<PAGE>


                      U.S. SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
                                  FORM 10-KSB

[X]   Annual report under section 13 or 15(d) of the Securities  Exchange Act of
      1934 [FEE REQUIRED] for the fiscal year ended June 30, 1996
[     ] Transition  report under section 13 or 15(d) of the Securities  Exchange
      Act of 1934 [NO FEE REQUIRED] for the transition period from to


Commission file number: 0-23524
                                   PHC, INC.
                (Name of small business issuer in its charter)

MASSACHUSETTS                             04-2601571
(State   or   other   jurisdiction   of   (I.R.S. Employer Identification No.)
incorporation or organization)


200 LAKE STREET,  SUITE 102, PEABODY,  MA 01960 (Address of principal  executive
(Zip Code) offices)

Issuer's telephone number: (508) 536-2777

             Securities registered under Section 12(b) of the Act:

                                     NONE.

            Securities registered under Section 12(g) of the Act:

                 Units  (each  unit  consisting  of one  share of CLASS A COMMON
                STOCK AND ONE CLASS A WARRANT)
                               (Title of class)

                CLASS A COMMON STOCK, PAR VALUE $.01 PER SHARE
                               (Title of class)

        CLASS A WARRANTS TO PURCHASE ONE SHARE OF CLASS A COMMON STOCK
                               (Title of class)

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

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

The issuer's revenues for the fiscal year ended June 30, 1996 were $21,802,758.

The aggregate market value of the voting stock held by  non-affiliates  computed
by  reference  to the price at which the stock was sold,  or the average bid and
asked prices of such stock,  as of September  13, 1996,  was  $17,840,970.  (See
definition of affiliate in Rule 12b-2 of Exchange Act).

At September 13, 1996,  2,327,624  shares of the issuer's  Class A Common Stock,
806,556  shares of the issuer's  Class B Common Stock and 199,816  shares of the
issuer's Class C Common Stock were outstanding.

                TRANSITIONAL SMALL BUSINESS DISCLOSURE FORMAT:
                               Yes      No  X


<PAGE>


                                      PART I

ITEM 1.           DESCRIPTION OF BUSINESS.

INTRODUCTION

      PHC, Inc. (the "Company") is a national  health care company  specializing
in the treatment of substance abuse,  which includes alcohol and drug dependency
and related  disorders,  and in the provision of psychiatric and long-term care.
The Company  currently  operates three  substance  abuse  treatment  facilities:
Highland Ridge Hospital,  located in Salt Lake City, Utah,  ("Highland  Ridge");
Mount Regis Center,  located in Salem,  Virginia,  near Roanoke ("Mount Regis");
and Good Hope Center,  located in West  Greenwich,  Rhode Island ("Good  Hope").
Until August 16, 1994,  the Company  operated  Marin  Grove,  a substance  abuse
treatment  facility in California  ("Marin  Grove").  On September 20, 1994, the
Company  acquired  the  business  and  certain  assets of Harbor  Oaks  Hospital
("Harbor  Oaks"),  a  64-bed  psychiatric  hospital  located  in New  Baltimore,
Michigan.  The Company's subacute and long-term care facility,  Franvale Nursing
and Rehabilitation Center ("Franvale"),  which until September 7, 1994 was known
as Franvale Nursing Home, is located in Braintree, Massachusetts. On November 1,
1995, the Company acquired the business and certain assets of Harmony Counseling
Services, a provider of outpatient psychiatric services in Las Vegas, Nevada for
a purchase  price of $575,000  plus 75,000  shares of PHC,  Inc.  Class A Common
Stock which now operates as Harmony  Healthcare.  On March 15, 1996, the Company
acquired  the business  and certain  assets of Total  Concept EAP, a provider of
outpatient  psychiatric  services in Shawnee Mission,  Kansas,  in a total stock
transaction  for 12,000 shares of Class A Common Stock which  operates under the
name of Total Concept.

      The Company's  substance abuse facilities  provide  specialized  treatment
services to patients who  typically  have poor  recovery  prognoses  and who are
prone to  relapse.  These  services  are  offered  in small  specialty  care and
subacute  facilities (i.e.,  facilities  designed to provide care to individuals
who no longer require  hospital care but who require some medical  care),  which
permits  the  Company to provide  its  clients  with  efficient  and  customized
treatment  without the  significant  costs  associated  with the  management and
operation of general acute care  hospitals.  The Company  tailors these programs
and services to  "safety-sensitive"  industries and  concentrates  its marketing
efforts  on the  transportation,  oil  and  gas  exploration,  heavy  equipment,
manufacturing, law enforcement, gaming, and health services industries.

      The  psychiatric  facility  which was purchased in September 1994 provides
psychiatric care to children, adolescents and adults. The Company draws patients
from the local  population and uses the facility as a mental health  resource to
complement its substance abuse facilities.  The outpatient  psychiatric  clinics
provide psychiatric treatment for adults, adolescents and children.

      The Company's long-term care facility provides traditional  geriatric care
services as well as specialized subacute services. The facility provides care to
the high acuity  segment  (patients  requiring a  significant  amount of medical
care) of the geriatric  population and to younger  patients who require  skilled
nursing care for longer terms than  typically  associated  with a general  acute
care  hospital.  The Company's  long-term care services are offered in a larger,
more traditional setting than the Company's substance abuse facilities, enabling
the Company to take  advantage of  economies of scale to provide  cost-effective
treatment  alternatives.  The Company  markets its long-term  care to hospitals,
insurers  and managed  care  providers,  in addition  to  marketing  directly to
prospective residents and their families.

      The Company's  strategy of providing  services to  particular  markets has
resulted in customized,  outcome-oriented  programs,  which the Company believes
produce  overall  cost  savings  to the  patient  or  client  organization.  The
substance  abuse  facilities  provide  treatment  services  designed  to prevent
relapse.  Such  services,  while  potentially  more costly on a per patient stay
basis, often result in long-term health care cost savings to insurers,  patients
and patients' families.  The Company's long-term care facility achieves its cost
containment  objective  by providing  care to high acuity  patients in a setting
that  produces  positive  outcomes  through  the use of tailored  services.  The
specific  skilled  services  that are provided  are similar to those  offered in
acute care hospitals without the added overhead cost.

       The Company was  organized  as a Delaware  corporation  in 1976 under the
name American  International  Health Services,  Inc. In 1980, the Company merged
into an inactive publicly held  Massachusetts  corporation and was the surviving
corporation  in the merger.  The Company  changed its name to "PHC,  Inc." as of
November 24, 1992.  The Company is based in  Massachusetts  and is  unaffiliated
with an inactive  Minnesota  corporation of the same name.  From the time of its
organization  in 1976 until 1992,  the Company  managed  treatment  programs for
addictive  disorders  for  acute  care  hospitals  located  in as many as twelve
states. Additionally, in 1984 the Company began to operate its own free-standing
treatment  facilities for addictive  disorders.  The Company does business under
the tradename "Pioneer  Healthcare." With the exception of the services provided
directly by the Company under the name Pioneer Development Support Services, the
Company  operates  as a holding  company,  providing  administrative,  legal and
programmatic support to its subsidiaries.

      The Company  plans to expand its  operations  through the  acquisition  or
establishment  of additional  substance  abuse,  long-term care and  psychiatric
treatment facilities.

SUBSTANCE ABUSE FACILITIES

      INDUSTRY BACKGROUND

      The demand for substance abuse treatment services increased rapidly in the
last  decade.  The  Company  believes  that the  increased  demand is related to
clinical  advances in the treatment of chemical  dependencies,  greater societal
willingness  to  acknowledge  the  underlying  problems as treatable  illnesses,
improved  health  insurance  coverage  for  addictive   disorders  and  chemical
dependencies  and governmental  regulation  which requires certain  employers to
provide  information  to employees  about,  among other things,  available  drug
counseling and employee assistance programs.

