<PAGE>

Conformed
---------
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
                                  FORM 10-K

                Annual Report Pursuant to Section 13 or 15(d)
                    of the Securities Exchange Act of 1934

      For the Fiscal Year Ended 12/31/96  Commission File Number 0-21752

                       Northstar Health Services Inc..
       ---------------------------------------------------------------
            (Exact name of registrant as specified in its charter)


                   Delaware                          25-1697152
       ---------------------------------      ------------------------
        (State or other jurisdiction of           (I.R.S. Employer
         incorporation or organization)        Identification Number)


         665 Philadelphia Street,    Indiana Pennsylvania      15701
       ---------------------------------------------------------------
         (Address of principal executive offices)           (Zip Code)

      Registrant's telephone number, including area code (412) 349-7500
                                                         --------------

         Securities registered pursuant to Section 12(b) of the Act:
          Common Stock, $.01 par value          NASDAQ*
          -----------------------               ------

*Due to circumstances described herein, the common stock was delisted on May 31,
                        1996 and currently trades OTC.

       Securities registered pursuant to Section 12(g) of the Act: None
                                                                   ----


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

 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 voting stock held by nonaffiliates of the
                        registrant as of March 21, 1997:

                  Common Stock, $.01 par value -- $ 12,388,590
 As of December 31, 1996, 5,867,154 shares of common stock, par value $.01 per
                            share, were outstanding.

                  Exhibit index is located on pages 42 to 43.
<PAGE>

Forward-Looking Statements

          From time to time, the Company will publish forward-looking statements
relating to such matters as anticipated financial performance, business
prospects, and projected plans for and results of its operations.  The Private
Securities Litigation Reform Act of 1995 provides a safe harbor for forward-
looking statements.  In order to comply with the terms of the safe harbor, the
Company notes that a variety of factors could cause the Company's actual results
to differ materially from the anticipated results or other expectations
expressed in the Company's forward-looking statements.  The risks and
uncertainties that may affect the operations and performance of the Company's
business include the following: changes in regulatory, governmental and payor
policies regarding reimbursement; competition, both directly in terms of other
providers of physical therapy and other services, and the competition for
qualified personnel; the outcomes of the current litigation involving the
Company, as well as its former and current officers and directors; defaults in
bank financing, including an inability to comply with various covenants in
connection with such financing; the ability of the Company to have its common
stock relisted on a recognized exchange; and the uncertainties surrounding the
health care industry in general.                                   .

Item 1.     Business
--------------------

          In addition to other sections of this document, this Business section
contains the type of forward-looking statements and projections discussed above
and must be read in connection with those disclosures.

General

          Northstar Health Services, Inc., a Delaware corporation ("Northstar"
or the "Company"), is a regional provider of rehabilitation therapy, mobile
diagnostics and related services at outpatient rehabilitation clinics and
patient care facilities in Western Pennsylvania, parts of West Virginia, Ohio,
and Illinois.  It provides services to patients suffering from physical
disabilities.  The goals of rehabilitation therapy are to improve a patient's
physical strength and range of motion, reduce pain, prevent injury, and restore
the ability to perform basic activities, including communication.  The Company
believes that rehabilitation therapy improves patient outcomes and shortens a
patient's recovery time and, as a result, has gained increasing recognition by
payors as both a clinically effective and a cost-effective means to lower total
health care expenses.

          The Company's strategy is to become the dominant provider of
rehabilitation therapy and diagnostic therapy  within its geographic market.  In
implementing this strategy, the Company continues to focus on acquiring
outpatient rehabilitation clinics and expanding the range of services it
provides.  The Company believes that a geographically focused strategy
efficiently utilizes its existing corporate structure and positions the Company
as a preferred rehabilitation provider to referring physicians, hospitals, and
managed care organizations.  This strategy is further enhanced via the Company's
ability to broaden the scope of  its mobile diagnostics and subacute contract
rehabilitation to referring physicians, hospitals, nursing homes, managed care
organizations and insurance companies.

          Between 1991 and December 31, 1996, the number of outpatient
rehabilitation clinics the Company operates has increased from zero to 62 and
the Company has increased the number of its contracts with patient care
facilities from 25 to 75.  In November 1993, the Company completed three
acquisitions that

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added 7 outpatient rehabilitation clinics and 23 contracts with patient care
facilities to its operations.  In addition, in July 1994, the Company completed
the acquisition of substantially all of the assets of Medical Rehabilitation
Services, Ltd. and two affiliated entities ("MRS"), which added five outpatient
rehabilitation clinics and two contracts with patient care facilities to its
operations.  On November 15, 1995, the Company completed its merger with
Keystone Rehabilitation Systems, Inc.  of Indiana, Pennsylvania ("Keystone").
Unless otherwise specified, references herein to the "Merger" are to the
Keystone merger. The Merger added 50 outpatient rehabilitation clinics and 24
contracts with patient care facilities. On December 1, 1995, the Company
completed the acquisition of Penn Vascular Labs ("PVL"), which performs
diagnostic, x-ray and other ultrasound services in seven fixed site clinics and
at 45 contracted facilities.

          The outpatient rehabilitation industry is experiencing significant
consolidation, due primarily to the highly fragmented nature of the industry and
the preference of managed care organizations to contract with regional providers
offering comprehensive, cost-effective programs.  The Company believes it is
well positioned to grow within the present industry environment.  During 1996,
present management completed a restructuring of the Company's corporate and
outpatient operations to position it to manage existing and emerging
opportunities in its primary markets.  In connection with such restructuring,
four operating subsidiaries were organized:

 .  Ability Plus Rehabilitation Management Company, Inc. ("Ability Plus")
   provides contracted sub-acute care to entities in need of such services.
   Ability Plus has the capacity to supply rehabilitation services to nursing
   homes and hospitals in arrangements that capitalize on the entities' current
   abilities to provide such services and enhance them to sub-acute
   capabilities. Ability Plus can potentially save a facility capital
   investment and human resource expenses by transitioning its existing base of
   beds in service to a planned number dedicated to sub-acute care.

 .  Direct Provider Network, Inc. is a sales and marketing entity organized to
   contract with third party payors, self-insured companies and managed care
   organizations that contract for the Company's services on a state, regional,
   or local basis.

 .  Keystone Rehabilitation Systems, Inc. provides outpatient rehabilitation,
   primarily to ambulatory patients at 58 outpatient sites specializing in
   orthopedics, sports and neurologic rehabilitation. Keystone utilizes physical
   therapists, occupational therapists and speech therapists to provide its
   services. Keystone also contracts with hospitals, nursing homes, home health
   agencies, personal care homes and school districts to provide physical
   therapy, occupational therapy, speech language pathology and Athletic
   Training services. Keystone is one of the largest providers of outpatient
   rehabilitation services in Pennsylvania. During the reorganization, the
   Company closed and consolidated 4 outpatient sites secondary to overlap of
   services with the Keystone Merger and existing Northstar facilities.

 .  Northstar Medical Services, Inc. and Northstar Diagnostic Services, Inc. were
   organized to consolidate the diagnostic division with its joint ventures.
   Northstar Medical Services provides multiple mobile diagnostic services
   including mammography, ultrasound and echocardiography to physicians,
   nursing homes and industries.  The combined network of services including
   its joint ventures represent the largest mobile diagnostic company in
   Southwestern Pennsylvania.  The Company also operates six freestanding
   diagnostic centers in Western Pennsylvania.  Services are available via a
   complete mobile fleet for occupational testing at industrial sites and in
   physician

                                       3
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   offices where patient convenience is emphasized.

          The Company's executive and operating management group has substantial
business operating and health care management experience.

          The Company believes that the growth in the outpatient medical
services and rehabilitation industry is largely the result of: (i) the
effectiveness of rehabilitation therapy; (ii) increasing emphasis on physical
fitness and the treatment of sports injuries; (iii) the aging population; and
(iv) earlier patient discharge from acute care hospitals to alternate sites.

Industry Background

          Rehabilitation is the process of restoring an optimum level of
physical capability to individuals suffering from disabilities.  Rehabilitation
therapy services are provided on an inpatient or outpatient basis, depending on
the type and severity of the physical disability.  Outpatient rehabilitation
therapy services are generally provided by licensed therapists in hospitals,
patient care facilities, and outpatient rehabilitation clinics, including those
owned by various national, regional and local companies.

          The Company believes that the rehabilitation therapy industry is
experiencing significant growth primarily as a result of the following factors:

          .  The Effectiveness of Rehabilitation Therapy.  Rehabilitation
             therapy is recognized by physicians and payors as a cost-effective
             method to reduce future health care expenses, shorten the
             recuperation time for injuries, reduce the likelihood of reinjury,
             and enable patients to regain skills necessary to return to
             independent living and a working environment. Additionally,
             rehabilitation therapy may result in significant savings by
             reducing the need for ongoing in-patient health care services and
             other related costs.

          .  Increasing Emphasis on Physical Fitness and the Treatment of Sports
             Injuries.  The growing emphasis on physical fitness, leisure
             sports, and conditioning, such as running and aerobics, has led to
             increased injuries requiring rehabilitation therapy and increased
             avenues for prevention.

          .  The Aging Population.  The aging population is expected to increase
             the demand for rehabilitation therapy.  As a person ages, he or
             she becomes more susceptible to both neurologic and
             orthopedic-related ailments, including osteoporosis, which may
             result in the type of injury or loss of function which can be
             aided by rehabilitation therapy.  The aging population is also
             active longer in their lifespan.

          .  Earlier Patient Discharge From Acute Care Hospitals to Alternate
             Sites.  The trends toward earlier patient discharge from acute
             care hospitals to sub-acute sites, from patient care facilities to
             outpatient care, and from hospital-based care to clinic-based and
             home-based treatment programs, have all increased the demand for
             rehabilitation therapy, mobile and fixed, as well as mobile
             diagnostic services.

          The Company believes that the demand for rehabilitation therapy
services will be favorably affected by the recognition of rehabilitation therapy
as both a clinically and a cost-effective method of

                                       4
<PAGE>

treating certain types of disabilities.  However, the Company also believes that
this market will be characterized by increased cost containment pressures and
the growing influence of managed care organizations, other third-party payors
and state government mandated workers' compensation programs in the selection of
rehabilitation service providers.

          Prices for rehabilitation therapy services have increasingly become
regulated by government or dictated by third-party payors who are capping or
reducing reimbursement rates for rehabilitation therapy services.  Such entities
are seeking to contract with rehabilitation therapy services providers capable
of delivering a full continuum of care at the lowest cost.  Accordingly,
marketing directly to these entities will become increasingly important.

          State governments mandate and regulate programs that require employers
to pay the costs for medical services, lost wages and other expenses resulting
from work-related injuries and disabilities through the purchase of insurance
from private workers' compensation insurance carriers, participation in a state
fund, or self insurance.  The costs associated with an injury often include
compensation for lost wages.  Consequently, there has been increased demand for
comprehensive and sophisticated rehabilitation therapy services, such as work
reconditioning and functional capacity assessment, which reduce the time
required to return a person to the workplace.  The Company believes that these
types of insurers will continue to represent a significant portion of the
Company's business.

          In addition, the Company believes that the rehabilitation industry is
highly fragmented and experiencing significant consolidation.  Growing
legislative and payor pressure to prohibit or limit referrals by physicians to
entities in which they have a financial interest is leading physicians to divest
themselves of their rehabilitation therapy practices.  As a result, many sole
practitioners and owners of small groups of outpatient rehabilitation clinics
are selling such clinics to larger organizations or establishing networks of
outpatient rehabilitation clinics within a geographic area.

Rehabilitation Services

          The Company utilizes licensed therapists and therapist assistants, to
provide physical, occupational and speech therapy to patients with
musculoskeletal injuries, physical disabilities associated with neurological
disorders, and post-surgical rehabilitation.  The following is a brief
description of rehabilitation therapy services offered by the Company:

          .  Physical Therapy.  Physical therapy is the evaluation and treatment
             of physical disabilities designed to improve a patient's physical
             strength, range of motion, and mobility.  Treatments include
             exercise and the application of modalities such as heat, cold,
             water, sound, and electricity.

          .  Occupational Therapy.  Occupational therapy is the evaluation and
             treatment of physical and cognitive deficiencies with the goal of
             improving self-care, work and leisure skills. Candidates for this
             treatment include people who have suffered traumatic injuries,
             have disease-related disabilities, or who have underdeveloped
             physical and cognitive skills. Occupational therapists use a
             variety of treatment techniques, including using therapeutic
             exercises and activities, designing and fabricating adaptive
             equipment (such as splints and custom-made handles for utensils)
             and teaching compensatory techniques to help these individuals
             achieve their potential for independent, productive living.

                                       5
<PAGE>

          .  Speech Therapy.  Speech therapy is the evaluation and treatment of
             speech, language, voice and swallowing disorders arising from
             strokes, head injuries, degenerative neurological disorders,
             developmental deficits, cancer and hearing impairment.  Speech
             therapists use treatment techniques such as thermal stimulation,
             muscle re-education, and hearing and/or speech aid through visual
             communication devices.

          .  Work Reconditioning.  Work reconditioning is a rehabilitation
             program that simulates the specific job activities of an injured
             worker in order to prepare the worker to return to work and
             addresses issues of productivity, safety, physical tolerances and
             worker behavior.  The goal is to prepare the patient to work a
             complete workday safely and without injury.  The Company utilizes
             a standardized industrial rehabilitation program at all of its
             sites to improve both patient and payor acceptance.

          .  Functional Capacity Assessment.  Functional capacity assessment is
             the evaluation of an existing or prospective employee's physical
             condition and endurance and of the ability to meet the
             requirements of employment.  The assessment may be used by
             employers, insurers and other payors to estimate the extent of
             rehabilitation treatment needed or as an objective method of
             evaluating specific work capacity.

          .  Pain Management.  Pain management programs are used to assist
             patients in the use of compensatory motor patterns and other
             coping mechanisms to minimize or eliminate the debilitating
             effects of acute and chronic pain.

          .  Diagnostic Services.  The Company performs non-invasive mobile
             testing at client facilities and at seven fixed sites. Tests
             performed include x-ray, mammography, echocardiography with
             Doppler, Abdominal and Pelvic sonograms, Carotid Duplex, Peripheral
             Vascular Thyroid and Breast Imaging, Osteoporosis -Bone Mineral
             Densitometry, and nuclear cardiology. Northstar Medical Services,
             Inc. employs Board Certified Cardiologists and Board Certified
             Radiologists.

          .  Preventive Services.  The Company also provides services designed
             to prevent or avoid injuries in the workplace.  These preventive
             services, which may be performed at an employer's work site,
             include programs to teach employees proper body mechanics and
             techniques and detailed analysis of specific job activities, such
             as lifting, with the goal of changing how a job is performed to
             prevent injuries to employees.  Although preventive services
             currently provide only a small amount of revenue for the Company,
             the Company believes pressure by insurers and managed care
             organizations to limit the cost of health care and requirements
             imposed on employers under the Americans with Disabilities Act may
             cause such industrial consulting to become more prevalent in the
             future.

Operations

          Outpatient Rehabilitation Clinics.  The Company currently owns and
operates 62 outpatient rehabilitation clinics in Pennsylvania, Ohio and West
Virginia at which the Company provides a wide range of outpatient rehabilitation
therapy services.  The Company leases or purchases equipment for the outpatient
rehabilitation clinics, provides licensed therapists, therapist assistants,
certified aides and related personnel, while coordinating the establishment and
maintenance of patient records, billings to third-party

                                       6
<PAGE>

payors, and management and operations of such clinics.  Although the amount and
type of equipment for each such clinic may vary, such equipment typically
includes whirlpools, electric stimulation and ultrasound units, exercise
machines and hot and cold pack units.

          The outpatient rehabilitation clinics are dependent upon patient
referrals from various sources within their communities, including orthopedists,
internists, neurologists, physiatrist, chiropractors, hospital discharge
planners, community organizations and insurance company case managers.
Referrals also come from non-physician sources, including insurance companies,
managed care organizations, lawyers and employers.  Management believes that its
use of direct mail advertising and personal visits with referral sources
increase physician referrals.  The Company's ability to attract managed care and
other third-party payor contracts in multiple locations is aided by its large
geographical market, central billing and collections, and direct marketing to
payors through Direct Provider Network.

          Contract Rehabilitation and Diagnostic Services.  As of December 31,
1996, the Company had contractual arrangements with 120 patient care entities,
including nine acute care hospitals.  Under these contracts, the patient care
facility generally furnishes the space for the rehabilitation therapy center,
and the Company provides all other necessary services, including the appropriate
rehabilitation therapies and diagnostic services, on-site management, billing
and collections,  staff recruitment, continuing education, insurance, and
quality assurance.  The Company provides complete "turn-key" operations to allow
its patient care facilities to offer advanced rehabilitation therapies without
incurring the financial and operational risks associated with start-up costs,
capital expenditures and therapist recruitment.  The Company is compensated
under such contracts on a fee-for-service basis and typically collects payment
for services directly from the patient care facility, which in turn receives
reimbursement from other third-party payors, or bills and collects from the
payor directly.  The Company has two joint ventures with hospitals and believes
that this risk sharing proposition gives it long-term stability in certain
markets.

          Generally, the Company enters into one-year or indefinite-term
contracts for medical rehabilitation services, cancelable by either party upon
as few as 30 days' notice and renewable from year to year.  The Company believes
that its contract renewal rate is competitive in the industry.

Business Strategy

          The Company is seeking to become the dominant provider of
rehabilitation therapy and mobile diagnostic services within its geographic
market through strategic alliances as well as acquisitions.  This strategy is
based on the Company's belief that managed care organizations and other third-
party payors prefer to contract for  service providers offering multiple
services within their geographic area.  Key elements of the Company's business
strategy are summarized below.

          .  Maintain Regional Presence.  The Company provides both inpatient
             and outpatient rehabilitation therapy and related services and
             thus seeks to position itself as the preferred option for
             physicians, hospitals and managed care organizations at its
             locations.

          .  Expand Geographic Focus.  The Company intends to further expand
             operations in Pennsylvania and states such as Ohio, West Virginia
             and Illinois. This growth within the Company's regional market
             will allow the Company to maintain its present cost structure and
             continue to maximize the productivity of therapists within its
             market.  Expanding services through affiliated providers will give
             our geographical presence more clout with

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             payors.

          .  Expand Referral Sources.  The Company seeks to expand the referral
             base of the outpatient rehabilitation clinic by aggressively
             marketing its rehabilitation therapy services to local and
             regional referral sources such as physicians, orthopedic surgeons,
             insurance companies, managed care organizations, lawyers and
             employers.  As part of its strategy, the Company is cross-selling
             services between rehabilitation and mobile diagnostics.

          .  Alignment with Physician Practices.  As part of its business
             strategy, the Company is looking to more closely align itself with
             physician practices, either through management service
             arrangements or through providing diagnostic services in their
             offices.

          .  Expand Contracts With Managed Care Organizations.  As managed care
             organizations become more prevalent in the marketplace, outpatient
             rehabilitation service providers will need to deliver a
             comprehensive range of services in a cost-effective manner with
             multiple locations within a metropolitan area or region.  The
             Company intends to market aggressively to these organizations, by
             providing a complete continuum of care.

          .  Expand Contracts With Patient Care Facilities.  The Company
             continues to seek additional contracts with, as well as expand the
             range of services it offers to, patient care facilities.

          .  Increase Range of Services.  The Company provides a wide range of
             services, including physical, occupational, and speech therapies
             and intends to increase our more specialized treatments such as
             hand therapy, aquatic therapy, sports therapy, neurological
             therapy and incontinence therapy.  Due to the Company's geographic
             focus, the Company will be able to hire a limited number of
             specialists to serve the Company's entire network from a
             centralized location. The Company believes that the additional
             specialized therapies will make it an attractive provider of
             rehabilitation therapy services to physicians, hospitals and
             managed care organizations.


          .  Increase Efficiency of Operations.  The Company has substantially
             completed the centralization of  accounting, payroll, certain
             other administrative activities, and the billing and collection
             process using standardized procedures.  The Company has also
             developed, and is in the process of implementing, systems designed
             to enhance productivity by standardizing and automating certain
             administrative functions at the outpatient rehabilitation clinic
             level.


Mergers, Acquisitions and Joint Ventures

          The Keystone Merger. On November 15, 1995, NSK Merger Corp., a newly-
formed subsidiary of the Company, was merged with and into Keystone.  Prior to
this Merger, Keystone was the largest privately held rehabilitation company in
Pennsylvania, providing services in physical, occupational and speech therapy,
including sports rehabilitation and work hardening in outpatient clinics, as
well as in patient care facilities, located throughout Pennsylvania and in New
York, Ohio and West Virginia.

                                       8
<PAGE>

          As a result of the Merger, the Company acquired substantially all of
the assets of Keystone, including accounts receivable of approximately
$5,300,000 and net assets used in the rehabilitation business of approximately
$2,300,000.  The company intends to continue to utilize these assets in the same
manner as did Keystone.  The liabilities of Keystone at the time of the Merger,
were certain current and non-current liabilities (which will be offset against
certain earn-out payments to be made in the future as discussed below) and
capital leases of approximately $1,200,000.

          As consideration for the Merger, the shareholders of Keystone, Thomas
W. Zaucha and Alice L. Zaucha and the Zaucha Family Limited Partnership
(collectively, the "Zaucha Shareholders"), received the following: (a)
$2,500,000  in cash; (b) a time note due January 3, 1996 in the aggregate
principle amount of $5,100,000;(c) a five-year, interest free term note in the
aggregate principal amount of $2,625,000; (d) the agreement by the Company to
issue, on January 3, 1996, a three-year, 6% term note in the aggregate principle
amount of $2,400,000 (the "Three-Year Note"); and (e) the agreement by the
Company to issue to the Zaucha Shareholders, on January 3, 1996, an aggregate of
944,352 shares of the Company's common stock, par value $.01 per share (the
"Zaucha Stock Consideration").

          In connection with the Merger, the Company (i) guaranteed the value of
the Zaucha Stock Consideration to be at least $5,600,000 through certain periods
ending no later that December 31, 1997; (ii) agreed to seek necessary
stockholder approval to allow the Three-Year Note to be converted into common
stock at the conversion price of $5.93 per share and to pay any guaranteed
amount in additional shares of Northstar common stock based on the trading price
of the common stock at the time of issuance; and (iii) issued a five-year
interest free note to David D. Watson, formerly Keystone's Chief Operating
Officer and Executive Vice President, in the aggregate principal amount of  $
375,000.

          The Company also agreed to make additional "earn-out" payments to the
Zaucha Shareholders of $1,600,000 per year in the event that Keystone's "EBITA"
exceeds $2,500,000 in any year from 1996 to 2000, inclusive.  EBITA is defined,
generally, to mean Keystone's earnings (including earnings from any internally
generated facility or contract but excluding earnings from any facility or
contract acquired from third parties) before taxes, interest, depreciation and
amortization.  In the event an earn-out is not earned and therefore not paid in
any given year, the earn-out will be paid in the next year if EBITA in such next
year exceeds the greater of $3,200,000 or $2,500,000  plus the amount of the
EBITA shortfall in such prior year.  Additionally, the Zaucha Shareholders could
receive an earn-out of up to approximately $270,000 in the event that Keystone's
EBITA for 1995 exceeds $2,500,000 million (as adjusted to exclude certain pre-
Merger expenses that will not recur).  The earn-out amounts for years 1996
through 2000 will be reduced if Keystone's accounts receivable at the date of
the Merger were less than $5,000,000 and in the event that the current
liabilities of Keystone at the date of the Merger (other than permitted capital
leases) exceeded $2,000,000.   In addition, such earn-out payments will be
reduced by 50% of such current liabilities up to $2,000,000.

          At the time of the Merger, the Company paid $2,500,000 in cash to the
Zaucha Shareholders and deposited $5,100,000 in a cash collateral account with a
bank to support a letter of credit securing the Company's obligation to pay the
Zaucha Shareholders $5,100,000 on January 3, 1996.  The Company borrowed
$3,500,000 of such amounts under the $6,500,000 acquisition line portion of its
existing $16,000,000 credit facility with IBJ Schroder Bank and Trust Company
("IBJ").  The remainder of the funds required at the  time of the Merger were
provided from working capital.

          Immediately prior to the Merger, Keystone transferred to the Zaucha
Family Limited Partnership,

                                       9
<PAGE>

of which Thomas W. Zaucha is a general partner, all of the real estate owned by
Keystone for approximately $5,000,000, which funds were used to pay off real
estate and other debt owed to a bank by Mr. Zaucha.  In connection with the
Merger, the parcels of such real estate used in Keystone's business were then
leased to Keystone by Zaucha.

          As part of the Merger, the Company paid a broker fee of $1,350,000 to
CFC Financial, Inc., an entity related to Mr. DeSimone. This obligation was
satisfied by the issuance of 150,000 shares of the Company's common stock and
$450,000 in cash.

          As part of the Merger, certain of the executive officers of Keystone
entered into employment agreements with and became executive officers of the
Company.  Thomas W. Zaucha, who formed Keystone in 1981, became the Chief
Executive Officer of the Company.  David D. Watson, the former Chief Operating
Officer of Keystone, became the President of the Company.  Lisa S. Guarino, the
Chief Financial Officer of Keystone, became the Chief Financial Officer and
Executive Vice President of the Company.  Brian K. Strong remained the Chief
Operating Officer of the Company and Michael J. Kulmoski, Jr., formerly Chief
Financial Officer and Treasurer, became Executive Vice President of Corporate
Development.  Additionally, within thirty (30) days of the Merger, Thomas W.
Zaucha and Steven N. Brody, a director of Keystone, joined Mark A. DeSimone, the
Chairman of the Board of Directors of the Company, and Michael P. Pitterich, an
outside director, as the four members of the Board of Directors of the Company.

          As of the date of this document, Mr. Zaucha had been fired for cause
as the Company's CEO, but remains as a director.  Mssrs. DeSimone, Kulmoski, and
Pitterich and Ms. Guarino have left the Company in all capacities, for various
reasons set forth herein.

          Joint Venture Agreements.  In 1994, the Company entered into the Joint
Ventures (as defined herein) to provide cardiac and other diagnostic testing
services in order to expand the range of products and services the Company could
offer to its clients, particularly in the contract rehabilitation segment of the
business.

          During 1994, the Company entered into joint venture arrangements with
C.F. Services, Inc. (the "C.F. Services Joint Venture") to develop mobile
diagnostic services in Western Pennsylvania and  West Virginia. The Company had
made loans totaling $100,000 for working capital purposes in connection with the
C.F. Services Joint Venture.  In April 1994, the Company entered into joint
venture arrangements with CDL Medical Technologies, Inc. (the "CDL Joint
Venture," and, together with the C.F. Services Joint Venture, the "Joint
Ventures") to provide mobile diagnostic testing services, including cardiac and
ultrasound diagnostic services.  In order to concentrate its managerial and
financial efforts on the Company's core rehabilitation business, the Company has
initiated negotiations with CFS  with respect to a possible sale of its interest
in the Joint Ventures to such joint venture partners, although no agreement or
understanding has been received with respect to any such possible sale.
However, there can be no assurance as to whether, when, or on what terms any
sale may be completed.

Marketing

          As of December 31, 1996, the Company had a marketing staff of 20
people responsible for expanding its patient base in outpatient rehabilitation
clinics, subacute and diagnostic centers through referrals by

                                       10
<PAGE>

physicians and health maintenance organizations and increasing the number of
contracts with patient care facilities served by the Company through targeted
mailings, telephone calls, and on-site meetings.

          Through its Merger with Keystone, the Company is in the process of
further implementing its marketing program at the local outpatient
rehabilitation clinic, regional, and corporate levels directed at hospitals,
physicians, insurance companies, managed care organizations, lawyers, and
employers.  The Company believes this program will enable the Company to market
its services effectively and increase patient flow.

