A. Hummel. (1)

10.5              Amendment, dated March 13, 1996, to Employment Agreement
                  between the Company and Brad A. Hummel. (3)

10.6              Amendment, dated January 1, 1998, to Employment Agreement
                  between the Company and Brad A. Hummel. (8)

10.7              Lease Agreement for Dallas headquarters. (1)

10.8              Agreement between the Company and Northeast Community Hospital
                  (Bedford, Texas). (1)

10.9              Agreement between the Company and Central Texas Medical Center
                  (San Marcos, Texas). (1)

                                      26
<PAGE>
 
10.10             Contingent Share Agreement between the Company and former
                  owner of Medmark. (2)

10.11             Contingent Payment Agreement between the Company and the
                  former owner of Reliascan.  (2)

10.12             Contingent Share Agreement between the Company and the former
                  stockholder of HDII.  (2)

10.13             Amended and Restated Loan Agreement, dated as of July 24,
                  1996, among the Company, its subsidiaries and Chase Bank of
                  Texas, N.A., formerly Texas Commerce Bank National Association
                  ("Chase"). (5)

10.14             Asset Purchase Agreement, dated September 27, 1996, by and
                  among the Company, DHS Management Services, Inc., Advanced
                  Clinical Technology, Inc., Horizon MDS Corporation, and
                  Horizon/CMS Healthcare Corporation. (4)

10.15             Asset Purchase Agreement, dated March 21, 1997 (but as of an
                  effective date of March 1, 1997), relating to first DIS
                  acquisition. (6)

10.16             Stock Purchase Agreement, dated March 21, 1997, relating to
                  the second DIS acquisition. (7)

10.17             Note Agreement, dated as of April 16, 1997, between the
                  Company and Prudential. (7)
 
10.18            Second Amended and Restated Loan Agreement, dated as of
                 December 31, 1998, among the Company, its subsidiaries and
                 Chase.

10.19            First Amendment to Note Agreement, dated as of December 31,
                 1998, between the Company and Prudential.

10.20            Amended Employment Agreement, dated January 8, 1999, between
                 the Company and Max W. Batzer.

10.21            Agreement and Plan of Merger, dated February 18, 1999, between
                 the Company and Medical Alliance, Inc.
                 
11.1             Statement re: computation of per share earnings.

21.1             Subsidiaries of the Company.

27               Financial Data Schedule (Securities and Exchange Commission
                 EDGAR filing only)
 
___________________

(1)  Incorporated by reference, filed as an exhibit to Amendment No. 2 to the
     Company's Registration Statement on Form SB-2 filed on June 11, 1993, SEC
     File No. 33-61392-FW.

(2)  Incorporated by reference, filed as an exhibit to the Company's report on
     Form 10-KSB filed on April 1, 1996.

(3)  Incorporated by reference, filed as an exhibit to the Company's
     Registration Statement on Form SB-2 filed on April 25, 1996, SEC File No.
     333-4034.

(4)  Incorporated by reference, filed as an exhibit to the Company's report on
     Form 8-K filed on November 26, 1996.

                                      27
<PAGE>
 
(5)  Incorporated by reference, filed as an exhibit to the Company's report on
     Form 10-KSB filed on March 31, 1997.

(6)  Incorporated by reference, filed as an exhibit to the Company's report on
     Form 8-K filed on April 4, 1997.

(7)  Incorporated by reference, filed as an exhibit to the Company's report on
     Form 8-K filed on May 2, 1997.

(8)  Incorporated by reference, filed as an exhibit to the Company's report on
     Form 10-KSB filed on March 31, 1998

Item 14(b):

No reports on Form 8-K were filed by the Company during the fourth quarter of
the Company's 1998 fiscal year.

                                      28
<PAGE>
 

               DIAGNOSTIC HEALTH SERVICES, INC. & SUBSIDIARIES.
               ------------------------------------------------
                                        
                 SCHEDULE II - VALUATION OF QUALIFING ACCOUNTS
                 ---------------------------------------------
                                        
<TABLE>
<CAPTION>
 
 
                                   Balance at  Acquisitions   Charged    Charged               Balance at
                                   beginning       and           to      to other                end of
                                   of period   dispositions  operations  accounts  Deductions    period
                                   ----------  ------------  ----------  --------  ----------  ----------
<S>                                <C>         <C>           <C>         <C>       <C>         <C>
 
Year ended December 31, 1998
Allowance for doubtful accounts    $  612,437  $     14,124  $1,913,004  $864,637  $1,975,566  $1,428,636
                                   ==========  ============  ==========  ========  ==========  ==========
 
Year ended December 31, 1997
Allowance for doubtful accounts    $1,413,168  $    349,501  $  890,161  $     --  $2,040,393  $  612,437
                                   ==========  ============  ==========  ========  ==========  ==========
 
Year ended December 31, 1996
Allowance for doubtful accounts    $  114,817  $  1,871,649  $   40,970  $     --  $  614,268  $1,413,168
                                   ==========  ============  ==========  ========  ==========  ==========
 
</TABLE>

                                      29
<PAGE>
 
                                  SIGNATURES

In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this report to be signed on its behalf by the undersigned, thereunto duly
authorized.

Dated:  March 16, 1999

                       DIAGNOSTIC HEALTH SERVICES, INC.



                       By: /S/ Max W. Batzer
                           ---------------------------------------
                           Max W. Batzer, Chairman

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

<TABLE> 
<CAPTION> 
         Signature                    Title                                     Date
--------------------------    ---------------------                   -------------------------
<S>                           <C>                                     <C> 
/S/ Max W. Batzer
--------------------------
Max W. Batzer                 Chairman and Director                   March 16, 1999


/S/ Brad A. Hummel
--------------------------
Brad A. Hummel                Chief Executive Officer, President,     March 16, 1999
                              Chief Operating Officer and Director


/S/ Christopher L. Turner
--------------------------
Christopher L. Turner         Chief Financial Officer and             March 16, 1999
                              Principal Accounting Officer

/S/ Bo W. Lycke
--------------------------
Bo W. Lycke                   Director                                March 16, 1999
</TABLE> 

                                      30