      To contain costs  associated with behavioral  health issues,  in the 1980s
many private payors instituted  managed care programs for  reimbursement,  which
include pre-admission  certification,  case management or utilization review and
limits on financial coverage or length of stay. These cost containment  measures
have  encouraged  outpatient  care  for  behavioral  problems,  resulting  in  a
shortening of the length of stay and revenue per day in inpatient chemical abuse
facilities.  The Company  believes that it has addressed these cost  containment
measures by specializing in treating  relapse-prone patients with poor prognoses
who have failed in other  treatment  settings.  These  patients  require  longer
lengths of stay and come from a wide geographic  area. The Company  continues to
develop  alternatives  to  inpatient  care  including  partial  day and  evening
programs in addition to onsite and offsite outpatient programs.

      The Company  believes that because of the apparent  unmet need for certain
intense clinical and medical services,  its strategy has been successful despite
national  trends  towards  outpatient  treatment,  shorter  inpatient  stays and
rigorous scrutiny by managed care organizations.

      The  Company  has  been  able  to  secure  insurance   reimbursement   for
longer-term  inpatient  treatment as a result of its success with poor prognosis
patients.  The Company's three substance abuse facilities work together to refer
patients to the center that best meets the patient's clinical and medical needs.
Each facility caters to a slightly different patient population.  Highland Ridge
in Utah specializes in providing  services to high-risk,  relapse-prone  chronic
alcoholics  and drug  addicts  and Mount Regis in  Virginia  specializes  in the
treatment of minority groups and dual diagnosis  patients (those  suffering from
both substance abuse and psychiatric  disorders).  Good Hope Center concentrates
on providing services to insurers,  managed care networks and health maintenance
organizations  for both adults and adolescents.  The Company's  clinicians often
work directly with managers of employee  assistance  programs to select the best
treatment facility possible for their clients.

      Each of the Company's  facilities  operates a case management  program for
each patient.  This includes a clinical and financial  evaluation of a patient's
circumstances to determine the most  cost-effective  modality of care from among
outpatient treatment,  detoxification,  inpatient, day care, specialized relapse
treatment  and others.  In addition to any care provided at one of the Company's
facilities,  the case management  program for each patient  includes  aftercare.
Aftercare  may  be  provided  through  the  outpatient  services  provided  by a
facility.  Alternatively,  the Company may arrange for outpatient aftercare,  as
well as family and mental  health  services,  through its numerous  affiliations
with clinicians located across the country once the patient is discharged.

      As a general rule, the Company  attempts not to accept patients who do not
have  either  insurance  coverage  or adequate  financial  resources  to pay for
treatment.  Each of the Company's  substance  abuse  facilities  does,  however,
provide treatment free of charge to a small number of patients each year who are
unable to pay for treatment but who meet certain  clinical  criteria and who are
believed by the Company to have the requisite degree of motivation for treatment
to be successful.  In addition, the Company provides follow-up treatment free of
charge to relapse patients who satisfy certain  criteria.  The number of patient
days  attributable  to all patients who receive  treatment free of charge in any
given fiscal year is less than 5%.

      The Company believes that it has benefited from an increased  awareness of
the need to make substance abuse treatment  services  accessible to the nation's
workforce.  For  example,  subchapter  D of the  Anti-Drug  Abuse  Act  of  1988
(commonly known as The Drug Free Workplace Act) (the "Drug Free Workplace Act"),
requires  employers who are Federal  contractors or Federal grant  recipients to
establish drug free awareness  programs to inform employees about available drug
counseling, rehabilitation and employee assistance programs and the consequences
of drug abuse  violations.  In response  to the Drug Free  Workplace  Act,  many
companies,   including  many  major  national  corporations  and  transportation
companies,  have adopted  policies that provide for  treatment  options prior to
termination of employment.

      Although the Company does not provide  federally  approved  mandated  drug
testing, the Company treats employees who have been referred to the Company as a
result  of  compliance  with the Drug  Free  Workplace  Act,  particularly  from
companies  that are part of  safety  sensitive  industries,  such as  railroads,
airlines,  trucking firms,  oil and gas exploration  companies,  heavy equipment
companies and manufacturing companies.

      HIGHLAND RIDGE

      Highland Ridge is a 34-bed  alcohol and drug treatment  hospital which the
Company has been operating since 1984. It is the oldest  free-standing  chemical
dependency  hospital  in  Utah.  Highland  Ridge  is  accredited  by  the  Joint
Commission on Accreditation of Healthcare  Organizations  ("JCAHO") and received
an  unconditional  three-year  accreditation  effective  July 1, 1993  which was
automatically  extended  pending the results of the  current  survey,  which was
completed  in  August,  1996.  Highland  Ridge  is  also  licensed  by the  Utah
Department of Health.

      The patient  population of Highland Ridge typically is between the ages of
18 and 70.  Approximately  21% of the  clients  are female and 11% are  minority
group members.  Most patients are from Utah and surrounding states.  Individuals
typically  access Highland  Ridge's  services  through  professional  referrals,
family members, employers, employee assistance programs or contracts between the
Company and health maintenance organizations located in Utah.

      A pre-admission evaluation, which involves an evaluation of psychological,
cognitive and situational factors is completed for each prospective  patient. In
addition,  each  prospective  patient  is  given  a  physical  examination  upon
admission.   Diagnostic  tools,   including  those  developed  by  the  American
Psychological  Association,  the American Society of Addiction  Medicine and the
Substance Abuse Subtle Screening Inventory are used to develop an individualized
treatment   plan  for  each   client.   The   treatment   regimen   involves  an
interdisciplinary  team which integrates the twelve-step principles of self-help
organizations,  medical detoxification,  individual and group counseling, family
therapy,  psychological testing, psychiatric support, stress management, dietary
planning, vocational counseling and pastoral support. Highland Ridge also offers
extensive aftercare assistance.  Individuals for whom treatment is inappropriate
are referred to other community and professional resources.

      Highland  Ridge was the  first  private  for-profit  hospital  to  address
specifically  the  special  needs of  chemically  dependent  women in Salt  Lake
County.  Approximately 40 women have been treated in an inpatient  setting at no
charge since the program's  inception in 1988. In addition,  Highland  Ridge has
contracted  with Salt Lake  County to provide  medical  detoxification  services
targeted to women.  The hospital  also operates a  specialized  continuing  care
support group to address the unique needs of women and minorities.

      Highland Ridge periodically conducts or participates in research projects.
Highland Ridge is presently the site for a research  project being  conducted by
the University of Utah Medical School.  The research  explores the  relationship
between individual motivation and treatment outcomes. This research is regulated
and reviewed by the Human Subjects Review Board of the University of Utah and is
subject to federal  standards  that  delineate  the nature and scope of research
involving  human  subjects.  Highland  Ridge  benefits  from  this  research  by
expanding its professional relationships within the medical school community and
by applying  the findings of the research to improve the quality of services the
Company delivers.

      See "Description of Property - Highland Ridge."

      MOUNT REGIS

      Mount Regis is a 25-bed,  free-standing  alcohol and drug treatment center
located in Salem,  Virginia,  near Roanoke. The business,  which was acquired in
1987, is the oldest  program of its kind in the Roanoke  Valley.  Mount Regis is
accredited by the JCAHO, and licensed by the Department of Mental Health, Mental
Retardation and Substance Abuse Services of the Commonwealth of Virginia.

      Mount Regis' patient population  typically ranges in age from 18 to 70. In
the June 30, 1996 fiscal year,  approximately  36% of Mount Regis'  clients were
minority group members and 19% were females.  Approximately  101 women have been
treated in an inpatient setting at no charge since the program's inception.  The
programs  at Mount  Regis are  designed  to be  sensitive  to needs of women and
minorities.   The  majority  of  Mount  Regis  clients  are  from  Virginia  and
surrounding  states. In addition,  because of its relatively close proximity and
accessibility  to New York,  Mount Regis has been able to attract an  increasing
number of referrals from New York-based labor unions.

      Mount  Regis has  established  programs  which allow the Company to better
treat dual diagnosis  patients  (those  suffering from both substance  abuse and
psychiatric  disorders),  cocaine  addiction  and  relapse-prone  patients.  The
multi-disciplinary  case management,  aftercare and family programs are designed
to prevent relapse.