          At the local outpatient rehabilitation clinic level, the facility
directors for each clinic  are expected to maintain relationships with existing
referral sources and to establish relationships with new referral sources,
typically physicians, in that clinic's geographic area.  Therapists contact
referral sources on a regular basis in order to maintain personal relationships
and to be responsive to their service needs.  The Company believes that being
responsive to the needs of the referral sources and reducing their
administrative burden in referring patients will enhance the Company's prospects
of obtaining additional referrals from such sources.

          At the regional level (which are groups of related offices and
services), the Company has recognized the value of sales personnel in marketing
to larger regional referral sources (multi-physician groups, home health
agencies, and hospital-owned physicians) that may be in a position to refer of
groups to the Company's facilities.  Sales personnel can set up meetings for the
facility directors with referral sources and meet with case managers, employers,
and local community groups. Their marketing efforts are responsible for
developing and expanding business relationships with all referral sources  such
as insurance companies, managed care organizations, lawyers, and employers, as
well as the physicians targeted by the clinical personnel.  In addition, these
regional sales personnel are responsible to the Company's sales and marketing
directors.

          At the corporate level, the Company concentrates on establishing
contracts with multi-regional managed care organizations, insurance companies,
employers and long-term care facilities.  When appropriate, the Company may
consider service provider alliances in which two or more large rehabilitation
organizations enter into an arrangement such that, collectively, these two
organizations are able to secure a contract with a large referral source.
Corporate marketing programs are effective in establishing links with larger
employers and third party payors.

          The Company is aware of the growing importance of managed care
organizations in controlling patient referrals and their demand for high-
quality, cost-effective care from service providers with a regional presence.
Accordingly, both its corporate and regional sales personnel devote substantial
efforts to building relationships with these organizations.  The Company has
been able to secure contracts and establish relationships with such
organizations in the past and believes that its sales and marketing efforts will
allow it to acquire additional contracts from, and establish additional
relationships with, managed care organizations in the future.

Reimbursement

          The health care industry is generally experiencing a trend toward cost
containment as private and governmental payors seek to respond to rapidly
escalating health care costs.  One means of cost containment has been to limit
reimbursement rates by capping or lowering fees or restricting the number of
treatments which will be reimbursed for any given condition.  Pennsylvania, as
well as the other states into which the Company anticipates expanding, have fee
schedules which limit the reimbursement rates under workers' compensation
programs.  Another cost reduction methodology is increased utilization
management by third-party payors

                                       11
<PAGE>

through the use of physician "gatekeepers" and other pre-certification
mechanisms to control utilization of services.  The Company expects that
legislation and payors' fee schedules and payment methodologies will continue to
limit the reimbursement of fees for various services and control access to
various services, including rehabilitation therapy services, which may have a
material adverse effect on the business, financial position, and results of
operations of the Company.

          Reimbursement for the Company's services may also be limited by third-
party payors.  Such payors often limit the amount of fees per visit, regardless
of the number or type of therapies applied to the patient, or otherwise limit by
the terms of the managed care contract the amount of fees which may be charged.
The Company expects the trend toward third-party payor limiting of reimbursement
levels for various outpatient and inpatient services, including outpatient
rehabilitation therapy services, will continue.

          As a consequence, there can be no assurance that reimbursement for the
Company's rehabilitation therapy services will remain at current levels.  The
reduction or limitation of reimbursement levels for the Company's services could
have a material adverse effect on the business, financial condition, and results
of operations of the Company.  In addition, such payors are expected to continue
to develop programs designed to control or reduce the cost of health care
services, which may have a material adverse effect on the business, financial
condition, and results of operations of the Company.

          Through December 31, 1995, Northstar Therapy Services, Inc., a
subsidiary of the Company ("NTS"), was a Medicare-certified rehabilitation
agency, and several outpatient rehabilitation clinics of the Company have been
certified as "extension sites" of NTS which can bill Medicare through NTS.
Beginning January 1, 1996, all direct bill Medicare is being handled through one
of eight certified rehabilitation agencies throughout Pennsylvania, West
Virginia and Ohio. All clinics throughout the Company have been certified as
extension sites of one of these agencies. The use of NTS as such an agency is no
longer necessary, and therefore has been terminated.  In addition, patient care
facilities that contract with the Company for rehabilitation therapy services
and which bill Medicare directly for reimbursement of such services also must be
certified.  The Company believes that all of its facilities are in compliance
with such certification requirements; however, the loss of the Company's
Medicare certification, or the Medicare certification of a significant number of
the patient care facilities with which the Company contracts could materially
adversely affect the Company's ability to obtain Medicare reimbursement for
services.

          The Company anticipates that much of its future growth will continue
to be through expanding the number of its outpatient rehabilitation clinics
through start-ups and acquisitions, contracting for outpatient rehabilitation
and adding further services at existing locations..  Rehabilitation therapy
services provided in the Company's outpatient rehabilitation clinics are
reimbursed primarily from third-party payors, which typically take longer to
reimburse the Company than Medicare.  Reimbursement from third-party payors is
dependent in large part on the Company's timely and correct submission of claims
in accordance with the varying requirements of different payors.  In addition,
expansion beyond Pennsylvania might require the Company to seek payment from a
larger number of payors, which could result in longer collection cycles and
increased costs of collection.

          Most third-party payors, including Blue Cross/Blue Shield, compensate
the insured or a service provider, such as the Company, for physical,
occupational, and speech therapy at fee levels that are determined to be
"reasonable and customary" for such services within a geographic area.  The
determination of what is "reasonable and customary" is based on "objective
industry data."  Reimbursement based on this criteria may be substantially less
than rates the Company customarily charges and may not cover all of the
Company's costs

                                       12
<PAGE>

and expenses.  As a result, the Company often will seek the balance of such
claims, if any, as well as the portion of the claims not covered by third-party
payors, directly from the patient.  However, certain third-party payor
agreements may prohibit the Company from billing a patient for any amount by
which the Company's fees exceed those allowed by the payor.  Therefore,
attempting to collect fees from patients may be uneconomical in light of the
associated costs, or may be prohibited by government regulations or contractual
arrangements with third-party payors, and may be unsuccessful.  Additionally,
third-party payors could adopt more restrictive reimbursement schedules, which
may affect the Company's profitability.

Governmental Regulation

          General.    The provision of physical therapy services and
reimbursement for such services are subject to a number of federal, state, and
local laws, regulations, and rules, some of which are very complex.  Although
the Company believes that it is currently in compliance with applicable laws,
regulations, and rules, some of such laws are broadly written and subject to
little or no interpretation by courts or administrative authorities. Hence,
there can be no assurance that a third-party or governmental agency will not
contend that certain aspects of the Company's operations or procedures are not
in compliance with such laws, regulations, or rules or that state agencies or
courts would interpret such laws, regulations, and rules in the Company's favor.
The sanctions for failure comply with such laws, regulations, or rules could be
denial of the right to conduct business, significant fines, and/or criminal
penalties.  Additionally, an increase in the complexity or substantive
requirements of such laws, regulations, or rules could have a material adverse
effect on the business, financial condition, and results of operations of the
Company.

          Fraud and Abuse Laws.  The Social Security Act and certain provisions
of state law provide civil and criminal penalties for persons who knowingly and
willfully solicit, pay, offer or receive any remuneration, directly or
indirectly, as an inducement to make a referral of a patient for services or
items for which payment may be made under the Medicare programs.  Often termed
"fraud and abuse" or "anti-kickback" laws, the provisions have been broadly
interpreted by the courts.

          The Officer of Inspector General of the Department of Health and Human
Services ("HHS") has issued regulations specifying certain business arrangements
and payment practices involving providers or other entities, such as the
Company, which will not be considered prohibited activities.  Commonly termed
"safe harbor regulations," the regulations set forth certain standards which, if
satisfied, will ensure that the arrangement will not be subject to criminal
prosecution or civil sanctions under the fraud and abuse laws. Failure to
satisfy the safe harbors in and of itself does not render an arrangement
illegal.  The Company believes it is in compliance with the safe harbor
regulations applicable to its current operations.

          One principal focus of the fraud and abuse laws has been on
arrangements in which profit distributions are made by a partnership or other
business venture for health-related items or services to venture.  Where such
arrangements exist, a question is raised as to whether the profit distributions
are illegal payments in exchange for referrals.  Certain safe harbors set forth
criteria which, if met, will ensure that investors in business ventures for
health-related items or services will not be subject to scrutiny under the fraud
and abuse laws.

          One safe harbor protects profit distributions to investors made by
publicly-traded companies with tangible assets of more than $50 million.  At
present, the Company does not satisfy the asset threshold for protection under
this safe harbor.  Another safe harbor covers investment interests in small
entities.  The criteria that must be satisfied for protection under this safe
harbor include, among other things, requirements that no more than 40% of the
investment interests of each class of investment interests in the entity may be
held

                                       13
<PAGE>

by persons, or so-called "tainted investors," who are in a position to make or
influence referrals (including hospitals and physicians), furnish items or
services to the entity or otherwise generate business for the entity, and that
no more than 40% of the entity's gross revenues may come from referrals, items,
or services furnished, or business otherwise generated by "tainted investors."
Unless a large percentage of the Company's common stock is held by "tainted
inventors," investments in the Company should fall within the safe harbor for
investment interests.  None of the Company's physical therapy activities are
carried out through partnerships or other ventures with hospitals, physicians,
or other third parties in a position to make or influence referrals to, or
otherwise generate business for, the joint ventures.

          The laws involving fraud and abuse and the safe harbor regulations are
currently in a rapid state of development, and it is difficult to provide a
clear analysis of the risks in this area. There can be no assurance that
enforcement agencies or courts will determine that any existing arrangements
comply with all applicable laws and regulations.

          Stark II.  The Omnibus Budget Reconciliation Act of 1993 enacted new
federal anti-referral legislation, more commonly known as "Stark II."  Effective
January 1, 1995, Stark II bans referrals by physicians of Medicare patients to
entities for certain designated health services, including physical therapy
services, if a physician or immediate family member has a financial relationship
with the entity providing the service which does not meet any of the exceptions
(or safe harbors) set forth in Stark II.  A financial relationship is generally
defined as an ownership or investment interest in or compensation arrangement
with the entity, subject to certain exceptions.  One exception (or safe harbor)
relates to ownership of investment securities in publicly traded companies that
had, at the end of its most recent fiscal year, or on average during the
previous three fiscal years, stockholder equity exceeding $75 million.  At
present, the Company does not satisfy the asset threshold and physicians may not
make referrals of Medicare patients to the Company where the physician or his or
her immediate family member holds an ownership or investment in the Company.
Penalties for prohibited referrals include nonpayment for services rendered
pursuant to a prohibited referral, civil money penalties, and fines and possible
exclusion from the Medicare programs.  The Company believes it is currently in
compliance with the requirements of Stark II.  However, there can be no
assurance that enforcement agencies or courts will determine that existing
arrangements comply with all applicable laws and regulations.

          The Practice of Physical Therapy.  In the State of Texas, a 1979
opinion of the State Attorney General provides that corporate entities may not
engage in the practice of physical therapy unless such corporations are
professional corporations with all stockholders being licensed therapists.  The
Company knows of no similar opinion or of the existence of any similar law,
regulation, or rule, whether pending or currently in effect, in Pennsylvania or
in any state into which the Company currently plans to expand its operations.
If such an opinion were expressed and enforced in Pennsylvania or in any state
in which the Company may in the future operate, management believes that it
could restructure its operations so as to be in compliance therewith. However,
such restructuring could materially adversely affect the Company, and there can
be no assurance that a satisfactory restructuring, under such circumstances,
could be accomplished.

          Other Legislative and Regulatory Actions.  The Pennsylvania
legislature has enacted automobile insurance reforms which became effective in
1991 and which limit payments to providers for non-emergency services rendered
to patients who suffer injuries as a result of automobile accidents.  The
Pennsylvania Legislature also enacted workers' compensation legislation
effective September 1, 1993 which limits payments to provides for services
rendered to patients with work-related injuries.  The Pennsylvania Workers'
Compensation Act, among other things, altered the methodology for payment of
health care services to persons covered by workers' compensation, limiting
health care providers to payment of no greater than 113% of the

                                       14
<PAGE>

applicable governmentally imposed standard fees for medical services as
determined principally under the Medicare Program.  If such services do not fall
under the Medicare fee structure, the Pennsylvania Department of Labor and
Industry establishes rates, which may not be more than 80% of the prevailing
rate for such services in the area.  The law also requires employees to obtain
treatment from designated providers for a specified period of time and contains
restrictions concerning patient referrals, similar to those established in the
Medicare fraud and abuse and Stark II laws, which are designed to prevent fraud
and abuse in the delivery of services to patients covered by workers'
compensation insurance.

Competition

          The rehabilitation industry is highly competitive and subject to
continual changes in the manner in which services are delivered and in which
providers are selected.  The Company believes the most significant competitive
factors in the rehabilitation market are quality patient care, comprehensive
scope of service offered, treatment, alignment with physicians outcome measures,
cost-effectiveness through the reduction of the need for more costly health care
intervention, convenience of rehabilitation locations to patients, regional
dominance, and the ability to develop and maintain relationships with
rehabilitation referral sources such as physicians, insurance companies, managed
care organizations, lawyers and employers.  The Company competes, and will
compete, with many national, local, and regional providers of rehabilitation
therapy services, including the outpatient rehabilitation operations of acute
hospitals, managed care organizations and other long-term care rehabilitation
therapy providers.  Many of the Company's competitors have equal or longer
histories of operations and longer-term relationships with therapists and
referral sources than the Company and have greater financial, marketing, human
and other resources than the Company.


          The Company also competes with other health care companies in
acquiring rehabilitation providers. Several larger national companies with
substantially greater financial resources than the Company have been actively
acquiring rehabilitation providers.  Certain of these companies, because of the
size of their stockholders' equity, may not be affected by present or future
laws limiting or prohibiting referrals by stockholders who may be referral
sources.  Continued competition in this area may increase the valuation of
rehabilitation providers and limit the Company's ability to make future
acquisitions.

          The Company also competes for the services of therapists with
hospitals, nursing homes, other outpatient rehabilitation clinics and
physicians' offices.  Although the Company has not experienced significant
difficulties in attracting and retaining qualified therapists, it is generally
recognized that the demand for qualified therapists exceeds the supply and there
can be no assurance that the Company will continue to be able to attract or
retain sufficient therapists to meet its needs.

Employees

          As of December 31, 1996, the Company had 652 employees of which seven
were executive officers of the Company; 288 were licensed therapists or
therapists' assistants; and 20 were involved in marketing and business
development. The Company also has contracts with certain independent physical,
occupational, and speech therapists who are utilized by the Company on an as-
needed or minimum-number-of-hours-per-week basis.

          None of the Company's employees is represented by a labor union, and
the Company is not aware of any activities seeking such organization.  The
Company considers its relationships with its employees to be

                                       15
<PAGE>

satisfactory.

          The Company's business is dependent on its ability to attract and
retain qualified therapists and therapists' assistants.  The Company employs a
variety of recruiting techniques, including employee referral, personal phone
contact and follow-up, advertising, convention attendance, mass mailings, loan
programs, and on-site college recruiting.  The Company also maintains
relationships with six local physical therapy colleges and two physical therapy
assistant schools.  The ability of the Company to attract and retain qualified
physical, occupational, and speech therapists and therapists' assistants is
crucial to the Company's operations, and competition for therapists is intense.
Therapists are in short supply and may be attracted to hospitals and other
facilities which may provide predictable locations and work schedules in
contrast to the nature of the Company's services at patient care facilities,
which provide less predictable work schedules and changing locations.  Although
there can be no assurance, the Company believes that it is able to compete
effectively for therapists due to its local Pennsylvania presence near several
certified rehabilitation schools, provision for reimbursement for continuing
education, quality reputation, and attractive compensation and benefits package.
In addition, the Company believes that its management philosophy appeals to many
therapists because it encourages therapists to manage the operations of their
respective patient care facilities or outpatient rehabilitation clinics on a
semi-autonomous basis, including scheduling, hands-on therapy, facility
financial results, retaining staff, and, if applicable, relations with the
patient care facility.  The Company also provides therapists with career
advancement opportunities beyond the individual-facility level.  To date, the
Company has been able to attract a sufficient number of physical, occupational
and speech therapists, either as employees or as independent contractors;
however, there can be no assurance that this will continue.  The Company
believes its future success will depend in part on its continued ability to
attract and retain highly skilled employees.  If the Company is unable to
attract and retain a sufficient number of qualified therapists to staff all of
its facilities, the Company could be materially adversely affected.  The Company
believes its annual turnover rate among therapists compares favorably with that
of its competitors.

          In most states, physical, occupational, and speech therapists,
therapist assistants, COTAs, and licensed technicians must be state-licensed
clinicians with clinically specific associate, baccalaureate, or masters
degrees.  All therapists must pass a national licensure exam administered by the
states.  A certified physical therapy assistant provides therapy under the
supervision of a physical therapist.  In order to be licensed, physical therapy
assistants must have an associate degree from an approved physical therapy
assistants program.  In addition, Pennsylvania requires physical therapy
assistants to complete successfully a state-wide written and practical
examination.  COTAs provide therapy under the supervision of an occupational
therapist. In order to be certified, COTAs must also have an associate degree
and have successfully completed a national certification examination.
Therapists with the Company undergo an orientation program to familiarize
themselves with the Company's policies and procedures.

Liability Insurance

          The Company maintains professional malpractice liability insurance up
to $5,000,000 per incident and up to $5,000,000 in the aggregate on all of its
professional employees, in addition to coverage for the customary risks inherent
in the operation of health care facilities and businesses in general.  The cost
of liability insurance coverage and the availability of such coverage have
varied in recent years with a trend toward higher cost.  In an effort to control
the cost associated with such coverage, the Company has shifted from an
occurrence based policy to a claims made policy.  While the Company believes its
insurance policies to be adequate in amount and coverage for its current
operations, there can be no assurance that its coverage will, in fact, be or
continue to be available in sufficient amounts and on reasonable terms, or at
all.

                                       16
<PAGE>

Item 2.     Properties
----------------------

          The Company leases approximately 13,000 square feet as corporate
office space at 665 Philadelphia Street, Indiana, Pennsylvania 15701. Several
leases expire on dates ranging from November 2000 to November 2005. The Company
also leases and operates approximately 60 rehabilitation clinics in
Pennsylvania. These leases may be month-to-month or for a term of years. Monthly
payments under these leases range from approximately $100 to $15,000.

Item 3.    Legal Proceedings
----------------------------

          In September 1996, after an internal investigation by Northstar's
directors and Investigative Committee headed by Steven N. Brody, Northstar filed
suit in federal court against Mark A. DeSimone, his wife Leslie M. DeSimone, his
cousin James P. Shields and several other related parties as well as Richard A.
Eisner & Co., LLP, Northstar's former accountants and auditors (No. 96-1695 W.D.
Pa.).  The lawsuit seeks damages from the defendants for their allegedly illegal
actions which harmed the Company and its shareholders from late 1991 through
early 1996.  The suit sets forth allegations in connection with the defendants'
ongoing pattern of fraud, deceptive conduct, theft, and other offenses, as well
as DeSimone's and his associates' misappropriation, diversion and conversion of
Northstar assets and funds for their own illegal benefit.  Northstar's claims
against Richard A. Eisner & Co., LLP are based on that accounting firm's alleged
negligence, recklessness and failure to conduct proper audits which enabled
DeSimone and the other defendants to defraud the Company, resulting in sizeable
losses to the Company and its shareholders.  Northstar is currently engaged in
discovery and settlement discussions with certain defendants.  A copy of the
complaint, which includes claims under the Racketeer Influenced and Corrupt
Organizations Act ("RICO"), is available from the Company upon the request of
any shareholder.  Due to the preliminary nature of this proceeding, it is
impossible to make any representation regarding its outcome, although the
Company is committed to vigorously pursuing all of its remedies against the
defendants and any other party found liable for the damage to Northstar.

          In response to Northstar's suit against DeSimone and the other
defendants, Coregis Insurance Company, which insured DeSimone's former law firm,
brought an action in federal court (No. 96-2243 W.D. Pa.) to determine its
obligations to defend DeSimone and his former law firm.  Although the action
names Northstar, its primary purpose is to determine the obligations of the
insurance company; the outcome of this suit may have an impact upon Northstar's
ability to recover damages in connection with its lawsuit against DeSimone and
others.

          In April 1996, the first of seven class action lawsuits against
Northstar and certain of its former officers and directors was filed in federal
court by Northstar shareholders;  all of such suits were consolidated into one
action (No. 96-1399 W.D. Pa.).  The suit alleges violations of federal
securities laws by Northstar and its former officers and directors Mark A.
DeSimone, Michael Pitterich, Michael Kulmoski, Jonathon Petruska and Daniel
Dickman in connection with the defendants' alleged scheme to disseminate false
and misleading information regarding the Company, its operations, financial
status and related-party transactions and to enrich themselves in the process.
Settlement negotiations, which also involve Richard A. Eisner & Co., LLP,
Northstar's former independent accountant and auditor, are continuing, and the
plaintiffs have claimed damages of approximately $20,000,000.    It is not
possible to make any representations regarding the outcome of this suit at this
time; however, the Company is diligently pursuing all avenues for a reasonable
settlement.  The Company's current officers and directors, none of whom are
named in the class action suit, are pursuing settlement negotiations on behalf
of the Company, and have filed an action against Northstar's former officers,

                                       17
<PAGE>

directors and auditors, as set forth above.

          In May 1996, a group of Northstar shareholders filed an action in
California state court against Northstar and its former officers and directors
Mark A. DeSimone, Michael J. Kulmoski, Jr. and Northstar's former auditors,
Richard A. Eisner & Co., LLP.  The suit alleges violations of California state
law, as well as breaches of fiduciary duty and fraud.  These claims also arise
out of the false and misleading statements concerning Northstar and its
financial condition which were disseminated by the individual defendants. The
plaintiffs have not filed a statement of damages, and the court has scheduled
settlement and discovery activities. It is not possible to make an assessment of
the impact of this action upon the Company at this time.

          In July 1996, Michael Kulmoski, Jr., a named defendant in both
Northstar's lawsuit and the class action, filed a demand for arbitration against
Northstar for breach of his employment contract and other related matters.
Kulmoski is seeking damages of approximately $500,000.  A preliminary hearing
was held on February 19, 1997, at which a scheduling order and discovery
schedule were issued.  An arbitration hearing has been scheduled for the end of
June 1997.

          In January, 1997, the Company and Samuel Armfield III, M.D, reached a
settlement in regard to the various claims that each had against the other,
resulting from the acquisition by the Company of the stock of Vascusonics, Inc.
and certain of the assets of Penn Vascular Labs, P.C.  See Note 21 to the
financial statements.

          In January, 1997, the Justice Department initiated an action against
Samuel Armfield, III, M.D. for claims amounting to $300,000 in connection with
Dr. Armfield's Medicare billings.  Although such claims could be trebled if Dr.
Armfield is convicted, the Company  believes that its exposure, through its
dealings with Vascusonics, would aggregate $50,000 to $100,000.  In addition,
the Company has recourse against Dr. Armfield for any amounts assessed against
the Company, which the Company plans to aggressively pursue, if necessary.

          On February 10, 1997, Thomas W. Zaucha filed suit against Northstar
Health Services, Inc. ("Northstar") and all other members of its Board of
Directors in the Delaware Chancery Court, Civil Action No. 15530.  His
litigation commenced on the same day that Zaucha's Committee filed with the U.S.
Securities and Exchange Commission its preliminary consent materials in
connection with this current Solicitation. Zaucha began his lawsuit without
providing any prior notice to the Company or fellow Board members.  The Company
believes that, had Zaucha fulfilled his duty of candor to the Company, and
requested clarification of issues, he could have avoided unnecessary and
potentially costly litigation.

          The Company intends to move for dismissal of Zaucha's request for
declaratory relief for want of an actual or possible case or controversy.  His
request for declaratory relief is based upon Zaucha's own apparent misconception
of important shareholder suffrage rights.  Although the Board, with Zaucha
abstaining, approved certain Bylaw amendments, the Board has not proposed or
adopted amendments to the Company's articles of incorporation, which amendment
would be required to eliminate the shareholders right to take action by written
consent/1/.

------------------------
/1/  The Zaucha Committee's own current Solicitation of shareholder consents
bears testimony to the vitality of shareholder suffrage rights inherent in
Northstar's articles of incorporation under Delaware law.

                                       18
<PAGE>

          Zaucha also seeks injunctive relief to prevent the Company from
enforcing a conventional Bylaw feature adopted on January 21, 1997. That
amendment (providing for removal of directors for cause by a 2/3 vote of
shareholders) was enacted in response to the circumstances in which the Company
now finds itself due, in part, to Zaucha's own actions and omissions. The
amendments were designed solely to enable the Company to provide a stable Board
in negotiations with IBJ Schroder, the Company's senior lender. Moreover, the
Company has always had a staggered Board, believed by the Company, since its
inception, to be a desirable mechanism.

          The Company intends to oppose vigorously Zaucha's attempt to enjoin a
bylaw the Board believes is necessary, at this time, to reassure  the Company's
creditors.  While it is impossible to predict the outcome of the Delaware
litigation, the Company intends, if successful, to seek recovery from Zaucha of
the Company's costs expended in defending litigation.

          On March 19, 1997, the Company filed suit in the Western District of
Pennsylvania against Thomas W. Zaucha, its former Chief Executive Officer, and
Commonwealth Associates L.P., its former investment banker (No. 97-0510 W.D.
Pa.). Also named as defendants were Michael Falk, Basil J. Asciutto and Andreas
V. Bello of Commonwealth Associates; Joseph H. Micalleff of the Associated Sales
Tax Consultants, Inc. and Lawrence F. Jindra, M.D., James H. McElwain, Mark G.
Mykityshyn, Roger J. Reschini, and David B. White (members of the group seeking
to take control of Northstar). The suit alleges that the defendants'
solicitation of written consents contained false and misleading information in
violation of federal securities laws. The Company requested that the Court issue
a temporary restraining order against the defendants use of such misleading
proxy materials and order expedited discovery such that the Company can prepare
for a hearing on such equitable relief.

Item 4.    Submission of Matters to Vote
----------------------------------------

          Not applicable.

Item 5.    Market for Registrant's Common Equity and Related Stockholders
           Matters
--------------------------------------------------------------------------

          On May 31, 1996, NASDAQ suspended trading in the Company's common
stock.  Prior to its suspension, the Company's common stock was traded on the
NASDAQ National Market under the symbol "NSTR".  Since the suspension, the
Company's common stock is traded over the counter.   On March 21, 1997 the high
and low sales prices for the common stock of the Company as reported by NASDAQ
were $ 2.750 and $ 2.500. Pursuant to current disclosure guidelines, the
following table sets forth the high and low sales prices for the common stock of
the Company during the calendar periods indicated, through December 31, 1996, as
reported by NASDAQ:

<TABLE>
<CAPTION>

        Calendar Year and Quarter   High    Low
        -------------------------  ------  -----
<S>     <C>                        <C>     <C>

1993    Second Quarter              8.125  5.250
        Third Quarter               8.250  6.750
        Fourth Quarter              9.500  7.750

1994    First Quarter              10.375  7.875
        Second Quarter              9.125  6.750
        Third Quarter               8.250  6.250

</TABLE>

                                       19
<PAGE>

<TABLE>
<S>     <C>                        <C>     <C>
        Fourth Quarter              7.500  4.750

1995    First Quarter               8.500  6.500
        Second Quarter              7.625  5.750
        Third Quarter               9.625  7.000
        Fourth Quarter              7.625  5.375

1996    First Quarter               6.125  2.625
        Second Quarter              5.500  1.250
        Third Quarter               3.125  1.250
        Fourth Quarter              2.000  0.750
</TABLE>

          As of December 31, 1996, the Company had approximately 1,700 holders
of record, including those who hold in street name, for its common stock.

          The Company has not paid nor does it expect to pay in the future
cash dividends on its common stock.

          The Company's Registrar and Transfer Agent for its common stock is
Continental Stock Transfer and Trust Company, New York, New York.

Stock Option Plan

          The Company adopted two stock option plans: the 1992 Plan and the 1994
Plan. The Company adopted the 1992 Plan in order to attract and retain key
personnel.  A total of 650,000 shares of Common Stock are authorized and have
been reserved for issuance under the 1992 Plan.  Options may be either
"incentive stock options" within the meaning of Section 422 of the Code, or non-
qualified options.  Incentive stock options may be granted only to employees of
the Company, while non-qualified options may be issued to consultants, as well
as to employees of, the Company.  The 1992 Plan is administered by the
Compensation Committee which recommends to the Board, among other things, those
individuals who shall receive options, the time period during which the options
may be partially or fully exercised, the number of shares of Common Stock that
may be purchased under each option, and the option exercise price.  Currently
Messrs. Brody, Smallacombe and Jarrett serve on the Compensation Committee.  As
of December 31, 1995, options to purchase an aggregate of 502,880 shares of
Common Stock have been granted and remain outstanding under the 1992 Plan.  As
of December 31, 1996, options to purchase an aggregate of 320,300 shares of
Common Stock have been granted and remain outstanding under the 1992 Plan. To
date, 24,000 options granted under the 1992 Plan have been exercised.

          The Company adopted the 1994 Plan to promote the interests of the
Company and its stockholders by increasing the proprietary and vested interests
of non-employee directors in the growth and performance of the Company by
granting such directors options to purchase shares of Common Stock of the
Company. Options are non-qualified. Non-qualfied may be granted only to
directors who are non-employees of the Company. Each eligible director, as of
June 7, 1994 and June 7, 1995, was granted an option to purchase 7,500 and 2,500
shares, respectively, pursuant to the Plan. A total of 150,000 shares of Common
Stock are authorized and have been reserved for issuance under the 1994 Plan.
The 1994 Plan is also administered by the Compensation Committee as described
above. As of December 31, 1995 and 1996, options to purchase an aggregate of
37,500 and 87,500 shares of Common Stock, respectively, have been granted and
remain outstanding under the 1994 Plan. To date no stock options under the 1994
Plan have been exercised.

                                       20
<PAGE>

Change in Control Provisions

          The merger agreement between Northstar and Keystone Rehabilitation
Systems provides that in the event of a "change in control" of Northstar during
December 31, 1996 through and including the fiscal year ending December 31,
2000, all contingent payments for each remaining fiscal year shall immediately
and fully vest and be payable by Northstar to Thomas Zaucha, Alice Zaucha, and
the Zaucha Family Limited Partnership ("the Zaucha Shareholders") within 90 days
of the change in control. Contingent payments shall mean for each fiscal year
during the above described time period if the EBITA of Keystone exceeds
$2,500,000, Northstar shall pay to the Zaucha Shareholders a sum equal to
$1,600,000 divided by such Shareholder's percentage ownership interest in
Keystone.  In general a "change in control" is deemed to have occurred if (i)
there is a sale of all or substantially all of the assets of Northstar or
Keystone or (ii) the sale and transfer of 50% or more of the outstanding capital
stock of Northstar or Keystone in one or a series of related transactions.

Item 6:    Selected Financial Data
----------------------------------

          The information set forth below is provided only for the years ended
December 31, 1996 and 1995 because the Company and its independent public
accountants cannot provide such information for any prior years with the
requisite level of accuracy due to prior mismanagement and the resultant
resignation of its previous auditors.

<TABLE>
<CAPTION>

                                    1996            1995
                               --------------  --------------
<S>                            <C>             <C>

Current Assets                 $   9,446,000   $  14,603,000

Intangible Assets (Net)        $  21,132,000   $  23,947,000

Total Assets                   $  34,542,000   $  43,355,000

Current Liabilities            $  26,265,000   $  26,584,000

Total Liabilities              $  31,350,000   $  32,988,000

Total Stockholders' Equity     $   3,192,000   $  10,367,000

Net Patient Service Revenue    $  35,176,000   $  15,424,000

Gross Profit                   $  16,220,000   $   4,784,000

Operating Loss                   ($5,956,000)   ($11,962,000)

Non-Operating Expenses         $   2,226,000   $   1,041,000

Extraordinary Loss             $           0   ($    274,000)

Net Loss                        ($ 8,947,000)  ($ 13,101,000)


</TABLE>

                                       21
<PAGE>

<TABLE>
<S>                            <C>             <C>
Net Loss Per Share                    ($1.44)         ($3.28)

</TABLE>

Item 7.    Management's Discussion and Analysis of Financial Condition and
--------------------------------------------------------------------------
Results of Operations
---------------------

Forward-Looking Statements

          In addition to other sections of this report, the Management's
Discussion and Analysis section also contains the type of forward-looking
statements discussed on page 2 herein.

          The information presented in this Management's Discussion and Analysis
is of a summary nature; please refer to the Financial Statements, including
notes, which are included in this report.

                               EXECUTIVE SUMMARY

          Current management prepared a comprehensive Business Plan that was
presented to the Company's senior lender, IBJ Schroder Bank and Trust ("IBJ")
and its primary subordinated creditor (Thomas Zaucha) in early December, 1996.
This plan outlines specific strategic tasks and goals which will enable the
Company to improve its cash flow as well as operating results.  The plan,
portions of which are summarized below, is based on projections, goals and
anticipated results, all of which are the type of forward-looking statement
discussed on page 2 herein, and are subject to the contingencies discussed both
in this section and on page 2. No assurances can be given as to the probability
of or the actual implementation of any part of this plan.

          This plan addresses the critical issues of debt restructuring with
both IBJ and Mr. Zaucha.  Some highlights of this plan include:

 .  Overhead reductions in 1997 of approximately $700,000, in addition to the
   $1,500,000 overhead cost reduction that was implemented in mid 1996.

 .  Restructure of the Company into four operating subsidiaries.  This will allow
   significant revenue and operating income growth in the emerging areas of
   sub-acute care and medical diagnostics in addition to outpatient
   rehabilitation clinics and patient care facilities.

 .  The plan calls for restructuring the IBJ debt on mutually agreeable terms as
   well as conversion of Mr. Zaucha's debt to equity on mutually agreeable
   terms.

          The Company has had conversations with a major stock exchange about
getting its common stock relisted by the end of 1997.  This past year has been
very traumatic for Northstar.  The investigation into malfeasance of past
officers  was made necessary by current management's discovery of such
malfeasance and the resignation of our auditors.  It has  been a very necessary
and expensive undertaking,  but it has served and continues to serve as the
platform to support litigation against prior management and the people with whom
they dealt.

          As outlined in detail in the liquidity and capital resources section,
the Company funded approximately $1,700,000 of non-recurring legal, professional
and other expenses through its operating cash flow.  The Company still had cash
flow from operations of $2,481,000 after consideration of the above expenses.
This exhibits the strength of the Company's core operations and their ability to
produce consistent cash flow which

                                       22
<PAGE>

will aid the Company in its restructuring efforts.  This cash flow from
operations was also a result of the Company's efforts to extend payment terms to
some of its professional advisors and certain trade creditors.

          The Company posted an operating loss for 1996 of  $5,956,000 compared
to $11,962,000 during 1995.  Exclusive of the non-recurring items discussed
above, write-offs of intangible assets and write-offs of notes receivable, the
Company's operating loss during 1996 would have been $987,000 down from
$5,085,000 in 1995.  This marked improvement is indicative of the strength of
the businesses which were acquired during late 1995, for which a full year of
results was not included in 1995, as well as cost reductions and strategies
implemented by current management.

          The Company was able to finance its operations and non-recurring
expenses without significantly increasing its debt load.  Current management of
the Company strongly believes, although it cannot guarantee, that in 1997, cash
flow and net operating results will be improved through additional cost
reductions and revenue enhancements.  Management believes that these
improvements will enable the Company to enhance its core operations, begin to
restructure its debt, and increase shareholder value.

                             RESULTS OF OPERATIONS

          In addition to other sections of this report, this Management's
Discussion and Analysis section  contains the type of forward-looking statements
discussed on page 2 herein.  Please refer to such discussion in connection with
the information presented here.

Net Revenues
------------

          In 1996, the Company's net patient service revenues increased to
$35,176,000 from $15,424,000 in 1995 with $23,090,000 of the increase being
generated by acquired companies, primarily Keystone Rehabilitation Systems, for
which a full year's operations are included in 1996 compared to 45 days in 1995.
Excluding acquisitions, net revenues declined by $3,338,000 reflecting extensive
reorganization and resulting in the closure or termination of unprofitable
clinics and contracts.  Management expects, but cannot guarantee, revenue growth
during 1997 due to the addition of new business units, including a new sub-acute
care business and an expanding presence in the diagnostics medicine arena.

Costs of Service
----------------

          The Company's costs of service increased to $18,956,000 in 1996
compared to $10,640,000 in 1995.  Of the increase, $10,714,000 arose from
acquired companies, with the remainder of the group declining by $2,398,000.  As
the increase in total cost was proportionately less than the increase in net
revenues, gross profit in 1996 rose by $11,436,000 to $16,220,000 in 1996 (46%
of revenue) compared to $4,784,000 in 1995 (31% of revenue).  Acquired companies
accounted for $12,376,000 of the increase in gross profit and the operations
that existed prior to the acquisition declined by $940,000.

SG&A Expenses
-------------

          Total selling, general and administrative expenses increased to
$13,129,000 compared to $6,202,000.  As of percentage of net revenue, SG&A fell
from 40% to 37% .  This decrease as reflected in the percentage of net revenue
represents increased efficiencies due to the merger and consolidation of the
corporate office functions.

Restructuring and Non Recurring Expenses
----------------------------------------

          During 1995, non-recurring expenses included $3,827,000 for numerous
expenses including:  a write-down

                                       23
<PAGE>

of intangible assets that represented costs where no deemed value existed, non-
cash compensation recorded and corporate reorganization costs.  In 1996, the
Company incurred significant, non-recurring expenses related to investigation of
the actions of prior management, legal costs associated with both a defense of
shareholders litigation and a plaintiff suit filed against former management,
and additional asset write-offs.  A summary of these non-recurring expenses
during 1995 and 1996 follows:

<TABLE>
<CAPTION>
                                                                1996         1995
                                                             -----------  -----------
<S>                                                          <C>          <C>
Legal and accounting fees                                     $  629,000  $         -
Litigation costs                                                 565,000            -
Loss on notes receivable collateralized with common stock      1,772,000            -
Write off of intangible assets                                   960,000    3,421,000
Corporate restructuring costs                                    292,000      406,000
Professional fees related to investigation                       751,000            -
                                                              ----------   ----------
          Total                                               $4,969,000   $3,827,000
                                                              ==========   ==========
</TABLE>

  Though the Company will continue to defend the litigation  in which it is
currently a party, the Company anticipates that the legal and other professional
fees for these matters will be significantly lower than during 1996.  In
addition, the Company believes that the other non-recurring items outlined above
were also one-time charges which it has recorded in order to properly reflect
its financial position as of December 31, 1996.

  The Company will incur legal and other professional expenses related to the
proxy solicitation filed by the Company's former Chief Executive Officer.  As of
the date of this document, the Company is uncertain as to the aggregate amount
of such expenses.

Bad Debt Expense
----------------

  Other operating expenses of $1,820,000 and $2,301,000 were incurred for bad
debt provisions during 1996 and 1995, respectively.  The 1995 provision was
higher than in previous years and above the industry average due to the Company
writing the historical Northstar and acquired Keystone patient accounts
receivable down to the net collectable amounts.  During mid to late 1996, the
Company began to address certain operational difficulties in the billing area
and also began to aggressively pursue collection of its receivables. Thus,
although there can be no assurances, the 1996 provision for bad debt is still
higher than the level that management believes will be incurred in 1997.  Thus
far in 1997, additional operational improvements have been made to the accounts
receivable department, including the recruitment of an experienced accounts
receivable manager.  While the Company has reserved for approximately $3,300,000
of patient accounts receivable which are substantially  in excess of one year
old as of December 31, 1996, vigorous collection efforts are in process.

New Accounting Standards - Intangible Assets
--------------------------------------------

  In connection with the Company's early adoption in 1995 of under the
provisions of Financial Accounting Standards Board No. 121, the Company incurred
a charge of $3,050,000 as a result of impairment of goodwill and other
intangible assets.  The Company performed a similar analysis as of December 31,
1996 and believes that the remaining intangible assets do not require any write
off as a result of further impairment.

                                       24
<PAGE>

Depreciation and Amortization Expense
-------------------------------------

  Other operating costs include amortization of intangibles, depreciation and
other deferred charges totalling $2,258,000 in 1996, an increase of $892,000
over 1995, due primarily to the impact of amortization of intangible assets
recorded in conjunction with the Keystone acquisition in November 1995.

Interest Expense
----------------

  Interest expense of $2,130,000 for 1996 represented an increase of $1,297,000
over 1995, most of which was attributable to increased borrowing costs arising
from debt used to finance acquisitions.

Extraordinary Loss and Income Taxes
-----------------------------------

  The extraordinary loss of $274,000 for 1995 arose from write-offs of deferred
financing costs for the early extinguishment of debt during that year.  The
income tax credit of $236,000 for 1995 was primarily due to refunds arising from
carry-backs.  The Company recorded a tax liability of $471,000 for 1996 due to
state income and franchise taxes on some of its profitable subsidiaries.

Summary
-------

  In summary, the operating loss for 1996 and 1995 included the following
charges of an unusual nature:

<TABLE>
<CAPTION>
                                               1996            1995
<S>                                        <C>            <C>
Operating loss                              $(5,956,000)   $(11,962,000)
Non recurring expenses                        4,969,000       3,827,000
Impairment of long lived assets                       -       3,050,000
Operating loss prior to unusual charges     $  (987,000)   $ (5,085,000)
</TABLE>

  After taking into account the non-recurring nature of many of  the Company's
expenses, the Company's operating loss has been reduced by over $4 million in
1996.

                        LIQUIDITY AND CAPITAL RESOURCES

  In addition to other sections of this report, this Management's Discussion and
Analysis section contains the type of forward-looking statements discussed on
page 2 herein.  Please refer to such discussion in connection with the
information presented here.

Overview
--------

  The cash flow impact of the costs of the investigation, the lawsuits initiated
by and against Northstar, and much higher than normal audit and legal fees, was
adverse for the Company in the year ended December 31, 1996.  In addition, a
reorganization of the Company resulted in a sharp increase in payment of
professional fees for consulting, accounting and legal services.  Total costs
for all of these expenses amounted to approximately $2,237,000 during the year
ended in 1996.  The Company was able to finance approximately $1,700,000 of
these expenses through its current cash flow.

  Cash flow generated from operations was  $2,481,000 for the year 1996, despite
the outlays for the

                                       25
<PAGE>

legal investigation, the lawsuits and the reorganization of the Company,
compared to a use of cash of $4,781,000 in 1995.  The improvement arose from a
sharply reduced net loss of $4,154,000 as well as through the introduction of
extended payment terms to many of the Company's professional advisors and some
trade creditors.

  The change in working capital accounts during 1996 generated $2,561,000 in
cash compared to a net increase of only $395,000 in the previous year.
Receivables and other current assets declined by $786,000 and current
liabilities increased by $3,347,000 during 1996.  An extension of payment terms
resulted in accounts payable increasing from $456,000 to $2,048,000 during 1996.
Also during 1996, accrued expenses increased from $3,568,000 to $5,323,000.

  Investing activities used $349,000 in 1996, most of which was used to purchase
new equipment.  This compares to an outlay of $14,859,000 in 1995, which largely
reflected the payments made in conjunction with the acquisitions of Keystone and
PVL.

  Financing activities in 1996 used cash totaling $5,860,000 during the year
compared to a 1995 inflow of $25,683,000.  During 1996, the Company repaid
$6,666,000 in debt, of which $5,100,000 was paid to the sellers of Keystone (Mr.
Zaucha and entities controlled by him), and another $333,000 was paid to IBJ.
The remainder of the cash outflow represented primarily repayment of capital
leases and a line of credit for a joint venture.  The Company added $716,000
in new borrowings during 1996, $400,000 from the IBJ line of credit facility and
the remainder mostly from new capital lease obligations and a line of credit for
a joint venture.

  At December 31, 1996, the Company held $1,607,000 in general operating funds
representing an increase of $977,000 from 1995 year-end general operating funds
balance of $630,000.  Total  cash and equivalents of $5,730,000 for December 31,
1995 included a $5,100,000 deposit in a cash collateral account which was
reserved to pay the shareholders of Keystone on January 3, 1996.

  The company has no material commitments for capital expenditures in 1997.

Historical Overview of Capitalization and Liquidity
---------------------------------------------------

  The Company has historically financed its operations and its mergers and
acquisitions primarily from sales of common stock through both private and
public equity offerings, borrowings under bank credit facilities, loans from
related parties, directors, officers and stockholders, and cash flow from
operations.

  During 1995 and 1996, the Company raised additional funds for acquisitions and
capital expenditures through a public stock offering in May 1995, a bridge
financing in August 1995 and a three-tiered credit facility arranged with IBJ
Schroder Bank & Trust.  The details of these sources of capital are outlined
below.

    Stock Offering
    --------------

  On May 18, 1995, the Securities and Exchange Commission (the "Commission")
declared effective a registration statement for the offer and sale of 1,750,000
shares of Common Stock.  The Public Offering was closed on May 26, 1995.  On
June 8 and June 15, 1995, the underwriters of the Public Offering exercised
their over-allotment option to purchase an aggregate of 262,500 shares of Common
Stock.  The net proceeds of approximately $10,700,000 from the Public Offering
and the exercise of the over-allotment option were used to repay certain of the
Company's short-term indebtedness, including the Company's former bank line of
credit

                                       26
<PAGE>

of $2,000,000; $1,000,000 to satisfy an obligation under a seller note;
$1,825,000 of the net proceeds to pay other current obligations, including
certain expenses of the Company's Public Offering, and the remainder to
partially finance the Keystone acquisition as well as to satisfy general working
capital requirements.

    Bridge Loan
    -----------

  On August 30, 1995, the Company closed on a credit facility from a local bank
totaling $6,500,000, consisting of a $4,500,000 term loan and a $2,000,000
revolving line of credit.  The term loan had a maturity date of 60 months from
closing.  The proceeds of the term loan were used to consolidate the Company's
existing loan obligations with Med-Bill and certain sellers of acquired
companies.  The facility was repaid in full on October 20, 1995.  The Company
repaid the $4,500,000 term note in the favor of Med-Bill.  The Company does not
know the actual source of the funds for the $4,500,000 loan from Med-Bill;
however, when it was repaid to Med-Bill, Med-Bill re-distributed at least
$3,000,000 to Mr. DeSimone.  Related party interest expense was approximately
$235,000 during 1995.  Med-Bill distributed most, if not all, of the interest,
to Mr. DeSimone.

  The proceeds of the revolving credit facility provided working capital as
needed.    In addition, the President and Chief Executive Officer of the
Company, Mark A. DeSimone, personally guaranteed the loan, receiving a 5%
guarantee fee totaling $325,000 (See, "Certain Relationships and Related
Transactions").

    IBJ Schroder Credit Facility
    ----------------------------

  On October 20, 1995, the Company closed on a $16,000,000 credit facility with
IBJ.  The facility consisted of:

 .  $6,500,000 term loan to refinance existing operations;
 .  $3,000,000 revolving line of credit to fund operations; and
 .  $6,500,000 acquisition facility to fund the Company's existing and future
   acquisition activity.

     The total facility has a final maturity of five years from closing.  The
term loan was funded in full at closing and was used to repay the aforementioned
bank credit facility.

     As of December 31, 1995, and 1996, the Company was not in compliance with
certain covenants within the credit agreement between the Company and IBJ.  As
such, the Company is in default with the IBJ facility; however, as of December
31, 1996, the Company, through current management's continued communication with
IBJ, had succeeded in staying any formal action by IBJ in connection with such
default.

     As of December 31, 1995, the term loan portion of this facility had been
drawn in full, the revolving line of credit had $1,400,000 available, $6,000,000
of the acquisition facility had been used, and the remaining $500,000 has been
terminated by the bank.

     Payments for the acquisitions totaled $30,899,000, which consisted of
$15,200,000 in cash, $7,958,000 in notes from sellers and $7,741,000 in issuance
of the Company's common stock.  Of the $15,200,000 paid in cash for the
acquisitions during 1995,  $3,500,000 in acquisition loans from IBJ were used to
partially finance the merger with Keystone on November 15, 1995.  Another
$2,150,000 from the same source were used to finance the November 28, 1995
purchase from Penn Vascular Labs, P.C. of certain assets and the stock of
Vascusonics, Inc.  Other sources of cash payments for acquisitions came from the
Company's

                                       27
<PAGE>

initial public offering and a private placement, both of which occurred in 1993,
and a public offering in May of 1995, which generated proceeds of $3,400,000,
$1,800,000 and $10,697,000 respectively.

       Merger with Keystone Rehabilitation
       -----------------------------------

     On November 15, 1995, the Company completed a merger with Keystone
Rehabilitation Systems, Inc. Prior to the merger, Keystone was the largest
privately held rehabilitation company in Pennsylvania, with approximately
$21,000,000 in net revenues during 1994.  The merger added approximately 50
outpatient clinics to the Company's operations;

     As consideration for the merger, the shareholders of Keystone, Thomas W.
and Alice L. Zaucha and the Zaucha Family Limited Partnership (collectively, the
"Zaucha Shareholders"), received the following:

 .  $2,500,000 in cash;
 .  time note due January 3, 1996 in the aggregate principal amount of
   $5,100,000;
 .  five-year, interest-free term note in the aggregate principal amount of
   $2,625,000;
 .  agreement by the Company to issue on January 3, 1996, a three-year 6% term
   note in the aggregate principal amount of $2,400,000 (the "three year note");
   and
 .  agreement by the Company to issue to the Zaucha Shareholders on January 3,
   1996, an aggregate of 944,352 shares of Northstar common stock, which were
   guaranteed a value to be at least $5,600,000 through certain periods ending
   no later than December 31, 1997.

     The Company also agreed to make additional "earn-out" payments to the
Zaucha Shareholders of $1,600,000 per year in the event that Keystone's "EBITA"
exceeds $2,500,000 in any year from 1996 to 2000, inclusive.  Detailed
provisions of the earn out calculations are outlined in Note 3 to the Financial
Statements.

     At the merger date, the Company paid $2,500,000 in cash to the Zaucha
Shareholders and deposited $5,100,000 in a cash collateral account with a bank
to support a letter of credit securing the Company's obligation to pay the
Zaucha Shareholders $5,100,000 on January 3, 1996.  The Company borrowed
$3,500,000 of such amounts under the $6,500,000 acquisition line portion of its
existing $16,000,000 credit facility with IBJ.  The remainder of the funds
required were provided from working capital.

       Acquisition of Penn Vascular Labs, P.C.
       ---------------------------------------

     On November 28, 1995, the Company acquired from Penn Vascular Labs, P.C.
("PVL") certain assets as well as the stock of Vascusonics.  As consideration
for the above-mentioned items, the Company:

 .  paid $50,000 to the seller upon consummation of the agreement;
 .  loaned $2,150,000 to the seller in exchange for a note;
 .  provided the seller with 362,564 shares of Northstar common stock with a
   fair market value equivalent of $2,150,000 on the acquisition date;
 .  promised to pay $100,000 to the seller in twelve equal non-interest bearing
   installment payments beginning in December 1996; and
 .  promised to pay certain contingent payments to the seller as outlined in
   the notes to the financial statements.

     Additionally, in exchange for the loan and the common stock, the seller
agreed to pay back to Northstar

                                       28
<PAGE>

the lesser of $2,150,000 or the proceeds from the sale of the common stock,
whichever was less.  In December 1996, the Company foreclosed on this stock and
currently accounts for these shares as treasury stock.  The foreclosure also
resulted in a one-time, non-cash expense of $1,697,000 equal to the decline in
collateral value.

     The Company borrowed $2,500,000 under the $6,000,000 acquisition portion of
its existing $16,000,000 credit facility with IBJ.  These borrowings financed
the $2,150,000 promissory note to the seller and a $350,000 brokerage fee to Mr.
James P. Shields.

     The Company's funding under various joint venture arrangements with C. F.
Services, Inc. (the "C. F. Services Joint Venture") and with CDL Medical
Technologies, Inc. (the "CDL Joint Venture") to provide mobile diagnostic
testing services, has taken the form of approximately $200,000 in working
capital loans and $1,091,000 in equipment purchases through capital leasing.
Effective June 1, 1995, the Company transferred certain interests in the C. F.
Services Joint Venture in exchange for repayment of moneys invested ($70,000)
and the release of all liabilities.  The remaining joint ventures are cash flow
positive and are currently operating profitably.

Effect of Recently Issued Accounting Standards


     Financial Accounting Standard Board Statement No. 128, Earnings Per Share
(SFAS No. 128) was issued in February 1997 and is effective for fiscal years
beginning after December 15, 1997. This statement, upon adoption, will require
all prior-period earnings per share (EPS) data to be restated, to conform to the
provisions of the statement. This statements objective is to simplify the
computation of EPS and to make the U.S. standard for EPS computations more
compatible with that of the International Accounting Standards Committee. The
Company will adopt SFAS No. 128 in fiscal 1998 and does not anticipate that the
statement will have a significant impact on its reported EPS.

     Financial Accounting Standard Board Statement No. 129, Disclosure of
Information about Capital Structure (SFAS No. 129) was issued in February 1997
and is effective for period ending after December 15, 1997. This statement, upon
adoption, will require all companies to provide specific disclosure regarding
the entities capital structure. SFAS No. 129 will specify the disclosures, for
all companies, including descriptions of the securities comprising the capital
structure and the contractual rights of the holders such securities. The Company
will adopt SFAS No. 129 in fiscal 1997 and does not anticipate that the
statement will have a significant impact on its disclosure.







Item 8:     Financial Statements and Supplementary Data
-------------------------------------------------------

     The Company's financial statements appear on pages 1 through 38 of this
report.


Item 9:     Changes in and Disagreements with Accountants on Accounting and
---------------------------------------------------------------------------
Financial Disclosure
--------------------

     In March 1996, the Company's auditors, KPMG Peat Marwick ("KPMG"), who had
been appointed in late 1995, resigned prior to completing their audit of the
Company.  As a result, the Company's Form 10-K for the year ended December 31,
1995 was not filed timely. The Company retained Arthur Andersen LLP as its
auditors, and Arthur Andersen completed the audit of the Company for the years
ended December 31, 1996 and 1995 (See Note 1 to the Financial Statements).

Item 10: Directors and Executive Officers of the Registrant
-----------------------------------------------------------

<TABLE>
<CAPTION>

Name                       Age  Director Since           Position
-------------------------  ---  --------------  --------------------------
<S>                        <C>  <C>             <C>

Steven N . Brody            52  December 1995   Chairman of the Board

Charles B. Jarrett, Jr.     69  November 1996   Director

John Lombardi               31  N/A             Executive Vice President
                                                Chief Financial Officer

Hon. Timothy L. Pesci       52  January 1997    Director

Robert J. Smallacombe       61  May 1996        Chief Executive Officer
                                                and Director

David D. Watson             42  May 1996        President, Chief Operating
                                                Officer and Director

</TABLE>

                                       29
<PAGE>

<TABLE>
<S>                        <C>  <C>             <C>
Thomas W. Zaucha            51  November 1995   Director

</TABLE>

As of the date of this document, the officers and directors of the Company are
as follows:

STEVEN N. BRODY, age 52, has been a Director since December 1995 and Chairman of
the Board since February 1997.  His term as a Director of the Company is for
1995-1997.  He will stand for election at the next annual meeting in order for
the shareholders to approve his directorship.  He is the founder and principal
consultant of Steven N. Brody Associates, an independent management consulting
firm.  He has assisted dozens of companies with development opportunities,
market and product plans and strategies, expansion and corporate development
programs, financial and organization strategies and operational
performance/profit improvement.  Prior to establishing his consulting practice
in the late 1970s, Mr. Brody held senior management positions in strategic
planning, marketing, and corporate development with the Standard and Poor's
Corporation and Dun & Bradstreet Group.  He is a graduate of Yale University
(B.A. 1966) and in 1970 he received his M.B.A. from Columbia University's
Graduate School of Business.  He has been or is a member of the National
Association of Corporate Directors, the Pittsburgh High Technology Council and
the Central Pennsylvania Venture Investment Forum.  His business address is that
of the Company.