      Until April of 1994,  the  Company  leased the  facility  from Mount Regis
Center, Limited Partnership (the "Mount Regis Partnership"), a related party. In
April of 1994, PHC, Inc. purchased all of the limited  partnership  interests in
the Mount Regis  Partnership  which were not owned by the Company for a purchase
price of  $31,250  per share,  with the  exception  of shares  owned by Bruce A.
Shear, the President of the Company, for which PHC, Inc. paid $25,000 per share.
The initial  investment cost per share was $25,000.  PHC, Inc. then assigned its
interest to PHC of Virginia, Inc., thus dissolving the limited partnership.  The
Certificate of  Cancellation  of Limited  Partnership was recorded June 30, 1994
and, on the same date, the Limited Partnership transferred ownership of the real
estate for Mount Regis to PHC of Virginia,  Inc.  The  property was  transferred
subject to an  existing  outstanding  mortgage  of  approximately  $531,000.  In
connection with the dissolution of the Mount Regis Partnership, the Company paid
all of its  outstanding  debt to the Mount  Regis  Partnership  in the amount of
$262,500. The Company also paid $53,041 to the former limited partners for their
net profit share  through the date of  transfer.  See  "Description  of Property
Mount Regis."

      In April 1993, Mount Regis purchased a free-standing  outpatient clinic in
Roanoke called "Changes" from Alternative Counseling Services, Inc. The purchase
price of the clinic was  $69,535,  $23,900 of which was paid in cash and $45,635
of which was paid with two promissory notes of the Company, one in the principal
amount of  $15,635  and one in the  principal  amount of  $30,000.  The  $15,635
promissory note was paid off in July of 1994. Minimum monthly payments due under
the $30,000  promissory  note are $650.00 plus 12% of the clinic  receipts  over
$14,000 a month  from May 1993  through  April  1996  until  paid in full.  Such
payments not to exceed $30,000 in the aggregate.  See  "Description  of Property
Mount Regis."

      The Changes clinic provides structured  intensive outpatient treatment for
patients who have been  discharged  from Mount Regis and for patients who do not
need the formal  structure of a residential  treatment  program.  The program is
licensed by the Commonwealth of Virginia and approved for reimbursement by major
insurance carriers.



      GOOD HOPE CENTER

      On March 16, 1994,  the Company  completed  the purchase of the  operating
assets of Good Hope, a 49-bed substance abuse treatment facility located in West
Greenwich,  Rhode Island, together with related outpatient programs. In addition
to the West  Greenwich  facility,  Good Hope has a  satellite  location in North
Smithfield,  Rhode  Island.  The  West  Greenwich  facility  is  located  on  an
approximately  70-acre  site  three  hours  from New York City and one hour from
Boston. All 49 beds are located in West Greenwich.  Good Hope has both adult and
adolescent programs which are located in separate buildings.  Outpatient and day
treatment  programs are also located at this site.  The satellite  site operates
both outpatient and day treatment substance abuse programs.  See "Description of
Property - Good Hope."

      Good Hope  concentrates  on providing  services to insurers,  managed care
networks and health  maintenance  organizations  (HMOs).  Good Hope provides the
same  quality  of  individualized  treatment  provided  by the  Company's  other
facilities by working  closely with the managed care and HMO staff.  The Company
recognizes that not all clients are in need of, nor are  appropriate  recipients
of, acute care alcohol and drug treatment services.  Good Hope also utilizes its
outpatient  programs to provide a continuum of care to local  patients.  The day
treatment  license  permits  treatment of  substance  abuse,  which  encompasses
primary diagnoses of both alcohol abuse and drug abuse.

      Good Hope has the Company's only  substance  abuse  treatment  program for
adolescents.  This program has filled a need of the Company's  other  facilities
for a reliable  referral for  adolescents.  Most of the patients treated at Good
Hope are from the New England area and approximately 30% are minorities.

      Good Hope  Center has  experienced  a decline in census and  continues  to
operate  at a loss  primarily  as a  result  of the loss of  referrals  from the
Department of Child,  Youth and Family  Services  (DCYF)  contract funded by the
State of Rhode Island which created a substantial  decline in adolescent census.
Management changes have been made and the Company's  management team is focusing
its efforts to  re-engineer  this  program  from both an expense  reduction  and
revenue enhancement plan.


      DISCONTINUANCE OF OPERATIONS AT MARIN GROVE

      On August 16,  1994,  the Company  discharged  the last  patient  from and
discontinued  operations at Marin Grove, its substance abuse treatment  facility
located in Marin County,  California.  The operations were discontinued based on
the Company's assessment that the continued poor financial  performance of Marin
Grove did not justify the  pending  purchase of the Marin Grove  facility or the
expenditures of additional sums to cover  operating  losses.  This resulted in a
writedown of assets in the 1994 fiscal year of approximately $170,000 related to
the purchase and discontinued operations.

      The Company had been granted a purchase  option to acquire the real estate
for the Marin Grove  facility from the lessor for $950,000  under the terms of a
settlement  conference  order  issued as a result of  litigation  related to the
validity of the underlying lease agreement.

      A settlement  agreement with the lessor was finalized on September 8, 1994
which  terminated the purchase option for Marin Grove and allowed the Company to
continue  to occupy the  administrative  building  and rental  apartments  until
November 30,  1994.  Subsequently,  the  litigation  described in the  preceding
paragraph was dismissed with prejudice. The Company was obligated to pay rent in
the amount of $40,000 for the period ended November 30, 1994.


      PROPOSED SHORT-TERM INTENSIVE INPATIENT TREATMENT FACILITY

      The  Company  had  proposed to develop a  short-term  intensive  inpatient
treatment center in Lynn, Massachusetts. The site on which such treatment center
was to be  located is the former  Mt.  Pleasant  Hospital  which is owned by the
Shear Family  Trust and the NMI Trust (the "Shear  Trusts"),  two family  trusts
established by the Shear family. The Company has recently made a decision not to
pursue this project. As a result, the Company has received from the Shear Trusts
a refund  of its  option  deposit  payment  of  $50,000  previously  made by the
Company, plus accrued interest thereon, and will obtain reimbursement of certain
development  expenses over time.  The Company has been paid $6,000 through June,
1996 and the Company will receive  additional  monthly payments of $500.00 until
paid in full.

      HELPLINE REFERRAL SERVICE

In the  spring of 1994 the  Company  began to operate a crisis  hotline  service
under  contract  with  a  major  transportation  client.  The  hotline,  Pioneer
Development Support Services, or PDS2 ("PDS2"), is a national, 24-hour telephone
service  which  supplements  the  services  provided  by the  client's  Employee
Assistance  Programs.   The  services  provided  include   information,   crisis
intervention,  critical  incidents  coordination,  employee  counselor  support,
client monitoring,  case management and health promotion. The hotline is staffed
by counselors who refer callers to the  appropriate  professional  resources for
assistance  with  personal  problems.   Four  major   transportation   companies
subscribed to these  services as of June 30, 1996.  This operation is physically
located in Highland Ridge Hospital, but services are provided by staff dedicated
to PDS2. PDS2 is currently operated by the parent entity, PHC, Inc.

      OPERATING STATISTICS

      The  following   table  reflects   selected   financial  and   statistical
information for the operating companies offering substance abuse treatment:

                                         YEAR ENDED JUNE 30

                                         1996          1995
                                         ----          ----
Net patient service revenues......    $10,307,262   $8,894,976
PDS2                                   $233,164      $128,157
Revenues..........................
Net revenues per patient day (1)..       $380          $397
Average occupancy rate (2)........        63%          66%
Total number of beds at endof period      108          108

(1)   Net revenues per patient day is net patient  service  revenues  divided by
      total patient days.

(2)   Average  occupancy  rates were  obtained by dividing  the total  number of
      patient  days in each period by the number of licensed  beds  available in
      such period.  The total licensed beds  available  include only four months
      for  Good  Hope in 1994  and 47 days  for  Marin  Grove in 1995 due to its
      closing.  In  calculating  average  occupancy  rates,  the total number of
      patient days includes  patient days attributed to scholarship  patients as
      well as patient days attributed to relapse  patients for whom treatment is
      provided by the Company without charge.  In each of the fiscal years ended
      June 30, 1994,  1995 and 1996,  these patient days accounted for less than
      5% of the total number of patients for the fiscal year.

PSYCHIATRIC FACILITY

      INTRODUCTION

      On September 20, 1994 the Company acquired its first psychiatric facility,
Harbor Oaks  Hospital.  The Company  believes that its proven ability to provide
high  quality,  cost-effective  care in the  treatment of  substance  abuse will
assist it in growing  in the  related  behavioral  health  field of  psychiatric
treatment.

      HARBOR OAKS

      Harbor Oaks is a 64-bed  psychiatric  hospital  located in New  Baltimore,
Michigan,  approximately  20 miles northeast of Detroit along a highly populated
corridor  surrounding  Interstate  Highway-94.  Harbor  Oaks is  licensed by the
Department of Mental Health of the State of Michigan and is accredited by JCAHO.
Harbor Oaks provides  inpatient  psychiatric  care to children,  adolescents and
adults and operates a partial  hospitalization  program that includes outpatient
treatment services. In addition to drawing patients from Macomb, Oakland and St.
Clair  Counties in Michigan as the prior  owner did,  the Company  utilizes  the
Harbor Oaks facility as a mental health  resource to complement  its  nationally
focused substance abuse treatment programs.  See "Description of Property Harbor
Oaks."

      Through a management  agreement with New Life Treatment Centers,  Inc. the
Hospital  also offers  counseling  programs  with a Christian  philosophy  on an
inpatient and partial hospitalization basis. This program has attracted patients
from across the state, as well as from bordering Ohio.

      In  September,  1996,  Harbor Oaks  received  approval  from the  Michigan
Department  of  Public   Health  for  a  Certificate   of  Need  for  a  20-slot
Child/Adolescent  Partial  Hospitalization  Program to be located in Port Huron,
Michigan.

      OPERATING STATISTICS

      The  following   table  reflects   selected   financial  and   statistical
information for Harbor Oaks:

                                                         YEAR ENDED JUNE
                                                        30

                                      INPATIENT   INPATIENT   PARTIAL  PARTIAL
                                                             HOSPITAL  HOSPITAL
                                        1996        1995       1996      1995
                                        ----        ----       ----      ----
Net patient service revenues......   $5,296,874  $2,755,642  $921,537  $449,215
Net revenues per patient day (1)..      $548        $533       $261      $176
Average occupancy rate (2)........      64.4%       52.2%       N/A       N/A
 Total  number  of  beds  at  end of     64          64         N/A       N/A
period............................
  Sources of revenues:
    Private(3)....................      75.5%       63.6%       N/A       N/A
    Government(4) ................      24.5%       36.4%       N/A       N/A

(1)   Net revenues per patient day is net patient  service  revenues  divided by
      total patient days.

(2)   Average  occupancy  rate was  obtained  by  dividing  the total  number of
      patient  days in each period by the number of licensed  beds  available in
      such period.

(3)   Private pay  percentage  is the  percentage  of total patient days derived
      from all payors other than Medicare and Medicaid.

(4)   Government  pay percentage is the percentage of total patient days derived
      from the Medicare and Medicaid programs.


OUTPATIENT PSYCHIATRIC FACILITIES

      INTRODUCTION

      On November 1, 1995 the Company acquired its first outpatient  psychiatric
clinic,  Harmony  Healthcare.  On March  15,  1996 the  Company  acquired  Total
Concepts,  EAP, which  operates  Employee  Assistance  Programs and provides out
patient behavioral health care to adults,  adolescents and children. The Company
believes  its proven  ability  to provide  high  quality  inpatient  psychiatric
treatment  will be a catalyst  for the  further  development  of its  outpatient
treatment programs.

      HARMONY HEALTHCARE

      Harmony  Healthcare,  located in Las Vegas,  Nevada,  provides  outpatient
psychiatric care to children,  adolescents and adults in the local area. Harmony
also operates  Employee  Assistance  Programs for several large casino companies
including Boyd Gaming Corporation, the MGM Grand, the Mirage and Treasure Island
resorts, which includes a rapid response program to provide immediate assistance
24 hours a day.

      TOTAL CONCEPT EAP

      Total Concept EAP, located in Shawnee Mission, Kansas, provides behavioral
health care to children,  adolescents and adults and manages Employee Assistance
Programs for local businesses.

      OPERATING STATISTICS

      The  following   table  reflects   selected   financial  and   statistical
information for the outpatient  psychiatric  centers for the year ended June 30,
1996:

                       Net revenues
                             Individual              $  648,302
                             Contract                $  503,365
                                                    -----------
                                                     $1,151,667
                       Total
                       Sources of revenues:
                             Private                       89%
                             Government                    11%


      On  August  31,  1996,  the  Company  completed  the  acquisition  of four
outpatient  psychiatric  clinics  known as North Point located in Michigan for a
purchase  price of  $110,000  plus  15,000  shares of Class A Common  Stock.  On
September 7, 1996, the Company purchased three additional outpatient psychiatric
clinics from Value Behavioral Health for a purchase price of $150,000 adjustable
to $50,000 if certain contracts are not finalized within six months. The Company
will operate six of the acquired clinics as Pioneer Counseling Centers.


LONG-TERM CARE FACILITY

      INDUSTRY BACKGROUND

      The  fastest  growing  market in the health  care  industry is the segment
which  provides  services  for  people 65 years of age and  older.  Demographers
predict that this population  segment will increase  dramatically in the next 20
years.  The Company  believes that there is a current shortage of long-term care
facilities  which  provide  subacute  and  skilled  nursing  care and that  such
shortage will be exacerbated by this population trend.

      FRANVALE

      The  Company  owns and  operates a 128-bed,  multi-level,  long-term  care
facility in Braintree,  Massachusetts.  For the fiscal year ended June 30, 1996,
Franvale operated at 87.1% of capacity.

      In September, 1994, the Company received approval from The Commonwealth of
Massachusetts for a 25-bed addition to the Franvale  facility.  Under a one-time
regulatory exemption, the Company added an additional 12 beds to Franvale, for a
total of 37 new beds,  and renovated the existing  facility  during the 1995 and
1996 fiscal years. To finance this addition and renovation,  the Company applied
for and received Section 232 Mortgage  Financing in an amount of $6,822,700 from
HUD. Approximately $2.9 million of that amount was used for the new construction
and renovation, which began September 13, 1994, and approximately $2,327,230 was
used to repay all  indebtedness,  plus accrued  interest,  relating to Franvale,
including  $497,500 of  indebtedness  owing to the FDIC.  The  construction  was
completed in September  1995. The Company began operation of the new addition on
September  29,  1995.  The  final  amount  of the  mortgage  was  $6,822,700  as
determined by the HUD process of cost certification on July 9, 1996. The monthly
debt service is approximately $54,000.

      Currently,  the  majority of the  services  provided by the Company at its
Franvale  facility are skilled nursing services.  The short-term  rehabilitation
and subacute  services  provided  include several forms of intravenous  therapy,
total parenteral  (intravenous)  nutrition and pain  management.  Other subacute
services offered include hospice care,  wound  management and tracheotomy  care.
The skilled  therapeutic  services offered by the Company include  occupational,
physical and speech therapy,  respiratory  modalities and continence  retraining
programs.  Franvale was the first  long-term care facility in  Massachusetts  to
hold DPH  certification  in all of the  modalities of  parenteral  (intravenous)
infusion therapy,  and is a leader among long-term care facilities in responding
to the needs of the managed care market and for providing  transfusion  services
in a setting that combines the prerequisite skill and cost  effectiveness.  With
completion of the addition and renovation project,  the Company is expanding the
subacute  services it offers to include  expanded  respiratory  therapy services
(i.e.,  mechanically  assisted  ventilation),   peritoneal  and  neurobehavioral
therapeutic services.

      See "Description of Property - Franvale."