CHARLES B. JARRETT, JR., age 69, has been a Director since November 1996.  His
term as a Director of the Company is for 1996-1998.  He will stand for election
at the next annual meeting in order for the shareholders to approve his
directorship.  He is a practicing attorney and member of Plowman, Spiegel and
Lewis, P.C., a law firm in Pittsburgh, Pennsylvania.  Mr.  Jarrett's practice
focuses on corporate, banking, securities and commercial law.  Prior to joining
Plowman, Spiegel, Mr.  Jarrett served as Senior Vice-President and General
Counsel of Mellon Bank, N.A. and Vice-President, General Counsel and Secretary
of its parent company, Mellon National Corporation.  At Mellon Bank, Mr. Jarrett
was responsible for Mellon Bank's compliance with the rules and regulations of
the Federal Reserve Board, the Comptroller of the Currency and the Securities
and Exchange Commission.  Mr. Jarrett has also served as  Assistant Corporate
Secretary of Gulf Oil Corporation where he was responsible for compliance with
securities laws; proxy and other shareholder matters; legal issues of corporate
financing; employee benefit plans; and general corporate affairs.  His business
address is Plowman, Spiegel & Lewis P.C., 310 Grant Street, Pittsburgh, PA
15219-2204.

JOHN A. LOMBARDI, CPA, age 31, is the Executive Vice President and Chief
Financial Officer of the Company since September 1996; he is intimately involved
in the overall debt restructuring, bank negotiations and restructuring of the
operations of the Company.  Prior to joining Northstar, Mr. Lombardi was
promoted through the ranks of Arthur Andersen from staff auditor to senior
manager in the firm's audit and business advisory services practice.  Mr.
Lombardi has provided troubled company consulting services to publicly-held and
privately-owned businesses ranging from $5 million to $1 billion in revenues in
the distribution, healthcare, construction, manufacturing, real estate and
retail industries.  He is a Certified Insolvency and Reorganization Accountant,
a Certified Fraud Examiner and a member of the American and Pennsylvania
Institutes of Certified Public Accountants and the Turnaround Management
Association. His business address is that of the Company.

HON. TIMOTHY L. PESCI, age 52, has been a Director of the Company since January,
1997.  His term as a Director of the Company is for 1997-1999.  He will stand
for election at the next annual meeting in order for the shareholders to approve
his directorship.  He is a current member of the Pennsylvania House of
Representatives reelected to consecutive two year terms since May 1989,
representing Indiana and Armstrong counties.  Prior to election as a State
Representative, Mr. Pesci served as Armstrong County Controller from

                                       30
<PAGE>

1976 to 1989 while actively involved in numerous local public service
organizations. His extensive experience in the public sector assists the
Company in the areas of compliance and regulatory affairs as well as in
understanding various healthcare payer markets from a regulatory perspective.
His business address is Heritage Square; Suite #4, 170 Lincoln Street,
Vandergrift, PA 15690.

ROBERT J. SMALLACOMBE, age 61, has been a Director of the Company since May 1996
and Chief Executive Officer of the Company, since February 1997.  His term as a
Director of the Company is for 1996-1998.  He will stand for election at the
next annual meeting in order for the shareholders to approve his directorship.
Mr.  Smallacombe is an independent consultant specializing in crisis management
and the reorganization and rejuvenation of failing companies and the growth of
new or stalled companies. He has served as President and/or Chief Executive
Officer of eight companies, successfully increasing their profitability and
upgrading their management. He is experienced at negotiating out of troubled
banking relationships as well as with customers, labor and suppliers.  Most
recently, he served as President of O'Brien Environmental and President and
founder of Executive Advisory Group LTD.  He received a Bachelor of Science
degree from New York State University and served in the U.S. Marines from 1951 -
1953.  Currently, he is a member of the American Institute of Industrial
Engineers, World President Organization, and Philadelphia Presidents
Organization. His business address is that of the Company.

DAVID D. WATSON, M.S., P.T., E.C.S., age 42, has been a Director of the Company
since May 1996 and President of Northstar Health Services, since November 1995.
His term as a Director of the Company is for 1996-1998.  He will stand for
election at the next annual meeting in order for the shareholders to approve his
directorship.  Mr. Watson has over twenty (20) years of experience in healthcare
and physical therapy.  Prior to the Northstar merger with Keystone
Rehabilitation Systems, Mr. Watson was the Chief Operating Officer and Executive
Vice President of Keystone.  During Mr. Watson's employment with Keystone, he
served as Facility Director, District Director, and Vice-President, where he was
responsible for the management of 25 outpatient rehabilitation offices, 18
contracts and 4 hospitals.  He is a graduate of the University of California and
Duke University where he received his Masters degree in Physical Therapy. His
business address is that of the Company.

THOMAS W. ZAUCHA, age 51, has been a Director of the Company since November
1995. As part of the November 15, 1995 acquisition of Keystone Rehabilitation
Systems, Mr. Zaucha, the founder and Chairman of Keystone became the Chairman of
the Board and Chief Executive Officer of the Company until his removal for cause
in February 1997.

Item 11: Executive Compensation
-------------------------------

     The following table sets forth information concerning the annual and long-
term compensation for services in all capacities to the Company for the fiscal
years ended December 31, 1996, 1995 and 1994, for those persons who were, at
December 31, 1996 (i) the Chief Executive Officer, and (ii) the other most
highly compensated executive officers of the Company whose remuneration exceeded
$100,000 (the "Named Executives").

                                       31
<PAGE>

                           SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
                                                                                       (1)Long Term
                                                  Annual    Compensation               Compensation
------------------------------------------------------------------------------------------------------------------------------------

Name and                                  Year  Salary ($)  Bonus ($)    (2)         Awards           (2)All
Principal                                                               Other        ------            Other
Position                                                                 ($)        Securities        Compen-
                                                                                    Underlying        sation
                                                                                     Warrants
                                                                                       (#)
====================================================================================================================================

<S>                                       <C>   <C>         <C>        <C>        <C>                <C>

Thomas W. Zaucha,                         1996   $150,000   $      0   $125,000         -0-            $300
Chairman and
CEO (3)                                   1995   $ 17,308   $      0   $      0         -0-            $300

                                          1994        N/A        N/A        N/A         N/A             N/A

David D. Watson, President and COO (4)    1996   $ 75,000   $      0   $ 75,000         -0-            $300

                                          1995   $  6,635   $      0   $      0      50,000            $300

                                          1994     N/A           N/A        N/A         N/A             N/A

John A. Lombardi,                         1996   $ 30,156   $      0   $      0         -0-            $  0
 Executive V.P., CFO and Treasurer
 (5)                                      1995        N/A        N/A        N/A         N/A             N/A

                                          1994        N/A        N/A        N/A         N/A             N/A

Ralph C. Sweithelm, President  Keystone   1996   $ 85,531   $182,538   $      0         -0-            $300
 Rehabilitation Systems (6)
                                          1995   $  6,338   $  8,957   $      0         -0-            $300

                                          1994        N/A        N/A        N/A         N/A             N/A

====================================================================================================================================


</TABLE>
(1) The Company has a 401(k) plan which is being merged with the Keystone 401(k)
    plan.  The plans call for certain matching contributions by the employer
    equal to 50% of the participants contribution up to a maximum employer
    contribution of $300 per year.  The plan also calls for discretionary
    employer contributions, none of which were made after the November, 1995
    merger of Northstar and Keystone.

(2) During the year ended December 31, 1996, the Named Executives received
    medical benefits under the Company's group insurance policy, including
    disability and life insurance benefits which are equivalent to such benefits
    paid to all other full-time employees.  The aggregate amount of all
    perquisite compensation was less than 10% of the total annual salary and
    bonus reported for each Named Executive with the exception of Mr. Zaucha,
    who received $14,400 in lease payments for his Mercedes Benz in addition to
    his other benefits.

                                       32
<PAGE>

(3) During 1996, Mr. Zaucha received cash compensation in the amount of
    $275,000.  That amount is  comprised of $150,000 in salary and $125,000 in
    deferred compensation which was a provision of the November 1995 merger
    between Northstar and Keystone negotiated by Mr. Zaucha and Mark DeSimone.
    During 1995, Mr. Zaucha received compensation in the form of $150,000 in
    annual compensation, $125,000 pursuant to his employment contract, which is
    summarized herein.  Zaucha also receives funds from the Company in the form
    of lease payments, deferred compensation and other related-party
    transactions which relate to the merger of Keystone and Northstar (See,
    "Certain Relationships and Related Transactions").  Lease payments to Zaucha
    for 1996 and 1995 were $470,364 and $59,000, respectively.  In conjunction
    with the merger with Keystone, the Company makes earn out payments to
    Zaucha, Alice Zaucha and the Zaucha Family Limited Partnership discussed in
    Note 3 to the financial statements.  The Company also paid $86,320 in 1996
    and $9,156 in 1995 to Impulse Development Corporation, a company controlled
    by Zaucha for maintenance and housekeeping services.

(4) David Watson holds a note payable from Northstar resulting from the November
    1995 merger which pays him an additional $75,000 annually.

(5) Mr. Lombardi was hired by the Company in September 1996 pursuant to an
    employment contract which is summarized herein.  His annual salary pursuant
    to such contract is $112,000.

(6) Because Mr. Sweithelm is the president of the Company's largest  revenue-
    generating subsidiary, he performs policy-making functions for Northstar and
    is included as a Named Executive.

                     Option/SAR Grants in Last Fiscal Year

  No options or stock appreciation rights were granted to any Named Executive
                                  during 1996.

                      Option/SAR Grants During Fiscal 1995

     The following table sets forth the option grants to the Named Executive set
forth below.  This table is included because, due to problems discussed
elsewhere,  the Company did not file its Form 10-K for the Fiscal Year ended
December 31, 1995.

     There were no option or SAR grants to any Named Executive during the Fiscal
Year Ended December 31, 1996.  However, the Company is contractually obligated
to issue certain options (See, Note 13 to the financial statements.
<TABLE>
<CAPTION>
                                                                                                      POTENTIAL REALIZED
                                                                                                       VALUE AT ASSUMED
                                                                                                     ANNUAL RATES OF STOCK
                                                                                                      PRICE APPRECIATION
                                   INDIVIDUAL GRANTS                                                          FOR
                                                                                                        OPTION TERM (3)
                                                   Percent of
                                  Number of           Total
                                 Securities        Options/SARs
                                 Underlying         Granted to    Exercise or
                                Options/ SARs      Employees in   Base Price    Expiration
Name                             Granted (#)      Fiscal Year (1)   ($/Sh)         Date           5% ($)    10% ($)     0% ($)
------------------------------------------------------------------------------------------------------------------------==========
<S>                            <C>               <C>              <C>           <C>             <C>        <C>        <C>
David D. Watson, President          50,000             12.6%        $5.50         11/16/05       $174,500   $440,000   ($2,000)
 and COO                                                                            (2)
==================================================================================================================================
</TABLE>

__________________________________________

                                       33
<PAGE>

(1) For purposes of calculating this percentage, the total number of options
    granted during 1995 was 395,287.

(2) The options were granted for a term of ten years; however, in the event that
    the Named Executive's employment is terminated earlier, the options will
    expire three months after the Named Executive's termination.

(3) Potential realizable values reflect the difference between the option
    exercise price and the fair value of the Company's common stock price from
    the date of the grant until the expiration of the option.  The 5% and 10%
    appreciation rates, compounded annually, are assumed pursuant to the rules
    promulgated by the SEC and do not reflect actual historical or projected
    rates of appreciation of the common stock.  Assuming such appreciation, the
    following illustrates the per share value on the dates set forth (the
    expiration dates for the options), assuming the values set forth (the
    closing bid price on the date of the extension as reported by NASDAQ):

         STOCK PRICE ON          EXPIRATION
          DATE OF GRANT             DATE       5%         10%
          -------------             ----      ---        ----

          11/16/95: $5.54           11/16/05  $9.03     $14.34

   The foregoing values do not reflect appreciation actually realized by the
   Named Executive (See, "Option/SAR Exercises in Last Fiscal Year and Fiscal
   Year-End Option/SAR Value" Table, Below).

              AGGREGATED OPTION/SAR EXERCISES IN LAST FISCAL YEAR
                   AND FISCAL YEAR-END OPTION/SAR VALUE TABLE
<TABLE>
<CAPTION>
                                                       Number of       Value of
                                                      Securities     Unexercised
                                                      Underlying     In-the-Money
                                                     Unexercised     Options/SARs
                                                     Options/SARs    at FY-End ($)
                                                    at FY-End (#)
  Name                        Shares     Value       Exercisable/     Exercisable/
                             Acquired  Realize($) Unexerciseable (l) Unexercisable(2)
                             Exercise
                                (#)
=====================================================================================
<S>                          <C>       <C>       <C>                 <C>
David D. Watson                  0        $0         50,000 (3)           $N/A
=====================================================================================
------------------
</TABLE>

(1) All options held by the Named Executive are currently exercisable.

(2) Because the market price of the Company's common stock was $.9375 as of
    December 31, 1996, the Named Executive's options were not In-the-Money
    Options at fiscal year end.

(3) Includes options to purchase 50,000 shares of common stock at $5.50 per
   share.

                                       34
<PAGE>

Employment Agreements with Named Executives

     The Company has employment contracts with its Named Executives Thomas W.
Zaucha, David D. Watson, John A. Lombardi, and Ralph C. Sweithelm.

Zaucha

     Mr. Zaucha's contract with the Company is dated November 15, 1995 and has a
five-year term.  Pursuant to the contract, Mr. Zaucha was to serve as the
Company's CEO with a base salary of $125,000.  The contract contains
confidentiality and non-compete provisions. Mr. Zaucha also receives
compensation from the Company in other capacities outside of his role as its
CEO.  On February 13, 1997, the Board removed Zaucha for cause from his office
as Chief Executive Officer.

Watson

     Mr. Watson's contract with the Company is dated November 15, 1995 and has a
five-year term.  Pursuant to the contract, Mr. Watson serves as the Company's
President with a base salary of $ 75,000.  The contract contains confidentiality
and non-compete provisions.

Lombardi

     Mr. Lombardi's contract with the Company is dated September 16, 1996 and
has a renewable one-year term.  Pursuant to the contract, Mr. Lombardi serves as
the Company's Executive Vice President, Chief Financial Officer and Treasurer
with an annual salary of $112,000.  The contract also entitles Mr. Lombardi to
options to purchase 25,000 shares of common stock at a price of $1.75 per share
(the prevailing market price) on the effective date of his employment contract,
and options to purchase 50,000 shares of common stock at a price of $2.00 per
share; however, such options are not exercisable until the Company's common
stock is listed and trades at a price in excess of $5.93 per share for a period
of ten consecutive trading days.  None of the options have been issued as of the
date of this filing.  The contract contains confidentiality provisions and a
non-compete clause.

Sweithelm

     Mr. Sweithelm entered into an updated employment contract with the Company
in January, 1997. Pursuant to the contract, he serves as the president of
Northstar's subsidiary Keystone Rehabilitation Systems, Inc.  The contract has a
five-year term, renewable for one-year terms and provides for an annual salary
of $85,531.  In addition, Mr. Sweithelm is entitled to incentive compensation
based on Keystone's quarterly performance.   The contract entitles Mr. Sweithelm
to options to purchase 50,000 shares of common stock; none of those options have
been issued as of the date of this filing.   The contract contains
confidentiality provisions and a non-compete clause.

Director Compensation

     Each Director who is not an employee of the Company receives a quarterly
retainer fee of $3,000, an attendance fee of $1000 for each meeting at which he
is present in person and $250 for each telephonic meeting.  The meeting fees are
not paid to those directors with consulting contracts with the Company.  Each
member of the Audit Committee receives an attendance fee of $500 for each
meeting at which he is present in person.  In addition, Directors receive an
option to purchase 25,000 shares, at market value, for joining the board,
unless they own more than 10% of the outstanding common stock.  Those

                                       35
<PAGE>

directors with consulting contracts do not receive compensation for the
committee meetings.

     During 1996, Messrs. Brody and Smallacombe were compensated as consultants
to the Company.  A summary of their consulting contracts is set forth below.

Brody

     Mr. Brody's original consulting contract with the Company was dated January
1, 1996 for a term of one year, renewable month by month thereafter.  Pursuant
to the contract, Brody would provide to Northstar services related to strategic
planning and growth management.   For performance of these services Brody was
paid a monthly retainer fee of $3,000 plus expenses and an overage fee of $150
per hour for time in excess of 20 hours per month.  This contract was suspended
on March 19, 1996 when Brody began heading-up the  Investigative Committee.
On April 5, 1996, Brody entered into a contract with the Company whereby he
would perform all of the duties from the January 1, 1996 contract as well as
additional investor relations responsibilities, search activities for new
directors, negotiations with lenders and interfaces with investment bankers,
related to his position as head of the Investigative Committee.   This contract
calls for Brody to be compensated at the rate of $150 per hour plus expenses for
the services rendered.  In the event that Brody is engaged in services for
Northstar in excess of 60 hour per month, the excess hours are billed at a rate
of $250 per hour. The director services agreement also provided Brody with non-
qualified stock options ranging from 75,000 to 150,000 shares of common stock of
Northstar depending on his performance, exercisable at the lowest closing price
for Northstar common stock during the period March 19, 1996 and ending at the
formal termination of the investigation.  To date, none of such options have
been issued.  On the same date, Brody entered into another contract with the
Company whereby he would perform various services related to an investigation of
the former management of Northstar and its activities.  This contract calls for
Brody to be compensated at the rate of $150 per hour plus expenses for the
services rendered.  If Brody performs services in excess of  20 hours per month
regarding the above investigation, all hours in excess of 20 hours will be
billed to the Company at $250 per hour.  Since July 1996 when the Interim Report
of the Investigative Committee was completed, no material billings have been
made on this contract.

Smallacombe

     Mr. Smallacombe entered into a contract with the Company on August 18,
1996, whereby he agreed to provide consulting services related to crisis and
financial management and restructuring.  This contract was extended in January
1997 for a period of eight months, concluding September 30, 1997. The Company
agreed to compensate Smallacombe $6,500 per week for those services. The
contract also provided an option to purchase up to 25,000 shares of common stock
at $2.00 per share and 100,000 in non-qualified stock options for those
services, exercisable when the Company's common stock is listed and trades in
excess of $5.93 for at least fifteen consecutive trading days. The contract was
renewed for an additional eight months effective January 20, 1997 and provided
an additional option to purchase 25,000 shares at $1.75 per share. To date, none
of such options have been issued. When Smallacombe was appointed CEO, this
consulting contract was transformed into an employment contract with the same
terms.

Item 12: Security Ownership and Certain Beneficial Ownership
------------------------------------------------------------

     The following table sets forth the indicated information as of December 31,
1996 with respect to each person who is known by the Company to be the
beneficial owner of more than five percent (5%) of the outstanding common stock,
each director of the Company who owns common stock or options, and all directors
and executive officers of the Company as a group.  The table excludes disclosure
of entities such as Cede & Co. and other companies which would reflect the
ownership of entities who hold stock on behalf of shareholders.

     As of December 31, 1996, there were 5,867,154 shares of the Company's
common stock outstanding.   The first column sets forth the total number of
shares of common stock which each named person or group has the right to
acquire, through the exercise of options, within sixty (60) days, plus common
stock currently owned.  The third column sets forth the percentage of the total
number of shares of common stock outstanding as of December 31, 1996

                                       36
<PAGE>

which would be owned by each named person or group upon the exercise of all of
the warrants held by such person or group together with common stock currently
owned, as set forth in the first column. Except as otherwise indicated, each
person has the sole power to vote and dispose of each of the shares listed in
the columns opposite his name.

<TABLE>
<CAPTION>
Name and Address of                       Amount and Nature of
Beneficial Owner (1)                    Beneficial Ownership (2)   Percent of Class
-----------------------------------------------------------------------------------
<S>                                     <C>                        <C>
Steven N. Brody                              107,500 (3)                 1.8%
36 Overlook Drive
Indiana, PA 15701
-----------------------------------------------------------------------------------
Thomas Zaucha                                949,958 (4)                16.2%
100 Lafayette Circle
Indiana, PA 15701
-----------------------------------------------------------------------------------
David Watson                                  90,230 (5)                 1.5%
202 Forest Ridge Road
Indiana, PA 15701
-----------------------------------------------------------------------------------
All directors and executive officers          1,147,688                 19.2%
as a group
-----------------------------------------------------------------------------------
</TABLE>

________________________

(1) Includes ownership of all shares of common stock which each named person or
    group has the right to acquire, through the exercise of options, within
    sixty (60) days, together with the common stock currently owned.

(2) Represents total number of shares of common stock owned by each person,
    which each named person or group has the right to acquire, through the
    exercise of options within sixty (60) days, together with common stock
    currently owned, as a percentage of the total number of shares of common
    stock outstanding as of December 31, 1996. For computation purposes, the
    total number of shares of common stock outstanding as of December 31, 1996
    has been increased by the number of additional shares which would be
    outstanding if the person or group owned the number of shares set forth.

(3) Includes 50,000 shares of common stock and currently exercisable options to
    purchase 7,500 shares at $6.13 per share which expires at the earlier of 10
    years or one year after termination and options to purchase 50,000 shares at
    $5.25 with same features and terms.

(4) Includes 667,201 shares owned directly by Mr. Zaucha and his wife, Alice L.
    Zaucha, as joint tenants, 207,757 shares are held by the Zaucha Family
    Limited Partnership whose sole and general partners are currently Zaucha,
    his spouse and their four children, and 75,000 shares which are held by
    Zaucha as sole beneficial owner.

(5) Includes 40,230 shares of common stock and currently exercisable options to
    purchase 50,000 shares at $5.50 per share which expires at the earlier of 10
    years or one year after termination.

                                       37
<PAGE>

Item 13.     Certain Relationships and Related Transactions
-----------------------------------------------------------

     The Company does not adopt or affirm any related party disclosures made in
prior public filings including financial statements.  The transactions discussed
herein are based on current management's knowledge as of the date of this
document; however, management believes that other matters may come to their
attention during the various lawsuits and other actions as set forth in the
"Legal Proceedings" section herein, as well as those  discussed in Notes 1, 20
and 21 to the Financial Statements.  For more detailed financial information on
these matters see Note 12 to the Financial Statements.

Transactions Related to Zaucha

       Keystone Acquisition
       --------------------

     In connection with the Keystone acquisition, Mr. Thomas Zaucha is a former
officer and current director of the Company, has debt and other amounts due
directly to him of $3,919,500 and $7,897,500 as of  December 31, 1996 and
December 31, 1995, respectively.  In addition, Mr. Zaucha's family limited
partnership is due $1,105,500 and $2,227,500 as of December 31, 1996 and 1995,
respectively.

     As required under the Keystone Merger Agreement, immediately prior to the
merger, Keystone transferred to the Zaucha Family Limited Partnership, of which
Mr. Zaucha is a general partner, all of the real estate previously owned by
Keystone in return for a payment of $5,215,568. The parcels of such real estate
used in Keystone's business were then leased to Keystone. The current management
of the Company believes that the current leasing arrangements are in excess of
fair market value and continues its efforts to renegotiate the rental rates.
The leases are for a period of ten years, and commenced November 15, 1995.
Lease payments for 1996 and 1995 were $470,364 and $59,000, respectively.
Future minimum lease payments under these leases aggregate in excess of $4.6
million.

     Impulse Development
     -------------------

     During 1995 and 1996, the Company also paid to Impulse Development
Corporation, a company controlled by Thomas Zaucha, invoices for maintenance and
improvements to Company sites.  Current management discontinued its use of
Impulse when they determined that the invoices contained excessive mark-ups for
services.  In addition, a family member of the Company's former Chief Financial
Officer was employed by Impulse Development Corporation.

DeSimone Related Transactions

       Transactions Directly With Mr. Mark DeSimone
       --------------------------------------------

     During the year ended December 31, 1995, Mr. DeSimone paid the Company
$249,000 for expenses and interest which the Company had paid in previous years.
The Company repaid a loan of $162,000 to Mr. DeSimone on May 30, 1995 along with
8% per annum interest of $6,000.

     As of July 18, 1995, the Company amended its employment agreement with Mr.
DeSimone in exchange for Mr. DeSimone entering into an extended non-compete
agreement, fixing his annual compensation and returning 250,000 Northstar common
stock options.  In exchange, Mr. DeSimone received annual compensation and
benefits, 30,000 shares of Common Stock, a one-time bonus of $175,000 and the

                                       38
<PAGE>

repayment of a personal loan to PNC Bank in the amount of $150,000.  For each
year that Mr. DeSimone remained an employee of the Company, the Company agreed
to waive repayment by Mr. DeSimone of one-seventh of this loan.

     In February 1996, Mr. DeSimone terminated his employment with the Company
but continued to work as a consultant to the Company.  His employment contract
was changed to a consulting arrangement with similar terms underwhich the
Company paid him $47,000 during 1996.  In March 1996, Mr. DeSimone resigned from
the Board of Directors and the Company terminated its relationship with him.

     Mr. DeSimone personally guaranteed the Integra facility and received a 5%
guarantee fee totaling $325,000.

     Prior to 1995, Mr. DeSimone sold his consulting business to the Company.
During 1995, Mr. DeSimone was a director and consultant of SMT Health Services,
Inc. received $75,000 for consulting services to SMT. Current management
believes that these and possibly other fees for consulting services should have
been remitted to the Company and is seeking to recover such fees.

       Keystone Acquisition
       --------------------

     As part of the acquisition of Keystone, the Company paid $450,000 in cash
and issued 150,000 shares of common stock to Commercial Financial Corporation
(CFC), wholly-owned by Nichlaus P. Horoczko, a personal friend and business
associate of Mr. DeSimone.  Current management believes that CFC is a related
party. The Company guaranteed CFC that it would be able to be sell such shares
of common stock for at least $937,500. The Company believes that these shares of
common stock were sold on February 12, 1996 for approximately $840,000.  No
additional compensation has been requested by CFC for the shortfall in share
proceeds and in the opinion of current management, Mr. Horoczko did not perform
any services of value and therefore was not entitled to the common shares
discussed above or any additional compensation thereon.

       Transactions with Med-Bill Corporation, Inc., Med Consulting and Med-
       --------------------------------------------------------------------
Stat, Inc.
----------

     Mr.  James P. Shields, cousin of Mr. DeSimone, is an officer and sole owner
of Med-Bill.  Mr. DeSimone and his current wife, Leslie M. DeSimone are believed
by current management to be the principal financial interests in Med-Bill, with
similar relationships to Med-Consulting and Med-Stat.

     In 1994 the Company agreed to pay Med-Bill a financing fee of $250,000 at
the time of a loan.  On May 29, 1995, the Company paid the final installment of
$150,000 toward the aforementioned financing fee.

     In the first quarter of 1995, the Company loaned Med-Bill and Med
Consulting $41,000 and $25,000, respectively, pursuant to a demand note that
bears interest at the rate of 9% per annum. At December 31, 1995, these amounts
were deemed uncollectible and were written-off.

     On July 1, 1995, the Company entered into a lease agreement with Med-Stat,
Inc. for two pieces of ultrasound equipment in the amount of $225,000 and paid a
deposit of $30,000.  On August 31, 1995, the lease was bought-out by a reduction
in amounts due from Med-Bill of $167,500.  Current management believes that the
equipment leased/purchased may have been used and may not have been acquired at
fair market value.

                                       39
<PAGE>

       White-Oak Diagnostics Systems (White Oak)
       -----------------------------------------

     In November 1993, the Company acquired an interest in White Oak Diagnostic
Systems (White Oak) from Northern Diagnostics Services, Inc. (Northern
Diagnostics), an entity which was purportedly owned by Mr. James Shields. As
part of that acquisition, the Company agreed to make certain contingent payments
to either Northern Diagnostics or Med-Bill if gross collected revenues exceeded
$400,000 for 1995.  In 1995, the Company paid Med-Bill $85,000 for exceeding the
aforementioned gross collected revenues.