      OPERATING STATISTICS

      The  following   table  reflects   selected   financial  and   statistical
information for Franvale:



                                            YEAR   ENDED
                                               JUNE 30

                                          1996        1995

Net patient service revenues........   $5,043,922  $4,180,471

Net revenues per patient day (1)....      $137        $135

Average occupancy rate (2)..........      87.1%       92.7%

Total number of beds at end of period      128         91

  Source of revenues:
     Private (3)....................       8%          8%
     Government (4).................       92%         92%

(1) Net revenues per patient day equals net patient service  revenues divided by
    total patient days.

(2) Average occupancy rates were obtained by dividing the number of patient days
    in each period by the number of licensed beds available in such period.

(3) Private pay  percentage is the percentage of total patient days derived from
    all payors other than Medicare and Medicaid.

(4) Government  pay  percentage is the  percentage of total patient days derived
    from the Medicare and Medicaid programs.  Government total for 1996 reflects
    increase in higher acuity Medicare patients and Medicaid patients.


DAY-CARE

      The Company  operated  three day care  centers  from 1988 until 1993.  The
Company is in the process of phasing out these  operations  and, in this regard,
sold one of the  centers  in  fiscal  year 1993 and sold one of the  centers  in
fiscal year 1996. The Company is currently seeking a buyer for the remaining day
care center, which is located in Saugus, Massachusetts.

MARKETING

      Each  of  the  Company's  substance  abuse  facilities  conducts  its  own
marketing  efforts  on both a local and  national  level.  Mount  Regis has four
individuals on staff who are  responsible  for the marketing of that  facility's
services,  Highland Ridge has three such  individuals on staff,  and Harbor Oaks
Hospital has one such individual.  The Company's  national marketing efforts are
coordinated  by the  Company's  National  Marketing  Director who reports to the
Company's Executive Vice President.

      The Company  markets the services of its psychiatric  facility  locally in
Michigan and to its existing  chemical  dependency  and substance  abuse clients
nationally.

      With respect to substance abuse and psychiatric  care, the Company intends
to  continue  its  marketing   strategy  of  focusing  on  referral  sources  in
safety-sensitive industries such as transportation,  oil and gas exploration and
heavy machinery and equipment  manufacturing  the Company also sees  significant
growth in the gaming industry.  In addition to providing  excellent  service and
treatment outcomes, the Company will continue,  where appropriate,  to negotiate
pricing  policies to attract patients for long-term,  intensive  treatment which
also meet length-of-stay and clinical  requirements  established by insurers and
managed care organizations.

      The  Company's  marketing  efforts  for  long-term  care  facilities  will
emphasize the  specialized,  transitional  subacute  care  services  provided at
Franvale  and  which are  expected  to be  provided  at other  facilities.  Such
facilities provide care to patients who no longer require the higher acuity care
provided by acute care hospitals, but who still require nursing intervention and
use a significant  amount of ancillary medical services,  including  intravenous
rehabilitation,  respiratory and enteral  therapies.  The Company  believes that
acute care  hospitals  seek to transfer  certain  patients  who have entered the
recuperative  period but who are not yet well  enough to be cared for at home to
facilities  which offer the type of intensive  care  available at Franvale.  The
Company  believes  that such  patients  represent  a large  market but one which
currently is underserved.  The Company hopes to continue its  relationship  with
existing  acute care  hospitals for  transitional  patients and to develop other
networks  with health care  providers  to increase its census,  particularly  of
higher paying private pay and long-term care insured patients.

COMPETITION

      The Company's  substance  abuse  programs  compete  nationally  with other
health  care  providers,  including  general and chronic  care  hospitals,  both
non-profit  and  for-profit,  other  substance  abuse  facilities and short-term
detoxification  centers.  Some competitors have substantially  greater financial
resources than the Company. The Company believes,  however,  that it can compete
successfully  with  such  institutions   because  of  its  success  in  treating
poor-prognosis  patients.  The Company  will  compete  through its focus on such
patients,  its  willingness to negotiate  appropriate  rates and its capacity to
build and service corporate relationships.

      The  Company's  inpatient  psychiatric  facility  and  outpatient  centers
compete   regionally  in  the  State  of  Michigan  and  nationally  with  other
psychiatric  service  providers.  Harbor Oaks is located in the suburban Detroit
area and competes for patients with facilities in Macomb,  Oakland and St. Clair
Counties. The outpatient centers compete with other similar centers. The Company
specializes  in inpatient  and partial  hospitalization  for acute mental health
treatment of children,  adolescents and adults. Harbor Oaks is the only provider
of child and adolescent  services for nearby St. Clair County and is only one of
two facilities in its own county of Macomb. Dual diagnosis  programming provides
a niche  service  for  clients  with a primary  mental  health  and a  secondary
substance abuse diagnosis. The dual diagnosis program is the only program of its
type in metropolitan  Detroit offering subacute  detoxification and treatment of
the primary psychiatric and secondary substance abuse diagnosis.  It is the only
psychiatric   facility  in  the  area  offering  subacute   detoxification   and
psychiatric  evaluations  in the same facility.  The dual diagnosis  service was
developed  in  response  to  demand  from  insurers,   employees  and  treatment
facilities.  Harbor Oaks Hospital is placed  strategically  in terms of physical
proximity to large population centers,  competing hospitals,  populations served
and programming. The Company plans to acquire outpatient facilities in strategic
locations to further expand its market and integrate its delivery system.

      With  respect  to  long-term  care,  the  Company's   competitors  include
hospitals,  long-term care  facilities and hospices which provide both custodial
and  subacute  care.  The Company  competes  in the  long-term  market  within a
catchment area of an approximately  25-mile radius from its Franvale center. The
success of a long-term care facility depends on various  factors,  including the
quality of its amenities and facility,  the professionalism of its staff and its
location. The Company believes that it can compete successfully in the long-term
care market,  notwithstanding  the fact that its competitors are numerous and in
many cases have greater financial  resources than the Company,  by continuing to
provide intensive,  cost-effective and innovative treatment and by acquiring new
facilities  or  upgrading  its existing  facilities,  as it has done through the
construction  and  renovation  project at Franvale,  so that the physical  plant
appeals to private paying patients.

REVENUE SOURCES AND CONTRACTS

      The Company has entered into relationships with numerous employers,  labor
unions and third-party payors to provide services to their employees and members
for the treatment of substance abuse disorders.  In addition, the Company admits
patients who seek treatment  directly  without the intervention of third parties
and whose insurance does not cover these conditions in  circumstances  where the
patient either has adequate financial resources to pay for treatment directly or
is  eligible  to  receive  free  care at one of the  Company's  substance  abuse
facilities.  Free  treatment  provided  each year amounts to less than 5% of the
Company's total patient days.

      Each contract with an  institution is negotiated  separately,  taking into
account the  insurance  coverage  provided to  employees  and  members,  and may
provide for  differing  amounts of  compensation  to the  Company for  different
subsets of employees and members  depending upon such coverage.  The charges may
be capitated,  or fixed with a maximum  charge per patient day, and, in the case
of larger clients, frequently result in a negotiated discount from the Company's
published  charges.  The Company believes that such discounts are appropriate as
they are  effective in  producing a larger  volume of patient  admissions.  When
non-contract  patients are treated by the Company,  they are billed on the basis
of the Company's  standard per diem rates and for additional  ancillary services
provided to them by the Company.

QUALITY ASSURANCE AND UTILIZATION REVIEW

      The Company has established a comprehensive  quality  assurance program at
all of its  facilities.  Such programs are designed to ensure that each facility
maintains standards that meet or exceed  requirements  imposed upon the Company,
with the objective of providing  high-quality  specialized treatment services to
its patients.  The Company's  professional staff,  including physicians,  social
workers, psychologists, nurses, dietitians, therapists and counselors, must meet
the minimal requirements of licensure for their specific discipline,  as well as
the internal  professional staff requirements adopted by each of the facilities.
The Company  participates in the federally mandated National  Practitioners Data
Bank, which monitors professional accreditation nationally.

      In  response to the  increasing  reliance  of  insurers  and managed  care
organizations upon utilization review  methodologies,  the Company has adopted a
comprehensive  documentation policy to satisfy relevant reimbursement  criteria.
Additionally, the Company has developed an internal case management system which
provides  assurance that services rendered to individual  patients are medically
appropriate and reimbursable. Implementation of these internal policies has been
integral  to the success of the  Company's  strategy  of  providing  services to
relapse-prone, higher acuity patients.

GOVERNMENT REGULATION

      The Company's  business and the development and operation of the Company's
facilities  are  subject  to  extensive  federal,  state  and  local  government
regulation.  In recent years, an increasing number of legislative proposals have
been  introduced  at both the  national and state levels that would effect major
reforms  of the  health  care  system  if  adopted.  Among the  proposals  under
consideration   are  reforms  to  increase  the  availability  of  group  health
insurance, to increase reliance upon managed care, to bolster competition and to
require that all businesses offer health insurance  coverage to their employees.
The Company  cannot  predict  whether  any such  legislative  proposals  will be
adopted and, if adopted,  what effect,  if any, such proposals would have on the
Company's business.

      In  addition,  both the  Medicare  and  Medicaid  programs  are subject to
statutory and regulatory  changes,  administrative  rulings,  interpretations of
policy, intermediary  determinations and governmental funding restrictions,  all
of which may  materially  increase or decrease  the rate of program  payments to
health care facilities. Since 1983, Congress has consistently attempted to limit
the growth of federal spending under the Medicare and Medicaid programs and will
like continue to do so. Additionally,  congressional spending reductions for the
Medicaid  program  involving the issuance of block grants to states is likely to
hasten the reliance  upon managed care as a potential  savings  mechanism of the
Medicaid  program.  As a result of this reform  activity the Company can give no
assurance that payments under such programs will in the future remain at a level
comparable to the present level or be sufficient to cover the costs allocable to
such  patients.  In  addition,  many  states,   including  The  Commonwealth  of
Massachusetts  and the State of Michigan,  are  considering  reductions in state
Medicaid budgets.

    HEALTH PLANNING REQUIREMENTS

      Some of the states in which the Company  operates,  and many of the states
where the Company may consider  expansion  opportunities,  have health  planning
statutes which require that prior to the addition or  construction  of new beds,
the addition of new services,  the acquisition of certain  medical  equipment or
certain  capital  expenditures  in  excess of  defined  levels,  a state  health
planning  agency must  determine  that a need exists for such new or  additional
beds, new services, equipment or capital expenditures. These state determination
of need or certificate of need ("DoN") programs are designed to enable states to
participate in certain  federal and state health  related  programs and to avoid
duplication  of health  services.  DoNs  typically  are issued  for a  specified
maximum expenditure, must be implemented within a specified time frame and often
include  elaborate  compliance  procedures  for  amendment or  modification,  if
needed.  Several  states,  including The  Commonwealth  of  Massachusetts,  have
instituted  moratoria on some types of DoNs or otherwise stated an intent not to
grant approvals for certain health services. Such moratoria may adversely affect
the Company's  ability to expand in such states,  but may also provide a barrier
to entry to potential competitors.

      LICENSURE AND CERTIFICATION

      All of the  Company's  facilities  must be  licensed  by state  regulatory
authorities. The Company's Franvale and Harbor Oaks facilities are certified for
participation as providers in the Medicare and Medicaid programs.

      The  Company's  initial and  continued  licensure of its  facilities,  and
certification to participate in the Medicare and Medicaid programs, depends upon
many  factors,  including  accommodations,  equipment,  services,  patient care,
safety,  personnel,  physical  environment,  adequate  policies,  procedures and
controls and the regulatory  process regarding the facility's initial licensure.
Federal,  state and  local  agencies  survey  facilities  on a regular  basis to
determine whether such facilities are in compliance with governmental  operating
and health standards and conditions for  participating  in government  programs.
Such surveys include reviews of patient  utilization and inspection of standards
of patient  care.  The Company  will attempt to ensure that its  facilities  are
operated in compliance  with all such  standards and  conditions.  To the extent
these  standards  are not met,  however,  the  license  of a  facility  could be
restricted,  suspended or revoked,  or a facility could be decertified  from the
Medicare or Medicaid programs.

      MEDICARE REIMBURSEMENT

      Currently,  the Company's  chemical  dependency  facilities do not receive
reimbursement under the Medicare program for services rendered. The Franvale and
Harbor Oaks facilities do, however,  rely upon such  reimbursement as presumably
will other  long-term care and psychiatric  facilities  which may be acquired or
established  by the Company.  The Medicare  program  reimburses  long-term  care
facilities  for routine  operating  costs,  capital costs and  ancillary  costs.
Routine  operating  costs are subject to a routine cost  limitation set for each
location.  Such routine cost  limitations are not applicable for the first three
years of the facility's operations. Owing to its high acuity patient population,
Franvale has received an exception to this routine cost limit for calendar years
1993,  1994, 1995 and 1996.  Capital costs include interest  expenses,  property
taxes,  lease payments and depreciation  expense.  Interest and depreciation are
calculated  based upon the original  owner's  historical  cost (plus the cost of
subsequent  capital  improvements)  when changes in  ownership  occur after July
1984.  Ancillary  costs are reimbursed at actual cost to Medicare  beneficiaries
based on prescribed cost allocation principles.

      On December 13, 1989, the Catastrophic Care Act of 1988 (the "Catastrophic
Care Act") was repealed.  Prior to the effective date of the  Catastrophic  Care
Act,  federal law  provided as a  precondition  to Medicare  coverage of skilled
nursing  facility  services  that the  Medicare  beneficiary  must  have been an
inpatient in an acute care hospital for at least three days preceding  admission
to the nursing facility,  with such admission occurring within thirty days after
discharge from the acute care hospital.  Because the  Catastrophic  Care Act has
been  repealed,  that  precondition  to  Medicare  coverage  of skilled  nursing
facility  services  has been  reinstated.  However the  Catastrophic  Care Act's
expanded  definition of skilled care, which increased  beneficiaries'  access to
skilled nursing services, has been retained.

      The Medicare program generally reimburses  psychiatric facilities pursuant
to its prospective  payment system ("PPS"),  in which each facility  receives an
interim  payment of its allowable  costs during the year which is later adjusted
to reflect actual allowable direct and indirect costs of services based upon the
submission of a cost report at the end of each year.  However,  current Medicare
payment policies allow certain  psychiatric  service providers an exemption from
PPS. In order for a facility to be eligible for exemption from PPS, the facility
must  comply  with  numerous   organizational   and  operational   requirements.
PPS-exempt  providers  are cost  reimbursed,  receiving  the lower of reasonable
costs or reasonable charges. The Medicare program fiscal intermediary pays a per
diem rate based upon prior year costs, which may be retroactively  adjusted upon
the submission of annual cost reports.

      The  Harbor  Oaks  facility  is  currently  PPS-exempt.  The amount of its
cost-based   reimbursement   may  be  limited  by  the  Tax  Equity  and  Fiscal
Responsibility  Act of 1982 ("TEFRA") and  regulations  promulgated  thereunder.
Generally,  TEFRA limits the amount of reimbursement a facility may receive to a
target amount per discharge, adjusted annually for inflation. This target amount
is based  upon a  facility's  reasonable  Medicare  operating  cost  divided  by
Medicare  discharges,  plus a per diem allowance for capital  costs,  during its
base year of  operations.  It is not  possible  to predict the ability of Harbor
Oaks to  remain  PPS-exempt  or to  anticipate  the  impact  of  TEFRA  upon the
reimbursement received by Harbor Oaks in future periods.

      In order to receive Medicare  reimbursement,  each participating  facility
must meet the applicable  conditions of  participation  set forth by the federal
government  relating to the type of facility,  its equipment,  its personnel and
its standards of medical  care,  as well as compliance  with all state and local
laws and regulations.  In addition,  Medicare regulations generally require that
entry into such facilities be through physician referral. The Company must offer
services  to  Medicare  recipients  on a  non-discriminatory  basis  and may not
preferentially accept private pay or commercially insured patients.