     Northern Diagnostics acquired White Oak from a group of physicians.  In
August 1995 White Oak made payments to the former physician owners of
approximately $150,000.  Current management believes that these payments by
White Oak represent amounts due to these physicians by Northern Diagnostics for
the acquisition.

     On May 30, 1995 the Company paid $350,000 to Med-Bill to satisfy amounts
recorded as due Med-Bill.

       PVL Acquisition
       ---------------

     In connection with the purchase of PVL and Vascusonics, the Company for no
consideration transferred to Ultrasonics, Inc. (Ultrasonics), all the
receivables of PVL and Vascusonics as of December 1, 1995 valued at $350,000.
Ultrasonics is a related party, owned by Mr. James Shields and/or Mr. Jeff D.
Bergman, the CEO and Chairman of the Board of SMT.

     The purchase agreement specified that certain equipment lease obligations
would be transferred to Ultrasonics.  White Oak and Vascusonics then agreed to
sublease the equipment from Ultrasonics.  White Oak and the Company jointly and
severally indemnified the sellers from and against any liability resulting from
the failure of Ultrasonics to discharge all obligations to the lessors after the
date of the sale.  Current management is not aware of any consideration received
by the Company from Ultrasonics in exchange for the lease contracts, which
current management believes yielded lease payments to Ultrasonics which were in
excess of fair market value for the leased equipment, or issuance of the
previously-mentioned indemnification.

     During 1996, the Company paid $53,341 in lease payments.  Although the
lessor paid approximately $155,000 for the equipment which it leased to the
Company, the Company is scheduled to make lease payments totaling approximately
$1,333,000.  After March 1996, the Company refused to pay any further amounts
under this contract, believing the payments to be excessive.  The Company is
vigorously contesting this obligation.

       Shields Management Agreement
       ----------------------------

     In 1995 the Company paid $270,000 to Mr. James Shields or Med-Bill in
connection with certain management services that Mr. Shields  provided at White
Oak and PVL.  As of December 31, 1995, the Company had approximately $37,000 due
to Mr. Shields or Med-Bill.  During the first quarter of 1996, the Company paid
Mr. Shields approximately $59,106 under the terms of his contract.  After March
1996, the Company refused to pay any further amounts under the contract,
believeing the payments to be excessive. severed its relationship with Mr.
Shields.  The Company is vigorously contesting this obligation.

                                       40
<PAGE>

Transactions with Other Board Members

     In 1996, Brody Associates, a consulting firm wholly-owned by Steven Brody,
Director, was retained to perform a variety of consulting services for the
Company related to its investigation of former management and related to the
corporate restructuring of the Company.  During 1996, the Company paid $223,795
to Brody Associates for these services and related business expenses.  At
December 31, 1996, the Company owed $25,586 to Brody Associates.

     In 1996, the Company retained Executive Advisory Group, Ltd., whose sole
owner is Robert Smallacombe, Director, to serve as a management consultant and
to aid in the corporate restructuring. During 1996, the Company paid $189,503 to
Executive Advisory Group, Ltd. For these services.  As of December 31, 1996, the
Company owed $9,750 to Executive Advisory Group, Ltd.

     In connection with the Keystone Merger, Mr. David Watson, an officer and
director of the Company, has debt due directly to him of $293,750 and $368,750,
as of December 31, 1996 and December 31, 1995, respectively.

     To assist with the investigation of former management, the Company retained
Plowman, Speigel & Lewis, P.C.  Charles Jarrett, Jr., currently a director of
the Company, is a member of  that firm.  During 1996, but prior to Mr. Jarrett's
appointment to the Board of Directors, the Company paid to Plowman, Speigel &
Lewis, P.C. $32,548 for professional services rendered.

     Other
     -----

     During 1995, the Company paid $13,500 to Ogg Jones DeSimone & Ignelzi, a
law firm in which Mr. DeSimone was a partner, purportedly for rent.


Item 14.     Exhibits, Financial Statement Schedules, and Reports on Form 8-K
-----------------------------------------------------------------------------

a)   1.   Financial Statements

The financial statements, together with the report thereon of the Company's
independent accountants, are included in this report on the pages listed below.

<TABLE>
<CAPTION>
Financial Statements                                       Page
                                                           ----
<S>                                                        <C>
     Report of Independent Public Accountants.............   1

     Consolidated Balance Sheets
     December 31,1996 and 1995............................   2

     Consolidated Statements of Operations
     for the years ended December 31,1996 and 1995........   4

     Consolidated Statements of  Stockholders' Equity
     for the years ended December 31, 1996 and 1995.......   5

</TABLE>

                                       41
<PAGE>

<TABLE>
<S>                                                        <C>
     Consolidated Statements of Cash Flows
     for the years ended December 31, 1995 and 1996.......   6

     Notes to Consolidated Financial Statements
     December 31, 1995 and 1996...........................   7

</TABLE>

2.   Exhibits:

(b)  Reports on Form 8-K

   The Company filed a Form 8-K report dated March 29, 1995.  The items listed
   was Item 5, Other Events.

   The Company filed a Form 8-K report dated March 31, 1995.  The items listed
   was Item 5, Other Events.

   The Company filed a Form 8-K report dated September 18, 1995.  The items
   listed were Item 4 Change in Registrant's Certifying Accountant; Item 5,
   Other Events, and Item 7(c), Exhibits.

   The Company filed a Form 8-K report dated September 18, 1995.  The items
   listed were Item 5, Other Events, and Item 7(c), Exhibits.

   The Company filed a Form 8-K report dated November 15, 1995.  The items
   listed were Item 2, Acquisition and Disposition of Assets; Item 5, Other
   Events, and Item 7(c), Exhibits.

   The Company filed a Form 8-K/A#1 report dated November 15, 1995.  The items
   listed were Item 2, Acquisition and Disposition of Assets; Item 7(a),
   Financial Statements of business acquired; and Item 7(b), Pro Forma Financial
   Information.

   The Company filed a Form 8-K report dated December 1, 1995.  The items listed
   were Item 2, Acquisition and Disposition of Assets; Item 5, Other Events, and
   Item 7(c), Exhibits.

   The Company filed a Form 8-K report dated March 25, 1996.  The items listed
   were Item 4, Change in Registrant's Certifying Accountant; Item 5, Other
   Events, and Item 7(c) Exhibits.

   The Company filed a Form 8-K report dated June 13, 1996.  The items listed
   was Item 4, Change in Registrant's Certifying Accountant.

(c)  Exhibits Required by Item 601 of Regulation S-K

         The following exhibits required by Item 601 of Regulation S-K are filed
         as part of this report.

3.1(1)   Articles of Incorporation

3.2      By-laws, as amended

4.1(2)   1992 Stock Option Plan, as amended

                                       42
<PAGE>

<TABLE>
<S>        <C>
4.2(2)     1994 Stock Option Plan for Non-Employee Directors

10.1       Ralph Sweithelm Employment Agreement with Keystone Rehabilitation Systems dated January 26, 1995

10.2       Brian K. Strong Employment Agreement with Northstar signed September 5, 1995

10.3       Michael J. Kulmoski Employment Agreement with Northstar signed October 27, 1995

10.4       Lisa S. Guarino Employment Agreement with Northstar signed November 11, 1995

10.5       Steven N. Brody Consulting Agreement with Northstar signed April 5, 1996

10.6       Nancy B. White Employment Agreement with Northstar signed May 1, 1996

10.7       Forbearance Agreement between Northstar and IBJ Schroder Bank & Trust Company dated May 31, 1996

10.8       Robert J. Smallacombe Consulting Contract with Northstar August 20, 1996

10.9       Edward Banos Employment Agreement with Northstar signed September 1, 1996

10.10       Separation Agreement with Lisa S. Guarino signed September 10, 1996

10.11      John A. Lombardi Employment Agreement with Northstar signed September 16, 1996

16.1(3)    KPMG Peat Marwick Letter of Resignation dated March 25, 1996

17.1       Director Letter of Resignation from Daniel McMenamin dated November 15, 1995

17.2       Director Letter of Resignation from Daniel Dickman dated November 17, 1995

17.3       Letter of Resignation from Michael J. Kulmoski, Jr. dated February 20, 1996

17.4       Director Letter of Resignation from Michael P. Pitterich dated March 21, 1996

17.5       Director Resignation Letter from Mark A. DeSimone dated March 21, 1996

27         Financial Data Schedule
------------------------
</TABLE>

(1)      Filed as an exhibit to the Company's Registration Statement on
         Form sb-2 dated February 3, 1993 (Registration No. 33-57916).

(2)      Filed as an annex to the Company's 1994 Proxy Statement dated May 9,
         1994.

(3)      Filed as an Exhibit to Form 8-K dated March 25, 1996.

                                       43
<PAGE>

Conformed Copy
--------------
                                   SIGNATURES

     Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on the 30th day of
                                                                 ----
March, 1997.
-----

                                         NORTHSTAR HEALTH SERVICES, INC


                                         By:  /s/ Robert J. Smallacombe
                                              -------------------------
                                              Robert J. Smallacombe,
                                             CEO, Principal Executive Officer
                                             and Director


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

<TABLE>
<CAPTION>

Signature                              Title                  Date
---------------------------  --------------------------  --------------
<S>                          <C>                         <C>

 /s/ David D. Watson         President, Chief Operating  March 30, 1997
---------------------------  Officer, Director


/s/ John Lombardi            Executive Vice President,   March 30, 1997
---------------------------  Principal Accounting and
                             Financial Officer

/s/ Steven N. Brody          Director                    March 30, 1997
---------------------------

/s/ Charles B. Jarrett       Director                    March 30, 1997
---------------------------

/s/ Hon. Timothy L. Pesci    Director                    March 30, 1997
---------------------------

    Thomas W. Zaucha         Director                    March 30, 1997
---------------------------
</TABLE>

                                       44
<PAGE>

                    REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS


To the Stockholders and Board of Directors
  of Northstar Health Services, Inc.:

We have audited the accompanying consolidated balance sheets of Northstar Health
Services, Inc. (a Delaware corporation and the Company) and Subsidiaries as of
December 31, 1996 and 1995 and the related consolidated statements of
operations, stockholders' equity, and cash flows for the two years then ended.
These financial statements are the responsibility of the Company's management.
Our responsibility is to express an opinion on these financial statements based
on our audits.

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

In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Northstar Health
Services, Inc. and Subsidiaries at December 31, 1996 and 1995, and the results
of its operations and its cash flows for the two years then ended, in conformity
with generally accepted accounting principles.

As discussed in Note 4, to the consolidated financial statements, effective
December 31, 1995, the Company changed its methods of accounting for impairment
of long-lived assets.

The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern.  As discussed in Notes 1, 7 and 20 to
the consolidated financial statements, the Company has suffered significant
losses from operations in 1996 and 1995, has been named in certain stockholder
litigation and is not meeting its contractual obligations with regard to debt
principal and interest payments and certain financial covenants which the lender
has not waived.  These matters raise substantial doubt about the Company's
ability to continue as a going concern.  Management's plans in regard to these
matters are also described in Note 7.  The financial statements do not include
any adjustments that might result from the outcome of this uncertainty.

Our audit was made for the purpose of forming an opinion on the basic financial
statements taken as a whole. The schedule listed in the index of financial
statements is presented for purposes of complying with the Securities and
Exchange Commissions rules and is not part of the basic financial statements.
This schedule has been subjected to the auditing procedures applied in the audit
of the basic financial statements and, in our opinion, fairly states in all
material respects the financial data required to be set forth therein in
relation to the basic financial statements taken as a whole.

                                         Arthur Andersen LLP


Pittsburgh, Pennsylvania,
  March 25, 1997

                                      -1-
<PAGE>

               NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
               ------------------------------------------------

                  CONSOLIDATED BALANCE SHEETS (Notes 1 and 2)
                  -------------------------------------------


                            (Dollars in Thousands)
                            ----------------------

<TABLE>
<CAPTION>
                                             December 31,
                                           -----------------
              A S S E T S                   1996      1995
              -----------                  -------  --------
<S>                                        <C>      <C>
CURRENT ASSETS:
Cash and cash equivalents-
   General operating funds                 $ 1,607   $   630
   Cash collateral supporting a letter
    of credit (Notes 3 and 6)                    -     5,100
 Accounts receivable-
   Patients, net of allowances for
    doubtful accounts of
       $3,759 and $3,518, respectively       6,098     7,210
   Management fees                             766       361
   Miscellaneous                               244       445
 Prepaid expenses and other current
  assets                                       731       857
                                           -------   -------

          Total current assets               9,446    14,603
                                           -------   -------

PROPERTY AND EQUIPMENT, net (Notes 5, 6
 and 10)                                     3,682     4,422

INTANGIBLE ASSETS, net (Note 4)             21,132    23,947

OTHER ASSETS                                   282       383
                                           -------   -------

TOTAL ASSETS                               $34,542   $43,355
                                           =======   =======
</TABLE>

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

                                      -2-
<PAGE>

               NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
               ------------------------------------------------

                  CONSOLIDATED BALANCE SHEETS (Notes 1 and 2)
                  -------------------------------------------

                   (Dollars in Thousands, Except Share Data)
                   -----------------------------------------

<TABLE>
<CAPTION>
                                              December 31,
                                          -------------------
  LIABILITIES AND STOCKHOLDERS' EQUITY      1996       1995
  ------------------------------------    --------   --------
<S>                                       <C>        <C>
CURRENT LIABILITIES:
Current portion of long-term debt
 (Notes 6, 7, 10, 12 and 21)
   IBJ Schroder                           $ 14,083   $ 14,017
   Thomas Zaucha and Zaucha Family
    Limited Partnership                      1,285      5,500
   Other debt                                1,893      1,593
 Accounts payable                            2,048        456
 Accrued expenses (Note 8)                   5,323      3,568
 Contractual obligations to employees
  (Note 16)                                  1,633      1,450
                                          --------   --------

          Total current liabilities         26,265     26,584
                                          --------   --------

LONG-TERM DEBT (Notes 6, 7, 10 and 12)
 Thomas Zaucha and Zaucha Family             3,183      3,833
  Limited Partnership
 Other debt                                  1,718      2,455
                                          --------   --------
          Total long term debt               4,901      6,288

MINORITY INTEREST (Note 3)                     184        116
                                          --------   --------

          Total liabilities                 31,350     32,988
                                          --------   --------

STOCKHOLDERS' EQUITY (Notes 3, 6, 9,
 12, 13 and 19):
 Preferred stock, par value $.01 per
  share, 1,000,000 shares authorized,
  none issued
 Common stock, par value $.01 per
  share, 10,000,000 shares authorized;
  6,229,718 and 5,285,366 shares                62         53
  issued; 5,867,154 and 5,285,366
  outstanding in 1996 and 1995


 Common shares issuable 0 and 944,352
  shares in 1996 and 1995, respectively          -      5,591

 Additional paid-in capital                 26,208     20,626
 Warrants outstanding                        1,951      1,951
 Retained deficit                          (24,576)   (15,629)
 Less:  Treasury stock, 362,564 in 1996       (453)         -
  and 0 shares in 1995
   Notes receivable collateralized with
    common stock                                 -     (2,225)
                                          --------   --------

          Total stockholders' equity         3,192     10,367
                                          --------   --------

TOTAL LIABILITIES AND STOCKHOLDERS'
 EQUITY                                   $ 34,542   $ 43,355
                                          ========   ========
</TABLE>

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

                                      -3-
<PAGE>

               NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
               ------------------------------------------------

             CONSOLIDATED STATEMENTS OF OPERATIONS (Notes 1 and 2)
             -----------------------------------------------------

                 FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995
                 ----------------------------------------------

                   (Dollars in Thousands, Except Share Data)
                   -----------------------------------------
<TABLE>
<CAPTION>
                                             1996         1995
                                          -----------  -----------
<S>                                       <C>          <C>
NET PATIENT SERVICE REVENUE               $   35,176   $   15,424

COSTS OF SERVICE                              18,956       10,640
                                          -----------  -----------
   Gross profit                               16,220        4,784

OPERATING EXPENSES:
 Selling, general and administrative
  expenses                                    13,129        6,202
 Bad debt expense                              1,820        2,301
 Restructuring and other non-recurring
  expenses (Note 9)                            4,969        3,827
 Impairment of long-lived assets (Note
  4)                                               -        3,050
 Amortization of intangibles (Note 4)          1,623        1,193
 Depreciation and amortization                   635          173
                                          -----------  -----------
          Total operating expenses            22,176       16,746
                                          -----------  -----------


OPERATING LOSS                                (5,956)     (11,962)

NON-OPERATING EXPENSES:
 Interest expense, net                         2,130          833
 Other expense, net                               96          208
                                          -----------  -----------
          Total non-operating  expenses        2,226        1,041
                                          -----------  -----------


LOSS BEFORE INCOME TAXES                      (8,182)     (13,003)

INCOME TAXES (Note 14)                           471         (236)
                                          -----------  -----------

LOSS BEFORE MINORITY INTEREST AND
 EXTRAORDINARY LOSS                           (8,653)     (12,767)

MINORITY INTEREST (Note 3)                       294           60
                                          -----------  -----------


LOSS BEFORE EXTRAORDINARY LOSS                (8,947)     (12,827)

EXTRAORDINARY LOSS, (Note 6)                       -         (274)
                                          -----------  -----------

NET LOSS                                  $   (8,947)  $  (13,101)
                                          ===========  ===========

EARNINGS PER SHARE:
Loss before extraordinary loss                $(1.44)      $(3.21)
Extraordinary loss                                 -         (.07)
                                          -----------  -----------
NET LOSS                                      $(1.44)      $(3.28)
                                          ===========  ===========

WEIGHTED AVERAGE NUMBER OF COMMON
 SHARES AND EQUIVALENTS                    6,216,840    3,996,147
                                          ===========  ===========

</TABLE>
  The accompanying notes are an integral part of these financial statements.

                                      -4-
<PAGE>

               NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
               ------------------------------------------------

        CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (Notes 1 and 2)
        ---------------------------------------------------------------

                FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995
                ----------------------------------------------

                            (Dollars in Thousands)
                            ----------------------

<TABLE>
<CAPTION>
                                  Common Stock            Common Shares Issuable
                              -----------------------     ----------------------         Additional     Warrants
                              Shares Issued    Amount     Shares       Amount         Paid-In Capital  Outstanding
                              -------------    ------     ------       ------         ---------------  -----------
<S>                          <C>             <C>         <C>           <C>             <C>              <C>
   BALANCE, December 31,
    1994, as previously
    reported                 2,600,000           $26           -      $      -               $ 5,592    $       -

     Corrections of errors
      (Note 19)                      -             -      20,378           127                   113           342
                             ---------           ---     -------      --------               -------        ------
   BALANCE, December 31,
    1994, as restated        2,600,000            26      20,378           127                 5,705           342
     Issuance of common
      stock in secondary
      offering               2,012,500            20           -             -                10,678             -

     Issuance of stock for
      acquisitions (Note 3)    200,591             2           -             -                 1,678             -
     Shares issuable for
      acquisitions (Note 3)          -             -     944,352         5,591                     -             -
     Issuance of shares
      issuable                  20,378             -     (20,378)         (127)                  127             -
     Issuance of common
       stock in exchange
       for salary reduction     30,000             -           -             -                   198             -

     Interest accrued                -             -           -             -                     -             -
     Warrants issued in
      connection with bank
      financing                      -             -           -             -                     -           703

     Issuance of warrants
      for consulting
      services                       -             -           -             -                     -           220
     Issuance of warrants
      to underwriter                 -             -           -             -                  (686)          686
     Compensatory stock
      options issued                 -             -           -             -                   358             -
     Disproportionate
      dividend (Note 3 )             -             -           -             -                     -             -
     Reclassification of
      note receivable for
      new
      collateralization by
      common stock                   -             -           -             -                     -             -


     Issuance of common
      shares and
      collateralized note
      receivable (Note 3)      362,564             4           -             -                 2,146             -

     Exercise of stock
      options                   59,333             1           -             -                   422             -
                             ---------           ---     -------      --------               -------        ------
     Net loss                        -             -           -             -                     -             -

   BALANCE, December 31,
    1995                     5,285,366            53     944,352         5,591                20,626         1,951
     Issuance of shares
      issuable (Note 3)        944,352             9    (944,352)       (5,591)                5,582
     Receipt of common
      stock as treasury
      stock through
      surrender of a note
      receivable (Note 3)            -             -           -             -                     -             -


     Write off of
      uncollectible notes
      receivable                     -             -           -             -                     -             -
     Net loss                        -             -           -             -                     -             -
                             ---------           ---     -------      --------               -------        ------

   BALANCE, December 31,
    1996                     6,229,718           $62           -      $      -               $26,208        $1,951
                             =========           ===     =======      ========               =======        ======

<CAPTION>

                                               Treasury Stock
                                 Retained     ----------------       Notes
                                (Deficit)     Shares    Amount    Receivable       Total
                                ---------     ------    ------    ----------       -----
<S>                           <C>             <C>      <C>        <C>          <C>
   BALANCE, December 31,
    1994, as previously
    reported                       $  1,823         -       $  -     $   (30)      $  7,411

     Corrections of errors
      (Note 19)                      (3,173)        -          -           -         (2,591)
                                   --------   -------       ----     -------       --------
   BALANCE, December 31,
    1994, as restated                (1,350)        -          -         (30)         4,820
     Issuance of common
      stock in secondary
      offering                            -         -          -           -         10,698

     Issuance of stock for                -         -          -           -          1,680
      acquisitions (Note 3)
     Shares issuable for                  -         -          -           -          5,591
      acquisitions (Note 3)
     Issuance of shares                   -         -          -           -              -
      issuable
     Issuance of common
       stock in exchange
       for salary reduction               -         -          -           -            198

     Interest accrued                     -         -          -          (7)            (7)
     Warrants issued in
      connection with bank
      financing                           -         -          -           -            703

     Issuance of warrants
      for consulting
      services                            -         -          -           -            220
     Issuance of warrants
      to underwriter                      -         -          -           -              -
     Compensatory stock
      options issued                      -         -          -           -            358
     Disproportionate
      dividend (Note 3 )             (1,178)        -          -           -         (1,178)
     Reclassification of
      note receivable for
      new
      collateralization by
      common stock                        -         -          -         (38)           (38)


     Issuance of common
      shares and
      collateralized note
      receivable (Note 3)                 -        -           -      (2,150)             -

     Exercise of stock
      options                             -         -          -           -            423
     Net loss                       (13,101)        -          -           -        (13,101)
                                   --------   -------       ----     -------       --------

   BALANCE, December 31,
    1995                            (15,629)        -          -      (2,225)        10,367
     Issuance of shares
      issuable (Note 3)
     Receipt of common
      stock as treasury
      stock through
      surrender of a note
      receivable (Note 3)                 -   362,564        453       2,150          1,697


     Write off of
      uncollectible notes
      receivable                          -         -          -          75             75
     Net loss                        (8,947)        -          -           -         (8,947)
                                   --------   -------       ----     -------       --------

   BALANCE, December 31,
    1996                           $(24,576)  362,564       $453     $     -       $  3,192
                                   ========   =======       ====     =======       ========
</TABLE>

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

                                      -5-
<PAGE>

               NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
               ------------------------------------------------

             CONSOLIDATED STATEMENTS OF CASH FLOWS (Notes 1 and 2)
             -----------------------------------------------------

                FOR THE YEARS ENDED DECEMBER 31, 1996 AND 1995
                ----------------------------------------------

                            (Dollars in Thousands)
                            ----------------------

<TABLE>
<CAPTION>
                                            1996        1995
                                           --------   ---------
<S>                                        <C>        <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
 Net loss                                  $(8,947)   $(13,101)
 Adjustments to reconcile net loss to
  net cash provided by (used in)
  operating activities-
     Depreciation and amortization           4,293       1,781
     Impairment of long-lived assets             -       3,050
     Loss on early extinguishment of
      debt                                       -         274
     Provision for doubtful accounts         1,820       2,301
     Loss on note receivable
      collateralized by common stock         1,772           -
     Loss on write off of investment            25           -
     Interest on discounted obligation         241           -
     Deferred income taxes                       -        (128)
     Loss on sale of equipment                  47          16
     Provision for increase in
      contractual obligations to
      employees                                262           -
     Stock option and warrant
      compensation expense                     113         570
     Minority interest                         294          61
     Change in current assets and
      liabilities-
       Decrease/(increase) in
        receivables                           (912)         36
       Decrease/(increase) in other
        current assets                         126        (218)
       Increase/(decrease) in accounts
        payable                              1,592        (212)
       Increase in accrued expenses          1,755         789
                                           --------   ---------
          Net cash provided/(used) by
           operating activities              2,481      (4,781)
                                           --------   ---------

CASH FLOWS FROM INVESTING ACTIVITIES:
 Acquisitions, net of cash acquired            (10)    (13,124)
 Earn-out payments on prior period
  acquisitions                                   -        (617)
 Capital expenditures                         (345)       (420)
 Deposits, loans and investments               (12)        (33)
 Other investing activities                      -        (668)
 Proceeds from sale of equipment                18           3
                                           --------   ---------
          Net cash used by investing
           activities                         (349)    (14,859)
                                           --------   ---------


CASH FLOWS FROM FINANCING ACTIVITIES:
 Proceeds from issuance of common
  stock in public offering                       -      10,699
 Payments on long-term debt                 (1,566)    (15,695)
 Debt issuance and organization costs            -        (729)
 Payment of acquisition note to Thomas
  Zaucha                                    (5,100)          -
 Stock options exercised                         -         457
 Payments of contractual obligations to
  employees                                    (79)          -
 Distributions to minority interests          (226)        (57)
 Borrowings on long-term debt                  716      30,045
                                           --------   ---------
          Net cash (used)/provided by
           financing activities             (6,255)     24,720
                                           --------   ---------


NET (DECREASE)/INCREASE IN CASH AND
 CASH EQUIVALENTS                           (4,123)      5,080

CASH AND CASH EQUIVALENTS, beginning
 balance                                     5,730         650
                                           --------   ---------

CASH AND CASH EQUIVALENTS, end balance     $ 1,607    $  5,730
                                           ========   =========

SUPPLEMENTARY INFORMATION:
 Interest paid                             $   821    $  1,018
 Income taxes paid                             216         494

NONCASH INVESTING AND ACTIVITIES:
 Capital lease obligations                 $   395    $  1,467
 Issuance of stock for acquisitions              -       1,680
 Shares issuable for acquisition                 -       5,591
 Issue warrants to bank as debt discount         -         703
 Issue note receivable and related
  common shares collateralizing note             -       2,150
 Issuance of common stock in exchange
  for salary reduction                           -         198
 Issuance of common stock warrants for
  services                                       -         886
 Notes payable issued in connection
  with the acquisitions                          -       9,618
 Treasury stock received through
  surrender of note receivable
  collateral                                   453           -
</TABLE>

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

                                      -6-
<PAGE>

                NORTHSTAR HEALTH SERVICES, INC. AND SUBSIDIARIES
                ------------------------------------------------


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


1. DESCRIPTION OF BUSINESS ORGANIZATION AND SIGNIFICANT EVENTS:
   ------------------------------------------------------------

Nature of Operations
--------------------

Northstar Health Services, Inc. (Northstar or the Company) is a provider of
rehabilitation therapy and related services, such as diagnostics and sub acute
care, in Pennsylvania and surrounding states, providing services at outpatient
rehabilitation clinics and patient care facilities to patients suffering from
physical disabilities.  The goals of rehabilitation therapy are to improve the
patients' physical strength and range of motion, reduce pain, help prevent
injury, and restore the ability to perform basic activities, including
communication.  The Company primarily provides these services through outpatient
rehabilitation clinics and under contractual arrangements with patient care
facilities.  The term "Company" means, unless the context requires otherwise,
the Company and its subsidiaries and their respective predecessors.