      MEDICAID REIMBURSEMENT

      Currently,  the Company's  chemical  dependency  facilities do not receive
reimbursement  under any state  Medicaid  program.  The Franvale and Harbor Oaks
facilities do,  however,  rely upon Medicaid  reimbursement,  as presumably will
other  long-term  care  facilities  which may be acquired or  established by the
Company.  A portion  of  Medicaid  costs are paid by states  under the  Medicaid
program  and the  federal  matching  payments  are not made  unless the  state's
portion is made.  Accordingly,  the timely  receipt of  Medicaid  payments  by a
facility may be affected by the financial condition of the relevant state.

      Harbor Oaks, the Company's  psychiatric  facility, is a participant in the
Medicaid  program  administered by the State of Michigan.  The great majority of
patients  reimbursed  under this program are  adolescents.  Harbor Oaks receives
reimbursement  from the State of Michigan  Medicaid program on a per diem basis,
inclusive  of  ancillary  costs.  The rate is  determined  by the  state  and is
adjusted annually based on cost reports filed by the Company.

      The Franvale facility participates in the Medicaid program administered by
The   Commonwealth   of   Massachusetts.   Payment  to  Medicaid   providers  in
Massachusetts may be delayed or reduced due to budgetary  constraints or limited
availability  of  revenues  due to general  economic  conditions  affecting  the
Commonwealth.  Such  delays  and  reductions  have  occurred  in the past and no
assurance can be given that future  reductions  will not be made in the scope of
covered services or the rate of increase in reimbursement  rates, or that future
reimbursement  will be  adequate  to  cover  the  provider's  cost of  providing
service.  The  effect  of such  limitations  or  reductions  will be to  require
management  to carefully  manage  costs so that they will come within  available
reimbursement revenues, if possible.


   FRANVALE NURSING AND REHABILITATION CENTER


   For 1995 and 1996,  Massachusetts  Medicaid  continues to  reimburse  skilled
nursing  facilities  on an acuity based  prospective  system.  The 1995 and 1996
rates are based on costs  reported  and acuity data for 1993 and are adjusted by
inflation factors.  Under the rate formula  established for 1996,  Massachusetts
nursing  facilities  received  an average  increase in their  Medicaid  rates of
approximately 2%.

   Actual reimbursement of long-term care costs under the Massachusetts Medicaid
program  is based in part upon the acuity  levels of  individual  patients.  Any
changes by the Commonwealth to the methods used to determine patient acuity will
therefore affect Medicaid reimbursement to providers of long-term care. Although
the  specific  Medicaid  rate  formula for 1997 has not been  determined,  it is
expected  that the base year period will remain the same and a modest  inflation
adjustment will be incorporated  into the rates. At this time the Company cannot
predict the impact of the 1997 or future year rate changes on its operations.


      FRAUD AND ABUSE LAWS

      Various  federal and state laws  regulate the business  relationships  and
payment  arrangements  between  providers and suppliers of health care services,
including employment or service contracts, and investment  relationships.  These
laws  include  the fraud and  abuse  provisions  of the  Medicare  and  Medicaid
statutes as well as similar state statutes  (collectively,  the "Fraud and Abuse
Laws"),  which prohibit the payment,  receipt,  solicitation  or offering of any
direct or indirect  remuneration  intended to induce the referral of patients or
the ordering or  providing  of certain  covered  services,  items or  equipment.
Violations of these provisions may result in civil and criminal penalties and/or
exclusion  from  participation  in the Medicare  and Medicaid  programs and from
state programs  containing similar provisions relating to referrals of privately
insured patients.  The federal government has issued regulations which set forth
certain  "safe  harbors,"   representing  business   relationships  and  payment
arrangements  that can safely be  undertaken  without  violation  of the federal
Fraud and Abuse Laws. The Company believes that its business  relationships  and
payment  arrangements  either fall within the safe harbors or  otherwise  comply
with the Fraud and Abuse Laws.

EMPLOYEES

      As of September 15, 1996, the Company had 434  employees,  of which 15 (14
full time) were employed through the Company's  headquarters,  64 (34 full time)
at Highland  Ridge,  41 (29 full time) at Mount Regis, 47 (27 full time) at Good
Hope,  166 (90 full time) at Franvale,  and 84 (44 full time) at Harbor Oaks, 12
(9 full time) at Harmony  Healthcare,  5 (4 full time) at Total Concept.  Of the
Company's  434  employees,  268 are leased from Allied  Resource  Management  of
Florida, Inc. ("ARMFCO"), a wholly owned subsidiary of HRC ARMCO, Inc. (formerly
known as Alliance  Employee Leasing  Corporation),  a national  employee leasing
firm.

      The Company has elected to lease a substantial portion of its employees to
provide  more  favorable  employee  health  benefits at lower cost than would be
available  to  the  Company  as a  single  employer  and  to  eliminate  certain
administrative  tasks which  otherwise would be imposed on the management of the
Company.  The Company does not lease  employees for its long-term care facility.
The  arrangements  with ARMFCO are implemented  through separate leases with the
Company  relating to each facility,  other than Franvale,  and are terminable by
either party on 30 days' written notice. The agreements with ARMFCO provide that
for all leased employees,  ARMFCO will administer payroll (including withholding
of state and federal  payroll  taxes),  provide  for  compliance  with  workers'
compensation laws, including procurement of workers' compensation  insurance and
administering claims, and procure and provide designated employee benefits.  The
Company  retains  the right to reject the  services of any leased  employee  and
ARMFCO has the right to increase its fees at any time upon thirty days'  written
notice or immediately upon any increase in payroll taxes,  workers' compensation
insurance  premiums  or the cost of  employee  benefits  provided  to the leased
employees.

      The Company believes that it has been successful in attracting skilled and
experienced personnel;  competition for such employees is intense,  however, and
there can be no  assurance  that the Company  will be able to attract and retain
necessary qualified employees in the future. None of the Company's employees are
covered by a collective  bargaining  agreement.  The Company  believes  that its
relationships with its employees are good.

INSURANCE

      Each of the Company's facilities maintains separate professional liability
insurance  policies.  Mount Regis,  Harbor Oaks, Harmony  Healthcare,  and Total
Concept have coverage of $1,000,000  per claim and  $3,000,000 in the aggregate.
Highland  Ridge  has  limits of  $1,000,000  per  claim  and  $5,000,000  in the
aggregate.  Good Hope has coverage of $2,000,000 per claim and $6,000,000 in the
aggregate.  In addition,  these entities  maintain general  liability  insurance
coverage in identical amounts.  The Company's  long-term care facility maintains
general  and  professional  liability  coverage of  $2,000,000,  with a limit of
$1,000,000 per claim and an aggregate of $5,000,000 excess coverage.

      The Company  maintains  $1,000,000  of directors  and  officers  liability
insurance coverage and $1,000,000 of general liability insurance  coverage.  The
Company  believes,  based on its  experience,  that its  insurance  coverage  is
adequate  for  its  business  and  that it will  continue  to be able to  obtain
adequate coverage.

ITEM 2.           DESCRIPTION OF PROPERTY.

      EXECUTIVE OFFICES

      The Company's executive offices are located in Peabody, Massachusetts. The
Company's lease in Peabody covers approximately 3,600 square feet for a 60-month
term effective September 10, 1994 at an annual base rent of $28,800 in the first
year,  $32,400 in the second  year,  $34,020 in the third  year,  $35,721 in the
fourth  year and  $37,507 in the fifth  year.  The  Company  believes  that this
facility will be adequate to satisfy its needs for the foreseeable future.

      HIGHLAND RIDGE

      The Highland Ridge premises  consists of approximately  16,072 square feet
of space occupying two full stories of a three-story building. The Company is in
the twelfth year of a fifteen-year  lease term, which lease provides for monthly
rental  payments of  approximately  $21,000 for the remainder of the lease term.
The lease expires on September 30, 1998, and contains an option to renew. During
the term of the lease or any extension thereof, the Company has a right of first
refusal on any offer to purchase the leased premises.  The Company believes that
these premises are adequate for its current and anticipated needs.