Trading of Common Shares
------------------------

On May 18, 1995, the Securities and Exchange Commission (the Commission)
declared effective a registration statement on Form SB-2 originally filed by the
Company on March 31, 1995. The registration statement registered with the
Commission, among other things, the offer and sale of 1,750,000 shares of Common
Stock (the Public Offering). A closing on the Public Offering was held on May
26, 1995. On June 8 and June 15, 1995, the underwriters of the Public Offering
exercised their over-allotment option to purchase an aggregate of 262,500 shares
of Common Stock. The net proceeds of approximately $10,000,000 from the Public
Offering and the exercise of the over-allotment option were used to finance
acquisitions, to repay certain of the Company's short-term indebtedness, pay
certain expenses of the Company's Public Offering not paid at closing, and for
other general corporate purposes, including working capital.

The Company's common stock was traded on the NASDAQ National Market beginning
June 3, 1993 under the symbol "NSTR".  After some of the events outlined below
occurred, trading of the Company's common stock was halted by the NASDAQ
National Market on May 31, 1996.

Resignation of Auditors and Immediate Board Changes
---------------------------------------------------

In March 1996, the Company's auditors, KPMG Peat Marwick (KPMG), who had been
appointed in late 1995, resigned prior to completing an audit of Northstar.
Soon after KPMG's resignation, the Company's former Chairman of the Board, Mark
A. DeSimone was asked to resign from the Company's Board of Directors along with
one independent director.  Certain members of management were also relieved from
their duties.  Concurrently, Thomas W. Zaucha was appointed as Chairman of the
Board and an independent member of the Board of Directors was appointed to
investigate certain allegations of improprieties.

                                      -7-
<PAGE>

Employment Agreements
---------------------

During March 1996 the Company terminated Mr. DeSimone's employment agreement.
In accordance with the aforementioned agreement, Mr. DeSimone was to receive six
months salary after termination.  The Company has not paid any termination
salary to Mr. DeSimone.

On April 30, 1996, one of the former owners of an acquired business terminated
her employment agreement with the Company due to a change in control clause in
the employee's contract.  A new contract was negotiated with the same salary;
however, the new agreement ends approximately six months prior to the initial
contract.  The Company and this employee later agreed to terminate this
employee's contract as a result of operational difficulties. The Company is
currently in settlement discussions with this individual in order to settle
issues related to this severance.

In July 1996, the Company terminated a former officer who had been on suspension
pending the outcome of the Board of Director's independent investigation.  The
Company is currently involved in an arbitration with this former employee.  See
Note 20 for additional discussion.

In September 1996, the Company's former chief financial officer left the
employment of the Company to pursue other interests as part of a negotiated
settlement.  An employment contract has been accepted by the Company's new chief
financial officer.

Stockholders' Suits
-------------------

Following the resignation of KPMG, while the Company was conducting its
investigation and before the Company filed its suit as discussed below, the
Company was named in suits filed by groups of stockholders. The Company believes
that the basis for the stockholders' suits are the actions of certain members of
former management and other potentially responsible parties. See Note 20 for a
discussion of the status of this litigation.

Company's Suit
--------------

Based upon the investigation completed by special independent legal counsel, the
Board of Directors voted to pursue legal actions against the Company's former
Chairman of the Board, certain former employees, the predecessor auditors of the
Company, for years prior to 1995, Richard A. Eisner & Company and certain other
individuals and entities who were allegedly involved in improper actions and
diversion of funds to other entities.  A complaint was filed in the Western
District of Pennsylvania United States District Court on September 12, 1996.
Although the result of this lawsuit is indeterminable at this time, the Company
expects to actively seek restitution for damages from the responsible parties.
See Note 20 for a further discussion of this litigation.


2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
   -------------------------------------------

Principles of Consolidation
---------------------------

The consolidated financial statements include the accounts of the Company, its
wholly-owned subsidiaries, and its interests in partnerships and joint venture
arrangements only for the period subsequent to their acquisition.  All
significant intercompany balances and transactions have been eliminated. The
Company uses the equity method of accounting for less than majority-owned
entities.

                                      -8-
<PAGE>

Basis of Presentation
---------------------

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

Industry Risks
--------------

The U.S. health care industry continues to experience significant change even
without passage of comprehensive legislative reform at the federal level.
Today, the primary force for change is being created by a competitive
marketplace resulting in rapid change in health care delivery and financing.

An increasing number of the Company's third-party payors are adopting
prospective payment systems.  The Company has signed provider contracts with a
few managed care organizations, which emphasize utilization control and cost
containment, and the Company's business with these managed care organizations is
expected to increase significantly in the next few years.  Managed care
organizations either directly transfer risk to health care providers through
capitation payment arrangements or pay for units of service on a steeply
discounted basis.

These factors cause significant challenges to all providers, including the
Company.

Net Patient Service Revenue
---------------------------

The Company has agreements with third-party payors that provide for payments to
the Company at amounts different from its established rates.  A summary of the
payment arrangements with major third-party payors is as follows:

   Medicare - Services rendered to Medicare program beneficiaries are paid based
   on a cost reimbursement methodology subject to cost limitations.  The Company
   is reimbursed for services at a tentative interim rate with final settlement
   determined after submission of annual cost reports by the Company and audits
   thereof by the Medicare fiscal intermediary.  The Company's Medicare cost
   reports have been audited with final settlements determined by the Medicare
   fiscal intermediary through December 31, 1994 for the Northstar and Keystone
   "home offices" and through December 31, 1995, for branch operations.

   Medical Assistance and Blue Cross - Services rendered to Medical Assistance
   eligible patients and Blue Cross subscribers are paid at prospectively
   determined rates.

Any normal recurring types of changes arising from audit or settlement after the
close of the fiscal year are reflected in subsequent years' net patient service
revenue.

The Company has also entered into payment agreements with certain commercial
insurance carriers, health maintenance organizations and preferred provider
organizations.  The basis for payment to the Company under these agreements
includes prospectively determined rates and discounts from established charges.
Certain of these contracts provide capitation terms whereby the Company receives
a sum of money per covered person within the certain insurance plan and in
return the Company agrees to

                                      -9-
<PAGE>

provide all of the rehabilitation and certain diagnostic testing which is deemed
medically necessary for these plan members. In addition to the payments from the
insurance organizations, the Company receives in certain coverage circumstances
co-payment amounts from patients for each event of service.

The Company grants credit without collateral to its patients, most of whom are
local residents and are insured under third-party payor agreements.  The mix of
gross receivables from patients and third-party payors at December 31, 1996 and
1995, was as follows:

<TABLE>
<CAPTION>
                                          1996   1995
                                          -----  -----
<S>                                       <C>    <C>
Workers' compensation                       31%    23%
Other third-party payors                    26     24
Contracts with nursing homes and other
 such providers                             15     12
Medicare                                    14     23
Blue Cross                                  10     13
Self-pay patients                            3      5
Medicaid                                     1      -
                                          ----  -----
                                           100%   100%
                                          ====   ====
</TABLE>

The healthcare industry is subject to numerous laws and regulations of Federal,
state and local governments.  These laws and regulations include, but are not
necessarily limited to, matters such as licensure, accreditation, government
healthcare program participation requirements, reimbursement for patient
services, and Medicare and Medicaid fraud and abuse.  Recently, government
activity has increased with respect to investigations and allegations concerning
possible violations of fraud and abuse statutes and regulations by healthcare
providers.  Violations of these laws and regulations could result in expulsion
from government healthcare programs together with imposition of significant
fines and penalties, as well as significant repayments for patient services
previously billed.  Management believes that the Company is in compliance with
fraud and abuse as well as other government laws and regulations.  While no
regulatory inquiries have been made, compliance with such laws and regulations
can be subject to future government review and interpretation as well as
regulatory actions unknown or unasserted at this time.

Management Fees
---------------

The Company manages two businesses, in one of which the Company owns a minority
interest.  In conjunction with these contracts, the Company receives
compensation in the form of a monthly management fee.  This fee is to be the net
income or loss of the managed business after the payment of certain agreed-upon
salaries and benefits to certain parties.  As part of the management of the
operations, the Company is responsible for the process of writing accounts
payable checks.  In connection with the simplification and streamlining of
duties, the Company pays the aforementioned invoices from its corporate location
and has accepted a gross management fee which includes reimbursement for the
payment of such managed-organizations expenses.  A summary of the management
fees and related expenses is outlined below:

<TABLE>
<CAPTION>
                                            1996     1995
                                          --------  ------
<S>                                       <C>       <C>
Management fees                           $ 2,697   $ 347
Less:  expenses incurred with
 management function                       (3,092)   (406)
                                          --------  ------
Net loss from managed operations          $  (395)  $ (59)
                                          ========  ======
</TABLE>

                                      -10-
<PAGE>

The net of expenses in excess of management fees are presented in the selling,
general and administrative expenses section of the accompanying consolidated
statements of operations.

Insurance
---------

The Company presently insures against malpractice and workers' compensation
risks with independent third-party insurers and with the Commonwealth of
Pennsylvania Workers' Compensation fund utilizing claims-made policies.

Cash and Cash Equivalents
-------------------------

All cash equivalents are stated at cost, which approximates market.  The Company
considers all highly liquid investments purchased with a maturity of three
months or less when purchased to be cash equivalents.

Property and Equipment
----------------------

The Company's property and equipment are stated at cost and are depreciated
using the straight-line method over the estimated useful lives of the assets or
the term of the lease, as appropriate.  Most non-leased depreciable assets have
estimated useful lives in the range of 5 to 7 years.

Upon disposal of property items, the asset and related accumulated depreciation
accounts are relieved of the amounts recorded therein for such items and any
resulting gain or loss is reflected in income.

Deferred Costs
--------------

Organization costs are recorded at cost and amortized on a straight-line basis
over a five-year period.  Debt issuance costs are amortized over the term of the
debt.  Such costs are included in intangibles.

Intangible Assets
-----------------

Intangible assets consist of the excess of cost over net assets of acquired
organizations (goodwill), non-compete and employment agreements with certain key
employees of organizations which have been acquired, the Keystone tradename and
assembled workforce and other intangibles consisting of primarily deferred
financing costs.  Certain of the aforementioned non-compete agreements had been
amortized over a period of approximately fifteen years through December 31,
1994.  As of December 31, 1995, the Company recognized that it was an error to
amortize these agreements over the aforementioned periods.  Thus, as of December
31, 1995, the Company determined that the correct amortization period should
have been five years.  See Note 19.

In March 1995, the Financial Accounting Standards Board (the FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of."
This accounting pronouncement requires that long-lived assets and identifiable
intangibles to be held and used by an entity are to be  reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
the assets may not be recoverable.

The Company has chosen early adoption of this accounting pronouncement as of
December 31, 1995.  In accordance therewith, as of December 31, 1995 current
management believes that certain actions of

                                      -11-
<PAGE>

former management that lead to the litigation discussed in Note 1, and other
circumstances have occurred that indicate that the remaining balance of
intangible assets may not be recoverable. Thus, as these factors have indicated
that intangible assets should be evaluated for possible impairment, the Company
has used an estimate of the related operations' undiscounted cash flows over the
remaining life of the various intangible assets in measuring whether these
intangible assets are recoverable. The Company's evaluations have resulted in
adjustments to goodwill, non-compete and employment agreements. See Note 4.

Treasury Stock
--------------

The Company may periodically repurchase its own stock as a result of a specific
transaction or as part of an organized repurchase plan.  The Company accounts
for such stock repurchases on the cost basis and records the stock value as a
contra-equity line item on its financial statements.  Treasury stock was
received in December 1996 as a result of a surrender of 362,564 shares of common
stock in connection with a certain note receivable.  See Note 3.

Income Per Share
----------------

Income per share is calculated based on the weighted average number of shares of
common stock and common stock equivalents outstanding during the period.  Common
stock equivalents are not included in any period that has a net loss as they
would be anti-dilutive.

Income Taxes
------------

The provision for income taxes is based on earnings reported in the financial
statements.  Deferred income taxes are provided on the basis of timing
differences between reported earnings and taxable income.  Since 1994, the
Company and its subsidiaries have filed a consolidated federal income tax
return.  The general and limited partnerships file separate income tax returns.

3. MERGERS, ACQUISITIONS AND JOINT VENTURE AGREEMENTS:
   ---------------------------------------------------

Keystone Rehabilitation Systems, Inc. (Keystone)
------------------------------------------------

On November 15, 1995, NSK Merger Corp., a newly-formed subsidiary of the
Company, was merged with and into Keystone (a Pennsylvania corporation).  Prior
to this merger (the Merger), Keystone was the largest privately held
rehabilitation company in Pennsylvania, providing services in physical,
occupational and speech therapy, including sports rehabilitation and work
hardening in outpatient clinics, as well as in patient care facilities, located
throughout Pennsylvania and in New York, Ohio and West Virginia.

As consideration for the Merger, the shareholders of Keystone, Thomas W. Zaucha
and Alice L. Zaucha and the Zaucha Family Limited Partnership (collectively, the
"Shareholders), received the following: (a) $2,500,000  in cash; (b) a Time Note
due January 3, 1996 in the aggregate principal amount of $5,100,000; (c) a five-
year, interest free Term Note in the aggregate principal amount of $2,625,000;
(d) the agreement by the Company to issue, on January 3, 1996, a three-year, 6%
Term Note in the aggregate principal amount of $2,400,000 (the Three-Year Note);
and (e) the agreement by the Company to issue to the Shareholders, on January 3,
1996, an aggregate of 944,352 shares of common stock, par value $.01 per share
(the Common Stock), of the Company (the Stock Consideration).  The debt issued
in this acquisition was discounted using current market rates.  See Note 6.

                                      -12-
<PAGE>

In connection with the Merger, the Company (i) guaranteed the value of the Stock
Consideration to be at least $5,600,000 through certain periods ending no later
that December 31, 1997; (ii) agreed to seek necessary stockholder approval to
allow the Three-Year Note to be converted into Common Stock at the conversion
price of $5.93 per share and to pay any guaranteed amount in additional shares
of Northstar Common Stock based on the trading price of the Common Stock at the
time of issuance; and (iii) issued a five-year interest-free note to David D.
Watson, Keystone's Chief Operating Officer and Executive Vice President, in the
aggregate principal amount of $375,000, in release of any interest Mr. Watson
might have in Keystone.  Similar to the debt in the preceding paragraph, this
obligation to Mr. Watson has been discounted using the Company's current
borrowing rate.

As discussed above, a stock price of $5.93 per share was guaranteed to the
Shareholders for periods ending not later than December 31, 1997.  As of
December 31, 1996, the market price of the Company's common stock was valued at
$1.375 per share, as quoted by the Bloomberg Service.  The Company has a
contractual obligation to fund this shortfall in stock value through a cash
payment equal to the shortfall or, with shareholder approval, through the
issuance of additional shares to the Shareholders in an amount equal to the
shortfall.  Based on the December 31, 1996 stock quotation, the Company was
obligated to issue approximately 3,128,000 additional shares of stock with an
estimated market value of  $4,301,523.  The issuance of such additional shares
would not affect the purchase price (goodwill) or the statement of operations,
but rather would cause a reclassification of the par value of said shares to
common stock from additional paid in capital to the par value of common stock.
Further, such shares would be included in the calculation of fully diluted
earnings per share except for the fact that such effect would be anti-dilutive
because of the Company's net loss.

The Company also agreed to make additional "earn-out" payments to the
Shareholders of $1,600,000 per year in the event that Keystone's "EBITA" exceeds
$2,500,000 in any year from 1996 to 2000, inclusive.  EBITA is defined,
generally, to mean Keystone's earnings (including earnings from any internally
generated facility or contract but excluding earnings from any facility or
contract acquired from third parties) before taxes, interest, depreciation and
amortization.  In the event an earn-out is not earned and therefore not paid in
any given year, the earn-out will be paid in the next year if EBITA in such next
year exceeds the greater of $3,200,000 or $2,500,000  plus the amount of the
EBITA shortfall in such prior year.  The Shareholders are to receive an earn-out
of approximately $200,000 for 1995.   The earn-out amounts for years 1996
through 2000 will be reduced in the event that the current liabilities of
Keystone at the date of the Merger (other than permitted capital leases)
exceeded $2,000,000.   In addition, such earn-out payments will be reduced by
50% of such current liabilities up to $2,000,000.  Management of the Company
believes that, based on the results of operations for 1996 as well as
management's interpretation of the above outlined adjustments, the 1996 earn-out
computation results in no amounts due to the Shareholders. If the final earn-out
received or paid differs from that calculated, the change would affect goodwill.
The earn-out payments for all years will accelerate and become due within 90
days after any change in ownership or control of the Company or a sale of the
majority of the assets of the business. Any additional compensation due to a
change in stock price would be additional purchase price allocated to goodwill.

The consideration for the Merger was determined by arms-length negotiations
among the various parties.  In connection with this Merger, the Company paid
fees of approximately $145,000 to Commonwealth Associates and the Company paid
cash of $450,000 and issued 150,000 shares of common stock with a market value
of $937,500 to Commercial Financial Corporation.  See Note 12.

At the effective time of the Merger, the Company paid $2,500,000 in cash to the
Shareholders and

                                      -13-
<PAGE>

deposited $5,100,000 in a cash collateral account with a bank to support a
letter of credit securing the Company's obligation to pay the Shareholders
$5,100,000 on January 3, 1996. This obligation was paid on its due date. The
Company borrowed $3,500,000 of such amounts under the $6,500,000 acquisition
line portion of its existing $16,000,000 credit facility with IBJ Schroder Bank
and Trust Company. The remainder of the funds required at the effective time of
the Merger were provided from working capital.

Immediately prior to the Merger and in accordance with the Merger Agreement,
Keystone transferred to the Zaucha Family Limited Partnership, of which Thomas
W. Zaucha is a general partner, all of the real estate owned by Keystone for
approximately $5,200,000 which funds were used to pay off real estate and other
debt owed to a bank by Keystone.  In connection with the Merger, the parcels of
such real estate used in Keystone's business were then leased to Keystone.  See
Note 12 for discussion of these rental payments.

As part of the Merger, certain of the executive officers of Keystone entered
into employment agreements with and became executive officers of the Company.
See Notes 1, 15 and 21.

In connection with the Merger, the purchase price was allocated to the assets
acquired and liabilities assumed as follows based on an appraisal (dollars in
thousands):

<TABLE>
<S>                                       <C>
Excess of cost over acquired net assets    $ 9,895
Keystone tradename                           2,500
Assembled workforce                          1,000
Employment agreements                        1,000
Cash                                           266
Accounts receivable                          5,328
Other current assets                           591
Property and equipment                       2,291
Other assets                                   163
Accounts payable                              (294)
Other current liabilities                   (3,123)
Loans payable                               (1,271)
Minority interest                             (112)
                                           -------
                                           $18,234
                                           =======
</TABLE>

The operating results for the year ended December 31, 1995 are discussed below
assuming the acquisition of Keystone  had been effective as of January 1, 1995.
The pro forma information is, however, not necessarily indicative of the
combined results of operations as they might have been for the year ended
December 31, 1995.  The pro forma amounts give effect to, among other things,
depreciation and amortization on the revalued assets acquired and imputed
interest on the debt incurred at the average interest rate actually incurred by
the Company during the period indicated.

Assuming that Keystone had been acquired on January 1, 1995, the unaudited pro
forma operating results of the Company for the year ended December 31, 1995,
would have approximated the following:  total revenue would have been
$35,741,000; the net loss would have been $12,890,000; and the loss per common
share would have been $2.67.

Penn Vascular Lab, P.C.  (PVL)
------------------------------

On November 28, 1995, the Company  acquired from PVL (a Pennsylvania
professional corporation)

                                      -14-
<PAGE>

certain assets and the stock of Vascusonics, Inc. (a Pennsylvania corporation or
Vascusonics). The agreement provided for a management services contract whereby
the Company would provide such services to PVL for a period of two years in
exchange for a fee equal to the excess of collected revenue over the sum of
$75,000 and PVL's business expenses. Although the management services contract
expires on November 28, 1997, it is renewable annually at the mutual agreement
of both parties. The purchase agreement also provides the Company with the
option to purchase the stock of PVL for one dollar under certain circumstances;
during the period one year after the management services contract is terminated.
See Note 21.

As consideration for the above-mentioned items, the Company (a) paid $50,000 to
the seller upon the consummation of the agreement, (b) loaned $2,150,000 to the
seller in exchange for a note, (c) provided the seller with shares of Northstar
common stock with a fair market value equivalent of $2,150,000 on the date of
the acquisition, (d) promised to pay $100,000 to the seller in twelve equal non-
interest bearing installment payments beginning in December 1996, and (e)
promised to pay certain contingent payments to the Seller.  The non-interest
bearing note to the seller was discounted using a market rate of interest.  See
Note 6.  Additionally, in exchange for the loan and the common stock the Seller
agreed to pay back to Northstar the lesser of $2,150,000 or the proceeds from
the sale of the common stock.  The aforementioned Northstar stock was pledged by
the Seller as collateral for the note.  See Note 21.

The contingent payments to the seller are based upon the Net Collected Revenues,
as defined, for the years ending December 31, 1997 and 1998.  If during either
of the two years ending December 31, 1998, the Net Collected Revenues of the
businesses acquired exceed $3,200,000, then a payment of $100,000 is to be made
to the seller.  If the Collected Revenues are in excess of $3,400,000 million
and $3,600,000, in each year then the payment to the physician shall be $200,000
and $300,000, respectively.  See Note 21.

During 1996, the seller returned to the Company the shares of common stock which
were issued in conjunction with the acquisition and the note receivable which
was collateralized with those shares.  As of the date of the stock surrender,
the value of the stock collateral had decreased to $1.25 per share.
Accordingly, the Company included in its 1996 consolidated statement of
operations the effect of the reduction in collateral value.

The Company borrowed $2,500,000 under the $6,500,000 acquisition portion of its
existing $16,000,000 credit facility with IBJ Schroder Bank & Trust Company.
These borrowings financed the $2,150,000 promissory note to the seller and a
$350,000 broker fee.  Under the purchase agreement, Ultrasonics, Inc.
(Ultrasonics) took ownership of PVL's and Vascusonics accounts receivable on the
date of purchase just prior to the consummation of the purchase agreement.
Also, Ultrasonics assumed certain leases for equipment used by Company and
entered into new lease terms with the Company.  Ultrasonics is a related party
which is owned and operated by Jeff Bergman.  See Note 21.

The current management of the Company believes that the current lease
arrangements with Ultrasonics are for lease rates which are greatly in excess of
market rates.  At the date of the merger, Ultrasonics paid off leases which
represented a net liability to PVL of $155,000.  However, the lease arrangement
with Ultrasonics obligates the Company to principal payments totaling $1,333,000
over the term of the leases. The Company has treated the excessive lease
payments of $1,178,000 as a disproportionate dividend.  See Note 12.

In connection with the PVL acquisition, the Company paid a brokerage fee of
$350,000 to Mr. James P. Shields.  Mr. Shields is a cousin of Mr. DeSimone, the
former Chairman of the Board of Directors of the

                                      -15-
<PAGE>

Company. Additionally, in connection with the above-mentioned management
services contract, the Company provided shares of common stock with a fair
market value of approximately $300,000 to Mr. Shields in consideration for him
to renegotiate his employment agreement with the Company so as to include duties
with respect to both PVL and Vascusonics. The term of this management contract
is for a period of seven years and compensation consists of a management fee of
12% of the gross collections. Prior to this revised contract, Mr. Shields
received compensation equal to 5% of gross collections. In March 1996 the
Company canceled Mr. Shield's contract and severed his relationship with the
Company. See Note 12.

The Company has expensed during 1995 the amounts paid and shares issued to Mr.
Shields in connection with the above-mentioned brokerage fee and re-negotiation
of his employment contract.  The Company has also expensed $50,000 paid to
Commonwealth Associates in connection with this acquisition.

Joint Venture Activities
------------------------

Prior to 1995 the Company formed a joint venture with CDL Medical Technologies,
Inc. (CDL) to provide mobile diagnostic services, including cardiac services in
Western Pennsylvania.  The Company originally acquired a 51% interest in the
venture for a note receivable of $55,000.  In connection with the 1994 fiscal
year financial reporting the Company only recognized a 2% interest in CDL on a
cost basis due to a purported sale of 49% back to CDL in exchange for a note
receivable.  Effective January 1, 1995, the Company "re-purchased" its
additional 49% interest in the joint venture for $60,000.  For 1995 financial
reporting purposes, the Company's 51% equity interest in CDL's 1994 loss,
$150,000, has been reflected as a correction of an error.  See Note 19.

4. Intangible Assets:
   ------------------

Intangible assets and the related amortization periods consist of the following
(dollars in thousands):

<TABLE>
<CAPTION>
                                             December 31,
                                        --------------------
                                            1996      1995
                                        --------------------

<S>                                       <C>       <C>
Excess of cost over net assets acquired
(40 years)                                $17,481    $17,471
Employment agreements (2 to 7 1/2 years)    2,660      3,312
Keystone tradename (20 years)               2,500      2,500
Covenant not to compete (5 years)           1,258      2,438
Assembled Keystone workforce (5 years)      1,000      1,000
Deferred financing and other costs (5
 years)                                       861        883
                                        --------------------
                                           25,760     27,604

Less- accumulated amortization             (4,628)    (3,657)
                                        --------------------

Intangible assets                         $21,132    $23,947
                                        ====================
</TABLE>

As discussed in Note 2, the Company has chosen to adopt SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of" as of December 31, 1995.  In accordance therewith, as of
December 31, 1995, current management believes that certain actions of former
management that lead to the litigation discussed in Notes 1 and 20, and other
circumstances have occurred that indicated that the remaining balance of
intangible assets may not be

                                      -16-
<PAGE>

recoverable. Thus, as these factors have indicated that intangible assets should
be evaluated for possible impairment, the Company has used an estimate of the
related operations' undiscounted cash flows over the remaining life of the
various intangible assets in measuring whether these assets are recoverable.

The Company's evaluations have resulted in adjustments to decrease goodwill and
non-compete and employment agreements as follows as of December 31, 1995:

<TABLE>
<S>                      <C>
Goodwill                  $2,940,795
Non-compete                   32,334
Employment agreements         76,661
                          ----------
Total                     $3,049,790
                          ==========
</TABLE>

As of December 31, 1996, management of the Company does not believe that any of
the remaining intangible assets are impaired.  On a going-forward basis, the
Company will continue to evaluate whether later events and circumstances have
occurred that indicate the remaining estimated useful life of goodwill may
warrant revision or that the remaining balance of intangible assets may not be
recoverable. When factors indicate that intangible assets should be evaluated
for possible impairment, the Company will use an estimate of the related
operation's undiscounted cash flow over the remaining life of the goodwill in
measuring whether the goodwill or other intangible asset is recoverable.  Any
subsequent asset impairment will be accounted for as a charge to the operating
expenses of the Company.

5. Property and Equipment:
   -----------------------

Property and equipment consists of the following (dollars in thousands):

<TABLE>
<CAPTION>
                                     December 31,
                                  -----------------
                                    1996      1995
                                  -------   -------
<S>                               <C>       <C>
Vehicles                          $   342    $  274
Clinical equipment                  1,875     1,777
Furniture and fixtures                991       902
Leased medical equipment            1,885     1,701
Leasehold improvements                709       615
                                  -------    ------

       Total cost basis             5,802     5,269

Less -- accumulated depreciation   (2,120)     (847)
                                  -------    ------


Property and equipment -- net     $ 3,682    $4,422
                                  =======    ======
</TABLE>

                                      -17-
<PAGE>

6.  DEBT:
    -----

Debt consists of the following (dollars in thousands):

<TABLE>
<CAPTION>
                                              December 31,
                                          --------------------
                                            1996       1995
                                          ---------  ---------
<S>                                       <C>        <C>
Term loan with IBJ Schroder, due in 60
 monthly graduated payments, plus
 interest at a Base Rate plus 1.5% in
 1996 and at LIBOR plus 3.0% or a Base
 Rate plus 1.5%  in 1995  (Note 7)        $  6,083   $  6,417
Revolving line of credit with IBJ
 Schroder, due on demand and no later
 than 10/20/00, interest payable
 monthly a  Base Rate plus 1.5% in 1996
 and at LIBOR plus 3.0% or a Base Rate
 plus 1.5%  in 1995  (Note 7)                2,000      1,600
Acquisition facility with IBJ Schroder,
 due in equal monthly installments
 beginning 4/30/97 at a Base Rate plus
 2% in 1996 and at LIBOR plus 3.5% or
 a Base Rate plus 2.0% in 1995  (Note 7)     6,000      6,000
Non-interest bearing time notes to
 Thomas Zaucha and the Zaucha Family
 Limited Partnership, due 1/3/96,
 collateralized by irrevocable letter
 of credit supported by a compensating
 cash deposit (interest imputed at 9%)           -      5,100
Non-interest bearing term notes to
 Thomas Zaucha and the Zaucha Family
 Limited Partnership, approximately
 $85,000 due on 11/15/97 and then
 approximately $210,000 due quarterly
 until 11/15/00 (interest imputed at 9%)     2,625      2,625
Term notes to Thomas Zaucha and the
 Zaucha Family Limited Partnership, due
 in equal quarterly installments
 beginning on 9/30/96 of $200,000, 6%
 stated interest rate (interest imputed
 at 9%)                                      2,400      2,400
Capital lease obligations with interest
 rates ranging from 9% to 15.6%              3,059      3,380
Other debt                                   1,157      1,460
                                          ---------  ---------

Total long-term debt                        23,324     28,982

  Less:
     Current portion                       (17,261)   (21,110)
     Debt discount                          (1,162)    (1,584)
                                          ---------  ---------

Long-Term debt                            $  4,901   $  6,288
                                          =========  =========
</TABLE>

Med-Bill Financing
------------------

On September 1, 1995, a $4,500,000 term note was refinanced by the Integra
facility, described below, and all amounts due were paid in full. At the time of
the early extinguishment of debt, the Company recognized the remaining
unamortized debt issuance costs of $175,000 as an extraordinary loss. See Note
12.

Integra Facility
----------------

On June 29, 1995, the Company accepted a commitment letter from Integra Bank
(Integra facility) for a $6,500,000 credit facility, consisting of a $4,500,000
term loan and a $2,000,000 revolving line of credit. The proceeds of the term
loan were used to consolidate the Company's existing loan obligations to Med-
Bill.  The proceeds of the revolving credit facility provided working capital as
needed. In addition, the former President and Chief Executive Officer of the
Company, Mark A. DeSimone, personally guaranteed the loan.  Mr. DeSimone
received a 5% guarantee fee totaling $325,000.  The credit facility closed in
August, 1995.  At of the time of this early extinguishment of debt, the Company
recognized the remaining unamortized debt issuance costs of approximately
$100,000 as an extraordinary loss.

IBJ Schroder Facility
---------------------

On October 20, 1995, the Company closed on a credit facility with IBJ Schroder
Bank and Trust Company (IBJ). The facility consists of a $6,500,000 term loan to
refinance existing obligations, a

                                      -18-
<PAGE>

$3,000,000 revolving line of credit to fund operations and a $6,500,000
acquisition facility to fund the Company's existing and future acquisition
activity (collectively, the IBJ Facility). The total facility has a final
maturity of 5 years from the date of closing. The term loan was funded in full
at closing and was used to repay an existing bank credit facility. The term loan
is to be repaid through 60 monthly payments beginning at $83,333 and ending at
$133,337 with interest at either the LIBOR rate plus 300 basis points or a Base
Rate, as defined, plus 1.5%, subject to the terms and conditions of the credit
agreement. Repayment terms require the revolving line of credit to be paid in
full 5 years from closing, and interest accrues thereon at either LIBOR rate
plus 300 basis points or the Base Rate plus 1.5% subject to the terms and
conditions of the credit agreement. The repayment terms on the acquisition
facility are $142,857 per month beginning April 30, 1997, and for a period of 42
months at either the LIBOR rate plus 350 basis points or the Base Rate plus 2.0%
subject to the terms and conditions of the credit agreement. The IBJ facility is
secured by a first priority lien on substantially all of the assets of the
Company. In addition, the credit agreement has various financial compliance
covenants with which the Company must comply, including certain ratios and free
cash flow requirements. See Note 7. Fees paid in connection with the IBJ
facility consisted of a 1.25% commitment fee paid at closing, 0.5% unused
revolving line of credit fee and a 0.5% unused acquisition facility fee, subject
to the terms and conditions of a credit agreement. The Company's weighted
average interest rate was 9.867% for 1996.

In addition, the Company issued to IBJ certain warrants (the "IBJ Warrants").
Without the Company's written consent, the IBJ Warrants may not be transferred
except to affiliates of IBJ. The IBJ Warrants may be exercised to purchase up to
240,000 shares of the Company's Common Stock at an exercise price of $6.76 per
share until October 20, 2000. The IBJ Warrants and the Shares underlying the IBJ
Warrants have been registered.  The fair market value of the IBJ Warrants on the
date of issuance, October 20, 1995, was $703,000.  The Company accounted for the
IBJ Warrants as a debt discount and is amortizing the fair market value of these
warrants on a straight-line basis over the 60 months life of the IBJ Facility.

As of December 31, 1996, the term loan portion of this facility has been drawn
down in full, the remaining $1,000,000 of the original revolving line of credit
balance has been canceled and $6,000,000 of the acquisition facility has been
used and the remaining $500,000 has been terminated by the bank.  See Note 7.

At December 31, 1996 the scheduled aggregate annual maturities of long-term debt
are as follows (dollars in thousands):

<TABLE>
<S>                    <C>
Payments in arrears     $   775
1997                      7,638
1998                      5,776
1999                      5,204
2000                      3,918
2001                         13
                     ----------
Total                   $23,324
                     ==========
</TABLE>

7.  COVENANTS UNDER CREDIT AGREEMENT:
    ---------------------------------

Current management does not believe that the Company has ever been in compliance
with the covenants of the IBJ Facility.  During 1996, the Company entered into
two forbearance agreements with IBJ regarding the events of default on the IBJ
Facility.  Under the terms of these forbearance agreements, IBJ agreed not to
institute the default rate of interest on the notes and also agreed not to force
the company

                                      -19-
<PAGE>

into accelerated payment. The second forbearance agreement expired on December
31, 1996. However, the Company and IBJ are discussing an extension of that
agreement. Management of the Company believes that it has complied with
substantially all of the terms of the forbearance agreements throughout 1996.

The financial covenants of the IBJ Facility for fiscal year 1995 do not permit
(a) the ratio of Consolidated Current Assets to Consolidated Current
Liabilities, as defined, at any time to be less then 1.75 to 1.00, (b)
Consolidated EBITDA for the twelve months ended December 31, 1995, to be less
than $3,300,000, (c) the Consolidated Net Worth at any time to be less than the
sum of (i) $18,000,000, (ii) 80% of Consolidated Net Income on a cumulative
basis (without deduction for any losses) for the period commencing on October 1,
1995 and ending on the last day of the Determination Period most recently ended
and(iii) the Net Proceeds of any sale or other disposition of any equity
securities by the Borrower, (d) the ratio, for any Determination Period ending
on the last day of any calendar month during any period set forth, including the
three months ended December 31, 1995, of (i) Consolidated EBITDA for such
Determination Period minus Capital Expenditures made during such Determination
Period to (ii) Consolidated Fixed Charges for such Determination Period, to be
less than the ratio set forth of 1.20 and (e) (i) with respect to any
Determination Period, the aggregate principal amount of all Acquisition Loans
and Term Loans outstanding on the last day of such Determination Period plus the
aggregate Revolving Credit Commitments as of the last day of such Determination
Period to exceed the Free Cash Flow of the Borrower and its consolidated
Subsidiaries for such Determination Period multiplied by 3.25, and (ii) the sum
of Consolidated Indebtedness as of the last day of such Determination Period and
the aggregate Available RC Commitment as of the last day of such Determination
Period to exceed the Free Cash Flow of the Borrower and its consolidated
Subsidiaries for such Determination Period multiplied by 3.75.  Similar
covenants were applicable to fiscal year 1996 and are stated in the agreement
for subsequent fiscal years.

The non-financial covenants of the IBJ Facility include but are not limited to
the Company furnishing (a) annual audited financial statements within 90 days to
IBJ without a "going concern" opinion and (b) quarterly financial data within 45
days of a quarter-end.

Effective May 31, 1996, the Company entered into a forbearance agreement with
IBJ Schroder regarding certain events of default on the IBJ facility.  IBJ
agreed to forebear on the default events in the event that the Company complied
with certain additional covenants regarding cash receipts and disbursements,
levels of cash collections, and amount of service revenues.  Some of the
covenants in the loan agreement may have changed in conjunction with the
negotiation of the forbearance agreement.  In addition, there are numerous
reporting requirements of the Company to IBJ regarding these covenants.  As of
December 31, 1996, management of the Company believes that it has substantially
complied with all of these covenants.  In conjunction with the forbearance
agreements, IBJ and the Company agreed to convert all Eurodollar based loans to
base rate loans.  As of December 31, 1996, the interest rate on all outstanding
borrowing was denominated in the Base Rate.

Although the Company has obtained forbearance agreements from IBJ relating to
the payment of principal and interest, it has not received any waivers regarding
the events of noncompliance.  Given the aforementioned circumstances in
connection with the IBJ facility, all indebtedness due to IBJ has been
classified as current in the accompanying consolidated balance sheet.  Other
indebtedness does not contain cross-default provisions and long-term portions
thereof have not been classified as current.

Current management and members of the Board of Directors are vigorously pursuing
efforts to bring the Company to a level of profitability and cash flow
sufficient to meet all of its obligations.  Effective

                                      -20-
<PAGE>

January 1, 1997, the Company has reorganized itself into four operating
subsidiaries, while enhancing its level of service at the corporate office.
Management anticipates that the reorganization will reduce costs, provide
revenue enhancements and enable the Company to restructure its debt.

8. ACCRUED EXPENSES:
   -----------------

Accrued expenses consist of the following (dollars in thousands):

<TABLE>
<CAPTION>
                                            December 31,
                                           ---------------
                                            1996     1995
                                           ------   ------
<S>                                        <C>      <C>
Payroll, including payroll taxes, and
 deductions                                $1,867   $1,559

Other                                       3,456    2,009
                                           ------   ------

Total accrued expenses                     $5,323   $3,568
                                           ======   ======
</TABLE>

9.  RESTRUCTURING AND NON-RECURRING EXPENSES:
    -----------------------------------------

During 1996, following the resignation of KPMG as its independent public
accountants, the Company incurred professional fees in connection with the
ensuing independent investigation, shareholder litigation and suit against the
parties allegedly responsible for the wrong doings against the Company and its
shareholders.  The professional fees in connection with these actions are
anticipated to continue until the legal matters are resolved.  Additionally,
given the situations discussed above, the Company's fiscal year 1995 audit fees
were higher than would otherwise be incurred.

Because of the actions of former management, the Company has been faced with
recording certain transactions which are unusual in nature and are not expected
to be recurring in future years.  These transactions include, but are not
limited to, the recognition of losses on notes receivable collateralized with
common stock, payments to potentially related parties for acquisition-related
functions which can not be capitalized as part of purchase price APB No. 16, and
other unusual compensation arrangements offered to certain former employees.

Current management has recognized the need for the Company to restructure its
operations in order to create a level of cash flow and profitability in order to
meet scheduled debt payments.  Thus, the Company has undertaken certain
restructuring efforts which have included the creation of a detailed business
plan and the closure of certain locations which were not profitable.

A summary of these unusual and non-recurring expenses are as follows:

<TABLE>
<CAPTION>
                                            1996     1995
                                           ------   ------
<S>                                       <C>      <C>
Legal and accounting fees                  $  629   $    -
Litigation costs                              565        -
Loss on notes receivable collateralized
 with common stock                          1,772        -
Write off of intangible assets                960    3,421
Corporate restructuring costs                 292      406
Professional fees related to
 investigation                                751        -
                                           ------   ------
          Total                            $4,969   $3,827
                                           ======   ======
</TABLE>

                                      -21-
<PAGE>

10. LEASES:
    -------
The Company has entered into various non-cancelable operating leases expiring at
various dates through December 31, 2001 for office and medical equipment,
vehicles, and office space at its headquarters and certain rehabilitation
centers.  During the years ended December 31, 1996 and 1995, rental expense
included in the statement of operations was $3,345,000 and  $1,275,000,
respectively.  As discussed in Note 12, the Company leases certain properties
from a related party.

Future minimum lease commitments for all non-cancelable leases as of December
31, 1996 are as follows (dollars in thousands):

<TABLE>
<CAPTION>
                            Operating
 Year Ending December 31,    Leases
-------------------------   ---------

<S>                         <C>
1997                          $ 2,443
1998                            1,767
1999                            1,439
2000                            1,192
2001                              847
Thereafter                      2,857
                            ---------
Total Payments                $10,545
                            =========
</TABLE>

11. EMPLOYEE BENEFIT PLANS:
    -----------------------

The Company has a deferred compensation plan for its employees pursuant to
Section 401(k) of the Internal Revenue Code of 1986, as amended (the Northstar
Plan.). This plan provides for certain matching of employee contributions up to
prescribed limits of 10% of the employee contribution.  Keystone also had a
deferred compensation plan for its employees pursuant to Section 401(k) of the
Internal Revenue Code of 1986, as amended (the Keystone Plan).  The Keystone
Plan provides for certain matching of employee contributions equal to 50% of
participants' contributions up to three hundred dollars per year.  The Keystone
plan also provides that Keystone may make discretionary contributions; however,
no such contributions were made during the forty-five days ended December 31,
1995 or in 1996.

During 1996 and 1995 the Company made contributions to the Plans of
approximately $26,000 and $86,000, respectively.

12. RELATED-PARTY TRANSACTIONS:
    ---------------------------

The Company does not adopt or affirm any related party disclosures made in prior
financial statements or public filings.  The transactions disclosed below are
based on current management's knowledge at this point in time; however,
management believes that other matters may come to their attention during the
litigation discussed in Notes 1, 20 and 21.

Transactions Directly With Mr. Mark DeSimone
--------------------------------------------

During the year ended December 31, 1995, Mr. DeSimone reimbursed the Company for
$220,000 of expenses. During 1995 he also paid 7% interest of $29,000 to the
Company on this obligation. Conversely, the Company repaid a loan of $162,000 to
Mr. DeSimone on May 30, 1995 along with 8% per annum interest of $6,000.

                                      -22-
<PAGE>

As of July 18, 1995, in consideration for Mr. DeSimone entering into an extended
non-compete agreement with the Company, fixing his compensation over the term of
the agreement and for returning to the Company options covering 250,000 shares
of common stock, the Company amended, restated and replaced Mr. DeSimone's
previous employment agreement.  In addition to annual compensation and certain
benefits, Mr. DeSimone received 30,000 shares of common stock with a fair market
value of $198,000, a one-time bonus of $175,000 and the repayment of a personal
loan to PNC Bank in the amount of $150,000.  In connection with this loan
repayment, for each year Mr. DeSimone remained as an employee or consultant to
the Company, the Company agreed to waive repayment by Mr. DeSimone to the
Company of one-seventh of this loan satisfaction.

In September 1995, the Company received approximately $253,000 from Mr. DeSimone
for payment of third party receivables that the Company had recorded.

In February 1996, Mr. DeSimone terminated his employment with the Company but
continued to work as a consultant to the Company. His employment contract was
changed to a consulting arrangement with similar terms. The Company paid him
$47,000 under the terms of this agreement during 1996. In March 1996, Mr.
DeSimone resigned from the Board of Directors and the Company terminated its
relationship with him.

As discussed in Note 6, Mr. DeSimone personally guaranteed the Integra facility
and received a 5% guarantee fee totaling $325,000.

Mr. DeSimone was a director of SMT Health Services, Inc. (SMT) during 1995.  Mr.
DeSimone also had a 5-year consulting arrangement with SMT from which he
received $75,000 for consulting service.  Mr. DeSimone sold his consulting
business to the Company prior to 1995.  Current management believes that these
and possibly other fees for consulting services should have been remitted to the
Company and is seeking recover such fees.

Transactions with Med-Bill Corporation, Inc., Med Consulting and Med-Stat, Inc.
-------------------------------------------------------------------------------

Med-Bill Corporation, Inc. (Med-Bill), which is a company located in Western
Pennsylvania, is a related party.  Mr. James P. Shields, a cousin of Mr.
DeSimone is an officer and the sole owner of Med-Bill.  Additionally, Mr.
DeSimone and his wife, Leslie M. DeSimone, are believed by current management
to be associated with Med-Bill and had the principal financial interests in Med-
Bill.  Likewise, Med Consulting and Med-Stat, Inc. are believed by current
management to have relationships similar to that of Med-Bill.

Additionally, in 1994 the Company agreed to pay Med-Bill a financing fee of
$250,000 at the time of the loan in the preceding paragraph was received.  On
May 29, 1995, the Company paid the final installment of $150,000 toward the
aforementioned financing fee.

Prior to 1995, Med-Bill purchased certain obligations of the Company totaling
$930,000. This obligation was paid in full during 1995. No interest was paid on
this note.

In the first quarter of 1995, the Company loaned Med-Bill and Med Consulting
$41,000 and $25,000, respectively, pursuant to a demand note that bears interest
at the rate of 9% per annum. At December 31, 1995, these amounts were deemed
uncollectible and were written-off.

On July 1, 1995, the Company entered into a lease agreement with Med-Stat, Inc.
for two pieces of ultrasound equipment in the amount of $225,000 and paid a
deposit of $30,000.  On August 31, 1995, the lease was bought-out by a reduction
in amounts due from Med-Bill of $167,500.  Current management believes that the
equipment leased/purchased may have been used and may not have been acquired at
fair market value.

                                      -23-
<PAGE>

White-Oak Diagnostics Systems (White Oak)
-----------------------------------------

In November 1993, the Company acquired an interest in White Oak Diagnostic
Systems (White Oak) from Northern Diagnostics Services, Inc. (Northern
Diagnostics), an entity which was purportedly owned by Mr. James Shields.

In connection with the acquisition, the Company agreed to make certain
contingent payments to either Northern Diagnostics or Med-Bill if gross
collected revenues exceeded $400,000 for 1995.  The 1995 revenues exceeded the
aforementioned threshold and a contingent payment was made to Med-Bill during
the year of $85,000.  Given the related party nature of the transaction, this
payment was treated as a disproportionate dividend as the Company was required
to record its investment in White Oak at the same basis as that of the related
parties' investment in White Oak.

Northern Diagnostics acquired White Oak from a group of physicians.  In August
1995 White Oak made payments to the former physician owners of approximately
$150,000.  Current management believes that these payments by White Oak
represent amounts due to these physicians by Northern Diagnostics for the
acquisition.

On May 30, 1995 the Company paid $350,000 to Med-Bill to satisfy amounts
recorded as due Med Bill.

PVL Acquisition
---------------

In connection with the purchase of PVL and Vascusonics, the Company transferred
to Ultrasonics, Inc. (Ultrasonics), all the receivables of PVL and Vascusonics
as of December 1, 1995, with a value as stated in the acquisition agreement of
$350,000 for no known consideration.  Ultrasonics is a related party and is
owned by Mr. James Shields and/or Mr. Jeff D. Bergman, the CEO and Chairman of
the Board of SMT.

The purchase agreement stated that certain equipment lease obligations would be
transferred to Ultrasonics.  White Oak and Vascusonics then agreed to sublease
the equipment from Ultrasonics such that the sellers would have no future
liability under the leases.  Also, White Oak and the Company jointly and
severally indemnified the sellers from and against any liability resulting from
the failure of Ultrasonics to discharge all obligations to the lessors after the
date of the sale.  Current management is not aware of any consideration received
by the Company from Ultrasonics in exchange for the lease contracts, which
current management believes yielded lease payments to Ultrasonics which were in
excess of fair market value for the leased equipment, or issuance of the
previously-mentioned indemnification.

During 1996, the Company paid $53,341 in lease payments.  Further, although the
lessor paid approximately $155,000 for the equipment which it leased to the
Company, the Company is scheduled to make lease payments totaling approximately
$1,333,000.  After March 1996, the Company refused to pay any further amounts
under this contract, believing the payment to be excessive.  The Company is
vigorously contesting this obligation.

As discussed in Note 3, in connection with the this acquisition, the Company
paid a brokerage fee of $350,000 to Mr. James Shield.

                                      -24-
<PAGE>

Shields Management Agreement
----------------------------

Throughout 1995 the Company paid fees to Mr. James Shields or Med-Bill in
connection with certain management services that he provided at White Oak.
Additionally, upon the acquisition of PVL, Mr. Shields began providing such
services at PVL.  In total, management fees of approximately $270,000 were paid
to Mr. Shields/Med-Bill during 1995.  As of December 31, 1995, the Company had
approximately $37,000 due to Mr. Shields or Med-Bill.  The Company severed its
relationship with Mr. Shields during the first quarter of 1996.  See Note 3 for
information relating to the financial incentives provided to Mr. Shields to
renegotiate his employment contract with the Company to terms more favorable to
Mr. Shields.

During 1996, the Company paid Mr. Shields $59,106 under the terms of this
contract.  After March 1996, the Company refused to pay any further amounts
under this contract, believing the payments to be excessive.  The Company is
vigorously contesting this obligation.

Keystone Acquisition
--------------------

As part of the acquisition of Keystone, the Company paid cash of $450,000 and
issued 150,000 shares of common stock with a market value of $937,500 to
Commercial Financial Corporation (CFC) for services rendered.  CFC is wholly-
owned by Nichlaus P. Horoczko who is a personal friend and business associate of
Mr. DeSimone.  CFC is believed by current management to be a related party.
Additionally, the Company has made certain guarantees to CFC that the
aforementioned shares will be able to be sold with a net proceeds of at least
$937,500.  These costs were expensed during 1995.

The Company believes that these shares of common stock were sold on February 12,
1996 for approximately $840,000.  No additional compensation has been requested
by CFC for the shortfall in share proceeds.  In the opinion of current
management, as Mr. Horoczko did not perform any services of value, he was not
entitled to the common shares discussed above or any additional compensation
thereon. Mr. Horoczko is a defendant in the Company's suit as discussed in Notes
1 and 20.

In connection with the Keystone acquisition, Mr. Thomas Zaucha and Mr. David
Watson, who both sold interests in the former Keystone, and are now or were
officers with Northstar, have gross debt and other amounts due directly to them
of $3,919,500 and $293,750, respectively, as of December 31, 1996 and $7,897,500
and $368,750 as of December 31, 1995. In addition, Mr. Zaucha's family limited
partnership is due $1,105,500 and $2,227,500 as of December 31, 1996 and 1995,
respectively. See Note 6.

As required under the Merger Agreement, immediately prior to the merger,
Keystone transferred to the Zaucha Family Limited Partnership, of which Mr.
Zaucha, is a general partner, all of the real estate previously owned by
Keystone in return for a payment of $5,215,568. The parcels of such real estate
used in Keystone's business were then leased to Keystone.  The Company has
researched alternative leasing arrangements which are available for the Company
which would provide comparable quality space in similar areas.  As a result of
this comparison, the current management of the Company believes that the current
leasing arrangements are in excess of fair market value and is currently seeking
to renegotiate the rental rates.

                                      -25-
<PAGE>

The leases are for a period of ten years, and commenced November 15, 1995.
Lease payments for 1996 and 1995 were $470,364 and $59,000, respectively.
Future minimum lease payments under these leases, which are also disclosed
within Note 10, are as follows:

<TABLE>
<S>           <C>
1997           $  470,364
1998              470,364
1999              470,364
2000              470,364
2001              546,156
Thereafter      2,184,624
               ----------
Total          $4,612,236
               ==========
</TABLE>

The Company also paid to Impulse Development Corporation, a company controlled
by Thomas Zaucha, certain sums related to housekeeping, maintenance and
leasehold improvement construction.  In addition, a family member of the
Company's former Chief Financial Officer was employed by Impulse Development
Corporation.  These payments totaled $86,320 in 1996 and $9,156 in 1995.

Transactions with Board Members
-------------------------------

In 1996, Brody Associates, a consulting firm wholly-owned by Steven Brody,
Director, was retained to perform a variety of consulting services for the
Company related to its investigation of former management and related to the
corporate restructuring of the Company.  During 1996, the Company paid $223,795
to Brody Associates for these services and related business expenses.  At
December 31, 1996, the Company had a liability to Brody Associates of $25,586.
See Note 13 for option activity.  See Note 13 for stock option activity.

In 1996, the Company retained Executive Advisory Group, Ltd., whose sole owner
is Robert Smallacombe, Director, to serve as a management consultant and to aid
in the corporate restructuring. For these services and related business
expenses, the company paid $189,503 to Executive Advisory Group, Ltd.  As of
December 31, 1996, the Company owed $9,750 to Executive Advisory Group, Ltd.
See Note 13 for option activity.  See Note 13 for stock option activity.

In conjunction with the investigation of former management, the Company retained
Plowman, Speigel & Lewis, P.C.  in order to assist in understanding certain
corporate governance and securities litigation issues.  Charles Jarrett, Jr.,
currently a director of the Company, is also a member of  that firm.  During
1996, but prior to Mr. Jarrett's appointment to the Board of Directors, the
Company paid to Plowman, Speigel & Lewis, P.C. $32,548 for professional services
rendered.

As discussed in Note 16, the Company has certain contractual obligations due to
employees. One such employee is the wife of Mr. Watson, an officer and director
of the Company. Mrs. Watson's funds provided to the Company were $126,354 as of
December 31, 1996. The maximum amount payable in accordance with the terms
discussed in Note 16 is approximately $182,000 to Mrs. Watson.

The Company had transactions involving Thomas Zaucha and related parties as
discussed in Notes 3 and earlier in Note 12.  The Company also conducted
transactions with Mark DeSimone and related parties as discussed earlier in Note
12.

Other
-----

During 1995, the Company paid $13,500 to Ogg Jones DeSimone & Ignelzi, a law
firm in which Mr. DeSimone was a partner, purportedly for rent.  See Notes 3, 6,
10, 13, 15, 20 and 21.

                                      -26-
<PAGE>

13. STOCK OPTIONS AND WARRANTS:
    ---------------------------

Stock Options
-------------

The Company adopted a stock option plan in 1992 (the 1992 Plan) and a 1994 stock
option plan for non-employee directors (the 1994 Plan) collectively (the Plans).
The Company accounts for these plans under APB Opinion No. 25 under which
compensation expense does not normally require recognition of compensation
expense.  Had compensation cost been determined consistent with FASB Statement
No. 123, the Company's pro forma net loss and loss per share would have been:

<TABLE>
<CAPTION>
                                 1996        1995
                               ---------------------
<S>               <C>          <C>        <C>
Net Loss          As Reported   $(8,947)   $(13,101)
                  Pro Forma      (9,360)    (14,287)
Loss per Share    As Reported   $ (1.44)   $  (3.28)
                  Pro Forma       (1.51)      (3.58)
</TABLE>

Because the Statement 123 method of accounting has not been applied to options
granted prior to January 1, 1995, the resulting pro forma compensation cost may
not be representative of that to be expected in future years.

<TABLE>
<CAPTION>
                                                1996                  1995
                                       ---------------------------------------------
                                          Shares   Wt Avg. Ex   Shares   Wt Avg. Ex
                                                      Price                 Price
                                       ---------------------------------------------
<S>                                      <C>       <C>         <C>       <C>
Outstanding at beginning of year          540,380   $6.21       624,080   $7.06
Granted                                    50,000    5.25       300,000    6.03
Exercised                                       -       -        24,000    5.50
Forfeited                                 182,580    6.03       359,700    7.57
Expired                                         -       -             -       -
Outstanding at end of year                407,800    6.18       540,380    6.21
Exerciseable at end of year               317,867    6.20       360,086    6.17
Wt avg. fair value of options granted       $4.39                 $5.03
</TABLE>

The fair value of the 1995 option grant as outlined above is estimated using the
Black Scholes option pricing model with the following assumptions:  life of the
options ranging from 3 to 5 years; an assumed risk free rate of interest equal
to the zero coupon Treasury bill yield on the date of grant with the given
maturity; an expected dividend yield of 0%, consistent with the Company's
policy; expected volatility of 118% for the 1995 grant.

A total of 800,000 shares are authorized and have been reserved for issuance
under the Plans, 650,000 of which has been allocated to the 1992 Plan and
150,000 of which has been allocated to the 1994 Plan.  Options may be either
"incentive stock options" within the meaning of Section 422 of the United States
Internal Revenue Code of 1986, or non-qualified options.  The 1992 Plan is
administered by a committee of the Board of Directors who determine among other
things, those individuals who shall receive options, the time period during
which the options may be partially or fully exercised, the number of shares of
Common Stock that may be purchased under each option, and the option exercise
price.

                                      -27-
<PAGE>

The following summarizes the activity under the 1992 Plan:

<TABLE>
<CAPTION>
                                           December 31,        December 31,
                                              1996                1995
                                        ----------------------------------------
<S>                                       <C>                  <C>
Options-
 Outstanding at beginning of year           502,880              594,080
 Granted                                          -              285,000
 Exercised                                        -              (24,000)
 Expired/Canceled                          (182,580)            (352,200)
                                            -------              -------
 Outstanding at end of year                 320,300              502,880
                                            =======              =======
</TABLE>

<TABLE>
<CAPTION>
                                           December 31,        December 31,
                                              1996                1995
                                        ----------------------------------------
<S>                                       <C>                  <C>
Option price per share ranges-
 Outstanding at beginning of year         $ 5.25 - 7.88        $ 5.25 - 7.88
 Granted                                              -          5.50 - 8.30
Options exercisable at end of year              230,367              322,586
Exercisable option price ranges           $5.25  - 7.88         $5.25 - 7.88
Options available for grant at end of
 year under 1992 Plan                           329,700              147,120
</TABLE>

Under the 1994 Plan, on June 7, 1994, the four non-employee members of the Board
of Directors each received an option to purchase 7,500 shares of Common Stock at
an exercise price of $7.3125 per share that expires on June 7, 2004.  During
1995, options for 7,500 of these shares expired.  On June 7, 1995, the three
non-employee members of the BOD each received an option to purchase 2,500 shares
of common stock at an exercise price of $6.875 per share that expires on June 7,
2005. On December 15, 1995, a newly appointed director was granted an option to
purchase 7,500 shares of Common Stock at $6.125 per share. On February 2, 1996,
the Board of Directors ratified a consulting contract for Steven Brody which
called for an issuance of an option to purchase 50,000 shares of common stock at
an exercise price of $5.25 per share and an expiration date of February 2, 2001.
The option prices represented fair market value at the dates of grant.

In addition, the Company's former Chief Operating Officer received an option to
purchase 150,000 shares of Common Stock, issued outside of the Plans, at a price
equal to $5.25 (the fair market value at the date of grant).  During 1995, his
employment was terminated and the 50,000 options that were vested were exercised
in September 1995.

During 1996, the Company entered into four contracts which bound the Company to
provide stock options or some other type of compensation to the contracting
parties in return for some consideration. The terms of these contracts are
outlined below: (a) The Company entered into a contract with Steven Brody to
provide him with an option to purchase between 75,000 and 150,000 shares of
common stock at the lowest trading price during the term of the special
investigation; (b) The Company entered into Contracts with Robert Smallacombe
to issue him an option to purchase up to 25,000 shares of common stock at $2.00
per share and an option to purchase an additional 100,000 shares of common stock
at $2.00, exercisable when the Company's common stock is listed and trades in
excess of 5.93 per share for at least 10 consecutive trading days. The contract
was renewed in early 1997 and provided an option to purchase an additonal 25,000
shares of common stock at $1.75 per share; (c) As part of a severance agreement
with a former officer, the Company offered this employee an option to purchase
up to 10,000 shares of common stock at $2.00 per share; (d) In conjunction with
the signing of

                                      -28-
<PAGE>

an employment agreement, the Company offered this employee an option to purchase
25,000 shares of common stock at the fair market value as of the date of the
agreement and an option to purchase another 50,000 shares of common stock at
$2.00 per share based on certain performance measures. As of December 31, 1996,
none of these options have been issued.

In January 1997, pursuant to a valuation analysis prepared by Compass Capital
Group dated November 30, 1996 and submitted to the Compensation Committee for
review and acceptance, the Board of Directors considered recommendations to
issue up to 1,020,000 options to directors, officers, advisors and key employees
of the Company.  Further, the recommended issuances addressed the need to amend
the existing 1992 and 1994 option plans, subject to review by corporate counsel
and shareholder approval.  The recommended amendments would increase the
Company's capacity for issuance to a maximum of 1,500,000 shares with additional
increased over a three year period to a maximum of 2,000,000 shares.  Of the
1,020,000 shares recommended for issuance, a majority represent contractual
obligations approved by the Company's former CEO, Thomas Zaucha and the
remainder represent incentive stock option grants available within the capacity
of the 1992 and 1994 option plans previously approved by shareholders.  See Note
21.

Stock Warrants
--------------

Since the Company's initial public offering of common stock in June 1993, the
Company had numerous occasions to issue warrants to underwriters, their lender
and other organizations.

In connection with the Public Offering for underwriting services provided, the
Company issued 87,500 warrants to Pennsylvania Merchant Group, 70,000 warrants
to Commonwealth Associates and 17,500 warrants to Andreas V. Bello on May 18,
1995, for the purchase of its common stock at $8.29 per share.  These warrants
are exercisable over a four-year period commencing on May 18, 1996.  The total
fair value of these 175,000 warrants on the grant date was approximately
$686,000 as determined through a calculation using the Black-Scholes model.  The
value of these warrants have been accounted for as a deduction of the Offering
proceeds through a reduction in additional paid-in capital.

On June 13, 1995 the Company issued 110,000 warrants to US Equity Capital Corp.
for the purchase of its common stock at $5.63 per share as compensation for
consulting services.  These warrants were exercisable over a three year period
ending on June 13, 1998.  The fair value of these warrants on the grant date
based upon a Black-Scholes model calculation was approximately $220,000 and has
been expensed in the accompanying consolidated statement of operations.

As discussed in Note 6, the Company issued the IBJ Warrants on October 20, 1995.

                                      -29-
<PAGE>

The following summarizes the Company's warrant activity:

<TABLE>
<CAPTION>
                                          December 31,        December 31,
                                             1996                1995
                                         ---------------------------------------
<S>                                       <C>                 <C>
Warrants-
   Outstanding at beginning of year             693,500             168,500
   Granted                                            -             525,000
   Exercised                                          -                   -
   Expired/Canceled                                   -                   -
                                        -----------------------------------

   Outstanding at end of year                   693,500             693,500
                                        ===================================

Warrant price per share ranges-
   Outstanding at beginning of year       $ 5.50 - 6.25        $5.50 - 6.25
   Granted during the year                            -        $5.63 - 8.29
Warrants exercisable at end of year             693,500             518,500
Exercisable warrant price ranges          $ 5.50 - 6.25        $5.50 - 6.25
</TABLE>

14. INCOME TAXES:
    -------------

The provision (benefit) for income taxes consisted of the following (in
 thousand):

<TABLE>
<CAPTION>

                                                    Year Ended December 31,
                                              ---------------------------------
                                                       1996                1995
                                              -------------       -------------
<S>                                           <C>                 <C>
 Current:
  Federal                                           $(2,472)            $(2,105)
  State                                                (337)                111

Deferred:
  Federal                                                26              (2,596)
  State                                                   9                (587)
  Valuation allowance                                 3,245               4,941
                                              -------------       -------------
                                                    $   471             $  (236)
                                              =============       =============
</TABLE>

The reconciliation between income taxes computed by applying the statutory U.S.
 federal income tax rate to the loss before income taxes and the actual benefit
 for income taxes is as follows (in thousands):

<TABLE>
<CAPTION>

                                                    Year Ended December 31,
                                              ---------------------------------
                                                       1996                1995
                                              -------------       -------------
<S>                                           <C>                 <C>
Income tax at U.S. federal statutory                $(2,446)            $(4,336)
 rate
State income taxes, net of federal
 income tax benefit                                    (328)               (841)

Valuation allowance                                   3,245               4,941
                                              -------------       -------------
Income tax provision/(benefit)                      $   471             $  (236)
                                              =============       =============
</TABLE>

                                      -30-
<PAGE>

The Company had $9,350,000 in deferred tax assets at December 31, 1996 due
primarily to timing differences resulting from provisions for doubtful accounts
receivable, net book value of intangible assets and net operating loss
carryforwards.

A valuation allowance has been recorded to reduce deferred tax assets because
the Company believes, based on the weight of available evidence, it is more
likely than not that all of the deferred tax assets may not be realized.

15. EMPLOYMENT AGREEMENTS:
    ----------------------

The Company has entered into employment agreements, expiring from 1997 through
2002, with certain of its officers and other key employees.  The minimum annual
payments required under these agreements are as follows (dollars in thousands):

<TABLE>
<S>      <C>
1997      $1,454
1998       1,255
1999       1,199
2000       1,191
2001       1,047
          ------

Total     $6,146
          ======
</TABLE>

Included in the above figures are employment agreement obligations to facility
directors who have also provided working capital funds to the Company as
discussed in Note 16.  The employment agreements for these employees do not have
a fixed termination date.  As such, the payments to those individuals of
approximately $850,000 annually will continue indefinitely beyond 2001.

In addition to the aforementioned employment agreements, the Company has a
management agreement with Mr. James Shields to perform services within certain
business operations of the Company.  The agreement, before any extension,
expires on November 29, 2002.  Mr. Shield's compensation was to be a fee of 12%
of the gross collections of the operations that he managed.  See Note 12.

Also included in the above figures is the employment agreement of Mr. Zaucha who
the Company terminated as Chief Executive Officer in February 1997.  Mr.
Zaucha's compensation is $125,000 annually for the years 1997 through 2000 and
is included in the above table.  See Note 21.

16.  CONTRACTUAL OBLIGATIONS TO EMPLOYEES:
     -------------------------------------

Prior to the acquisition of Keystone, certain former partners of Keystone and
clinicians executed employment agreements with Keystone.  These contracts
required the employees to provide funds to Keystone as part of their incentive
compensation arrangements.  In return these employees received incentive
compensation equivalent to 25% of the net income for their facilities for each
month.  The total funds provided to Keystone was $952,000.

As provided for within these agreements, the change in controlling interest in
Keystone, enables these employees to terminate the contracts and be entitled to
either the funds they provided to Keystone or two times the most recent twelve
months of pre-commission net income of the facility that they operate.  As of
December 31, 1996, the Company has accrued $1,633,000, which is equal to the
maximum amounts under these agreements. See Note 12.

                                      -31-
<PAGE>

17.  FAIR VALUE OF FINANCIAL INSTRUMENTS:
     ------------------------------------

The carrying amounts and estimated fair values of the Company's financial
instruments as of December 31, 1996 and 1995, are as follows (dollars in
thousands):

<TABLE>
<CAPTION>
                                                     1996                         1995
                                        ----------------------------------------------------------
                                          Carrying                     Carrying
                                           Amount       Fair Value      Amount          Fair Value
                                        ----------------------------------------------------------
<S>                                       <C>           <C>            <C>              <C>
Cash and cash equivalents                 $ 1,607       $ 1,607        $ 5,730          $ 5,730
Long-term debt, including current          19,103        19,103         24,019           24,019
 portion
Notes receivable collateralized with
 common stock                                   -             -          2,187            2,159
</TABLE>

The following methods and assumptions were used by the Company in estimating the
fair value of each class of financial instruments for which it is practicable to
estimate that value.  Fair value is defined as the amount at which the
instrument could be exchanged in a transaction between willing parties.

Cash and Cash Equivalents
-------------------------

The carrying amount reported in the balance for cash and cash equivalents
approximates their fair value.

Long-Term Debt
--------------

The fair value of long-term debt is estimated based on the quoted market prices
for the same or similar issues or on the current rates offered to the Company
for debt of the same remaining maturities.

Notes Receivable Collateralized with Common Stock
-------------------------------------------------

The fair value of the notes receivable was estimated by calculating the fair
market value of the shares of common stock collateralizing the notes as of
December 31, 1995.

18.  SIGNIFICANT CUSTOMERS:
     ----------------------

Although net patient service revenue is generated by performing procedures or
services for the ultimate patients, who are referred for care through their
physician, the Company receives most of its revenues through payments made by
certain governmental programs, private insurers such as Blue Cross and Blue
Shield of Western Pennsylvania or organizations, such as a nursing homes.
Additionally, the Company receives management fees for certain entities for
which it perform certain management services.

19. CORRECTION OF ERRORS:
    ---------------------

The Company has determined that certain transactions occurring prior to 1995
were not recorded correctly and have misstated certain of the Company's December
31, 1994, stockholders' equity accounts, including an overstatement of retained
earnings.  The Company's current management was not employed with the Company
when the transactions discussed below took place.  The accounting errors
discussed below are based on current management's knowledge although other
information may become known during the litigation discussed in Notes 1 and 20.

                                      -32-
<PAGE>

The corrections of these errors are summarized below.

<TABLE>
<CAPTION>



                                 Common Stock          Common Shares Issuable   Additional
                              -------------------      ----------------------     Paid-In         Warrants
                              Shares       Amount      Shares     Amount          Capital        Outstanding
                              ------       ------      ------    -------       -----------       -----------
<S>                          <C>           <C>         <C>       <C>           <C>               <C>
Balance, December 31,
 1994, as previously         2,600,000      $26             -    $      -        $5,592           $      -
 reported
   Shares issuable in
    connection with
    employee dispute
    settlement (previously           -        -        20,378         127             -                  -
    recorded as a
    liability) (a)
   To record warrants
    issued to underwriters
    for-
      1993 initial public
       offering (b)                  -        -             -           -          (252)               252
      1994 attempt at a
       failed offering (c)           -        -             -           -             -                 90
   Write-off expenses on
    failed offering (d)              -        -             -           -            161                 -
   Record value of shares
    issued in NS Rehab
    acquisition (e)                  -        -             -           -            204                 -
   Expense compensation
    when vested (f)                  -        -             -           -              -                 -
   Change in estimated
    lives assigned to NS
    Rehab non-compete
    agreements (g)                   -        -             -           -              -                 -
   Disproportionate
    dividends, net of
    previous goodwill
    amortization in
    connection with the
    acquisition of-
      White Oak
       Diagnostics (h)               -        -             -           -              -                 -
      NS Consulting (i)              -        -             -           -              -                 -
   Record sick pay accrual           -        -             -           -              -                 -
    (j)
   Reverse receivables for
    revenue which was not
    supportable(k)                   -        -             -           -              -                 -
   Amortization on
    organization costs (l)           -        -             -           -              -                 -
   Reverse CDL goodwill
    recorded on purported
    sale and repurchase of
    stock of CDL (m)                 -        -             -           -              -                 -
   Record 1994 CDL loss on
    the equity basis of
    accounting (n)                   -        -             -           -              -                 -
   Assign value to
    non-compete agreement,
    net of amortization (o)          -        -             -           -              -                 -
   Adjust non-compete
    values and lives
    assigned and deal
    costs in NW Rehab
    acquisition (p)                  -        -             -           -              -                 -
                             ---------     ------      ------    -------       -----------       -----------
   Subtotal of corrections           -        -        20,378         127            113               342
Balance, December 31,
 1994, as restated           2,600,000      $26        20,378        $127         $5,705              $342
                             =========     ======      ======    =======       ===========       ===========
</TABLE>

<TABLE>
<CAPTION>
                                 Retained
                                 Earnings          Notes
                                (Deficit)       Receivable        Total
                                -----------   --------------    ----------
<S>                           <C>             <C>              <C>
Balance, December 31,
 1994, as previously
 reported                           $ 1,823             $(30)      $ 7,411
   Shares issuable in
    connection with
    employee dispute
    settlement (previously
    recorded as a
    liability) (a)                        -                -           127
   To record warrants
    issued to underwriters
    for-
      1993 initial public
       offering (b)                       -                -             -
      1994 attempt at a
       failed offering (c)              (90)               -             -
   Write-off expenses on
    failed offering (d)                (161)               -             -
   Record value of shares
    issued in NS Rehab
    acquisition (e)                       -                -           204
   Expense compensation
    when vested (f)                    (500)               -          (500)
   Change in estimated
    lives assigned to NS
    Rehab non-compete
    agreements (g)                     (403)               -          (403)
   Disproportionate
    dividends, net of
    previous goodwill
    amortization in
    connection with the
    acquisition of-
      White Oak
       Diagnostics (h)               (1,086)               -        (1,086)
      NS Consulting (i)                (214)               -          (214)
   Record sick pay accrual
    (j)                                (135)               -          (135)
   Reverse receivables for
    revenue which was not
    supportable(k)                      (86)               -           (86)
   Amortization on
    organization costs (l)              (25)               -           (25)
   Reverse CDL goodwill
    recorded on purported
    sale and repurchase of
    stock of CDL (m)                    (42)               -           (42)
   Record 1994 CDL loss on
    the equity basis of
    accounting (n)                     (150)               -          (150)
   Assign value to
    non-compete agreement,
    net of amortization (o)             (22)               -           (22)
   Adjust non-compete
    values and lives
    assigned and deal
    costs in NW Rehab
    acquisition (p)                    (259)               -          (259)
                                    -------   --------------       -------
   Subtotal of corrections           (3,173)               -        (2,591)
Balance, December 31,
 1994, as restated                  $(1,350)            $(30)      $ 4,820
                                    =======   ==============       =======
</TABLE>

(a) The Company had a dispute with a former employee.  During November 1994 the
Company's Board of Directors approved a settlement whereby 20,378 of common
shares were to be issued to the aforementioned employee.  The Company recorded a
liability for this amount as of December 31, 1994; however, the Company now
recognizes that such shares were in fact issuable at December 31, 1994.

(b) As part of their compensation for the 1993 initial public offering of the
Company's stock, Laidlaw Equities, Inc. was provided with 100,000 stock warrants
which had a Black Scholes Model value of approximately $252,000.  The Company
now believes that these warrants should have been recorded on

                                      -33-
<PAGE>

their accounting records as a reduction in additional paid in capital.

(c) The Company attempted to issue additional shares of common stock in late
1994.  In connection therewith, 38,500 warrants with a fair market value under
the Black Scholes Model of approximately $90,000 were issued to U.S. Equity
Capital.  Since the attempt at the offering failed, the Company now believes
that the value of the warrants should have been expensed at December 31, 1994.

(d) In connection with the failed offering described in item c above, the
Company had incurred approximately $161,000 of expenses during 1994 which the
Company now believes should have been recognized as a period cost during 1994.

(e) In connection with the acquisition of Northstar Rehabilitation, Inc. (NS
Rehab), the Company issued 15% of the Company's outstanding common shares as
part of the purchase price.  However, the Company did not account for the shares
issued in their calculation of purchase price.  Therefore, additional goodwill
and equity of $204,000 has been recorded as an adjustment.

(f) In accounting for the NS Rehab acquisition, the Company had assigned
$750,000 to an employment contract which was being amortized over 3 years.  Six
months later, the Company re-allocated $500,000 of this employment to the non-
compete agreement which was being amortized over 15 years.  As part of this
reallocation, a letter to the seller of NS Rehab indicated that the above-
mentioned $500,000 was deemed as earned as of the date of the letter.  The
Company now believes that this $500,000 should have been expensed immediately in
1992 when the letter was written.

(g) As indicated in item f above, the Company amortized the purchase price
allocated to non-compete agreements over 15 years; however, the Company now
believes that the proper amortization period for such an agreement is five
years.  In connection with the change in this estimated life, additional
amortization of $403,000 has been recorded for years prior to 1995.

(h) The Company acquired White Oak from Northern Diagnostics which has been
deemed by the Company to be a related party for the reasons outlined in Note 11.
Therefore, the Company cannot allocate a purchase price in excess of Northern
Diagnostic's basis in the business.  Thus, the excess of the purchase price
(approximately $1,086,000 as of December 31, 1994) over Northern Diagnostic's
basis has been recorded as a disproportionate dividend.

(i) Prior to 1994, the Company acquired Mr. DeSimone's consulting business which
had no assets or liabilities.  Thus, similar to item h above, the entire
purchase price should be recorded as a disproportionate dividend.

                                      -34-
<PAGE>

(j) Prior to 1995, any employee who left the service of the Company was paid for
any unused sick time at their current rate of pay.  Such time was not previously
accrued.  This entry corrects that error.

(k) As of December 31, 1994 the Company had receivables of approximately $86,000
recorded for consulting services that current management is unable to support.
Thus, the Company has reversed this consulting revenue.

(l) During the year ended December 31, 1995, the Company realized that
amortization of certain organizational costs had not been recorded since 1991.
Thus, a correction of $25,000 has been recorded to correct this error.

(m) In December 1993, the Company purchased a 51% interest in CDL Medical
Technologies, Inc. (CDL).  At the end of 1994, the Company purportedly sold 49%
of its interest in CDL back to their partner for $55,000 effective January 1,
1994.  Then in January 1995, the Company repurchased the 49% interest in CDL for
$60,000.  For accounting purposes, the Company now realizes that they in fact
had a 51% interest in CDL since December 1993.  Thus, one year of goodwill
amortization in the amount of $42,000 has been recorded.

(n) In connection with this series of transactions described in item m, the
Company did not recognize their portion of the equity loss of CDL during 1994.
Therefore, the Company is now recording their equity in the loss which amounted
to approximately $150,000.

(o) In connection with the Company's purchase of Tri State Sports Rehab &
Physical Therapy, P.C. (Tri State), no value was assigned within the accounting
records for the non-compete agreement.  The Company is therefore correcting this
error by assigning $110,000 of previously recorded goodwill to the non-compete
agreement and by amortizing this amount over five years.  Thus, a net charge of
$22,000 was needed to correct this accounting error.

(p) When the Company purchased NW Rehabilitation Associates, Inc. (NW Rehab),
$986,000 of purchase price was allocated to a non-compete agreement which NW
Rehab had with its former partners for which there was no future economic
benefit to the Company.  Additionally, the Company did not allocate $1,180,000
of purchase price to the non-compete agreement with the seller of NW Rehab.  The
Company has corrected these two errors and have adjusted the amortization of the
non-compete agreement to a period of five years.  The effect of this correction
was a $259,000 reduction to the December 31, 1994, retained deficit account.

20. COMMITMENTS AND CONTINGENCIES:
    ------------------------------

Certain stockholders have filed suits against the Company in regards to the
certain events which were allegedly caused by former management and other
potentially responsible parties.  Additionally, the Company has instituted legal
action against various parties, some of whom are former employees, alleging
improper actions and the diversion of funds to other entities.  See Note 1.
Although the results of these lawsuits are indeterminable at this time, the
Company expects to actively seek restitution for damages from the responsible
parties.

The Company has filed a claim under an existing fidelity insurance policy to
recover a portion of the damages from the above actions.  The timing and extent
of any recoveries are unknown at this time.

                                      -35-
<PAGE>

The Company is a defendant in several lawsuits resulting from the ordinary
course of business. Management believes that the outcome of such suits will not
have a material adverse effect on the Company's financial position or results of
operations.

The Company is currently involved in an arbitration involving a former officer
of the Company regarding that employee's severance from the Company.  The timing
of any final determination of this arbitration is currently unknown.  The
Company does not anticipate a materially adverse effect as a result of this
arbitration.

21.  SUBSEQUENT EVENTS:
     ------------------

In January 1997, the Compensation Committee recommended to the Board of
Directors that the Board authorize the issuance of certain options as discussed
in Note 13.  To date, the Board of Directors has not taken action to authorize
any new option grants.

In January 1997, the Company reached a settlement agreement with the seller of
PVL regarding several disputes.  In the terms of this agreement, the Company
reduced certain future payments due to the seller from $100,000 to $50,000,
acquired ownership rights to disputed equipment, and reduced contingent payments
amounts.

In January, 1997, the Justice Department initiated an action against Samuel
Armfield, III, M.D. for claims amounting to $300,000 in connection with Dr.
Armfield's Medicare billings. Although such claims could be trebled if Dr.
Armfield is convicted, the Company believes that its exposure, through its
dealings with Vascusonics, would aggregate $50,000 to $100,000. In addition, the
Company has recourse against Dr. Armfield for any amounts assessed against the
Company, which the Company plans to aggressively pursue, if necessary.


On February 6, 1997, Thomas W. Zaucha, the then Chief Executive Officer of
Northstar delivered to the US Securities and Exchange Commission (SEC) proxy
solicitation materials with the stated intention of changing the present Board
of Directors and management of the Company, changing the number and term of the
directors, filling the vacancies on the Board and making changes in the
Company's by-laws.


On February 10, 1997, Thomas W. Zaucha field suit against Northstar Health
Services, Inc. ("Northstar") and all other members of its Board of Directors in
the Delaware Chancery Court, Civil Action No. 15530. His litigation commenced on
the same day that Zaucha's Committee filed with the U.S. Securities and Exchange
Commission its preliminary consent materials in connection with this current
Solicitation. Zaucha began his lawsuit without providing any prior notice to the
Company or fellow Board members. The Company believes that, had Zaucha fulfilled
his duty of candor to the Company, and requested clarification of issues, he
could have avoided unnecessary and potentially costly litigation.

On February 13, 1997, the Board of Directors removed Mr. Zaucha from his office
as Chairman of the Board and Chief Executive Officer for cause.  On February 17,
1997, the Board appointed Robert J. Smallacombe as the new Chief Executive
Officer and his existing consulting contract was recast as an employment
contract.  The Board then named Steven N. Brody, a board member since December
1995, as the new Chairman.  As discussed in Note 15, Mr. Zaucha was party to an
employment agreement which called for compensation of $125,000 annually.

Effective February 14, 1997, Richard Andracsik, the former owner of Medical
Rehabilitation Systems, Ltd. resigned from the Company.  Andracsik will continue
his relationship with the Company through a consulting relationship for
occasional assignments.

On March 6, 1997, the Company filed a revocation of consent statement in order
to solicit revocation votes regarding the proxy solicitation by Mr. Zaucha.

On March 17, 1997, Ultrasonics filed suit against the Company as a result of
disputed lease agreements which the Company refuses to pay based on the fact
that such leases are for more than market rates.

On March 19, 1997, the Company filed a suit against multiple parties including
Thomas Zaucha, Commonwealth Associates and other members of the Committee to
Protect Northstar Health.

On March 24, 1997, Thomas Zaucha presented to current management of the Company
proxy solicitation cards which Mr. Zaucha claims represent a majority of the
shares authorized to vote in the proxy solicitation begun on February 6, 1997,
as described above.  To date, these solicitation cards have not

                                      -36-
<PAGE>

been independently verified. In addition, there are a multitude of litigation
matters pending regarding this solicitation.

                                      -37-
<PAGE>

               Northstar Health Services, Inc. and Subsidiaries
                       Valuation and Qualifying Accounts
                  For Years Ending December 31, 1996 and 1995
                           All Numbers in Thousands


<TABLE>
<CAPTION>
                                 Balance at
                                Beginning of  Charged to Costs            Deductions from               Balance at End
Description                       Period        and Expenses   Recoveries   Reserve [1]       Other        of Period
------------------------------------------------------------------------------------------------------------------------
<S>                             <C>           <C>              <C>        <C>               <C>         <C>
Year Ended December 31,           $  141          $2,301          $0         ($  715)       $1,791 [2]      $3,518
1995 - Allowance for doubtful
accounts

Year Ended December 31,
1996 - Allowance for doubtful     $3,518          $1,820          $0         ($1,579)       $    0          $3,759
accounts
</TABLE>

[1] Represents uncollected accounts charged against the allowance account.
[2] Represents allowance for doubtful accounts acquired through acquisition.


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