      MOUNT REGIS

      The Company owns the Mount Regis  facility which consists of a three-story
wooden  building  located on an  approximately  two-acre  site in a  residential
neighborhood.   The  building   consists  of  over  14,000  square  feet.  Mount
Regis/Changes occupies approximately 1,500 square feet of leased office space on
the first floor of an office building in Roanoke, Virginia. The Company believes
that these  premises  are adequate for its current and  anticipated  needs.  The
Mount Regis Center  property is subject to an  outstanding  mortgage in favor of
Douglas  Roberts  with an  outstanding  balance of $505,485 at fiscal year ended
June 30, 1996.


      GOOD HOPE

      The Company  leases the property from NMI Realty,  Inc., at an annual rent
of $206,000  for the second  year,  $231,000 in the third  through  fifth years,
$255,000 in the sixth year and $255,000 plus 5% of previous year's rent per year
in years seven  through  twenty of the lease.  The  Company  has an  irrevocable
option to purchase the property  for  $1,300,000  at the end of the second year,
for  $1,200,000 at the end of the third year,  for  $1,150,000 at the end of the
fourth  year and for  $1,100,000  at any time  after the end of the  fifth  year
through the end of the term of the lease.

      The West  Greenwich  facility  consists of three  buildings,  containing a
total of approximately  25,000 square feet, located on an approximately  70-acre
parcel of land. The satellite office is leased;  the Company is a tenant-at-will
at the North  Smithfield  satellite  location.  The Company  believes that these
premises are adequate for its current and anticipated needs.

      HARBOR OAKS

      Harbor Oaks is located in New Baltimore, Michigan,  approximately 20 miles
northeast  of  Detroit.  The  Company  owns the  property  on which  Harbor Oaks
operates,  consisting of a one-story  brick and wood frame  building  comprising
approximately  32,000  square  feet and  which is used  for the  operation  of a
psychiatric  hospital,  and the underlying  real estate of  approximately  three
acres.  There have been two  additions to the  building;  in 1982,  19 beds were
added and, in 1988, a new  administrative  area and  gymnasium  were built.  The
Company   believes  that  these  premises  are  adequate  for  its  current  and
anticipated needs.

      HARMONY HEALTHCARE

      The Harmony premises consists of approximately  2,628 square feet of space
located on the third floor of the building known as Charleston  Tower located at
1701 West Charleston Boulevard,  Las Vegas, Nevada. The property is under a four
year lease which  provides for lease payments of $4,599.00 per month plus common
area  charges of 3.48% of project  expenses  not to exceed  $300.00 in the first
year with  incremental  increases  of $50.00 per month  allowed each year of the
lease.  The lease also allows for an increase  in leased  space to 3,077  square
feet as soon as available for occupancy. This increase in leased space increases
the monthly  rent  charge to $5384.75  but the  allocation  of project  expenses
remains the same. The Company  believes that these premises are adequate for its
current and anticipated needs.

      TOTAL CONCEPT

      The Total Concept premises consists of approximately  1,850 square feet of
space known as Suite 101 located at King's Cove Office Park in Shawnee  Mission,
Kansas.  The  property  is under a three year lease which  provides  for monthly
lease  payments of $1,735.00  for the first year,  $1,773.00 for the second year
and $1,850.00 for the third year of the lease.  The Company  believes that these
premises are adequate for its current and anticipated needs.


      FRANVALE

      The Company owns the real  property and  improvements  for  Franvale.  The
operations  are located in a two-story  building  comprising  44,019 square feet
which is located on an approximately  two-acre parcel of land. The real property
was owned by PHC, Inc. until September 8, 1994, at which time it was transferred
to its subsidiary, Quality Care Centers of Massachusetts,  Inc., ("QCC"). At the
time the  property was  transferred  to QCC,  QCC  purchased an adjoining  5,825
square foot parcel of land and  refinanced  its  existing  debt and financed the
costs of renovations and the addition of 37 beds to the long-term care facility.
The  Company  believes  that these  premises  are  adequate  for its current and
anticipated needs.

      The  refinancing  described in the preceding  paragraph  was  accomplished
through  guarantees  provided  by the  U.S.  Department  of  Housing  and  Urban
Development  under Section 232 of The National Housing Act. A non-recourse  loan
in the amount of $6,822,700  was provided by Charles River  Mortgage  Company of
Boston,  Massachusetts  in return  for a  promissory  note and  mortgage  of the
Company in the same  amount.  This  amount was  adjusted  after HUD's final cost
certification  process completed in July, 1996. The annual interest is 9.25% and
the note is payable over a forty-year period commencing  January 1, 1996. During
the  twelve-month  construction  period,  only  interest was payable,  effective
October 1,  1994.  Pre-payment  is allowed  with  penalty  from  October 1, 2000
through October 1, 2005, with no penalty from October 1, 2005. All  pre-existing
debt  relating  to Franvale  was paid by the Company out of the  proceeds of the
refinancing;  $497,500.00  was paid to the Federal  Deposit  Insurance  Company,
$1,823,839.87 was paid to CMS Capital  Ventures,  Inc. and $5,888.77 was paid to
Trans National Leasing.

      The Company  completed  renovations  to and the addition of 37 beds to its
long-term care facility in September ,1995.


ITEM 3.           LEGAL PROCEEDINGS.

      Consistent  with its  discontinuation  of  operations  at the Marin  Grove
facility,  the Company  has  entered  into a  settlement  agreement  with Claire
Leonhard Morse, individually and as a trustee of the Anna Leonhard Trust, Arnold
Leonhard,  individually  and as a trustee of the Anna Leonhard Trust,  and Lloyd
Leonhard (collectively,  the "Lessor") in connection with litigation relating to
the Company's lease of the Marin Grove property. Under the settlement agreement,
the Company  paid the Lessor  $40,000,  less  approximately  $17,400 for amounts
already  paid,  as rent for the period from August 1, 1994 to November  30, 1994
and   continued  to  occupy  only  that   portion  of  the  property   used  for
administrative  purposes  and rented to current  subtenants  until  November 30,
1994. In December 1994, the litigation was dismissed with prejudice.

      The  Company   received  a  notice  from  Pioneer  Health  Care,  Inc.,  a
Massachusetts  non-profit corporation demanding that the Company discontinue use
of its PIONEER HEALTHCARE trademark upon the ground that that mark infringes the
rights of Pioneer Health Care, Inc. under  applicable law.  Pioneer Health Care,
Inc.  threatened  to proceed  with the  necessary  legal  action to prevent  the
Company from using the PIONEER  HEALTHCARE  mark, and to seek a cancellation  of
the  registration  that has been issued by the U.S. Patent Trademark Office (the
"PTO") to the  Company  for the  PIONEER  HEALTHCARE  mark,  unless the  Company
complied  with this  demand.  The Company  refused to comply  with this  demand,
whereupon  Pioneer  Health  Care,  Inc.  filed a petition in the PTO seeking the
cancellation of the Company's  registration of its PIONEER HEALTHCARE trademark.
The Company thereupon  commenced  litigation in the United States District Court
for the District of Massachusetts seeking a declaratory judgment that its use of
the PIONEER HEALTHCARE  trademark does not infringe any rights of Pioneer Health
Care,  Inc.  under  applicable  law,  and that it has the right to maintain  its
registration of that mark. Pioneer Health Care, Inc. has filed a counterclaim in
that litigation  seeking injunctive and monetary relief against the Company upon
claims of trademark infringement, trademark dilution and unfair competition. The
Company is defending itself  vigorously  against those claims.  Proceedings upon
the  petition  filed  by  Pioneer  Health  Care,  Inc.  in the PTO  seeking  the
cancellation of the Company's  registration of its PIONEER HEALTHCARE  trademark
have been stayed pending the  resolution of the litigation  between the parties.
The Company  does not  believe  that an adverse  decision  would have a material
adverse effect on the Company.

      In January 1996, the Company received notice that Mullikin Medical Center,
A Medical Group, Inc., located in Artesia, California, filed a petition with the
PTO seeking cancellation of the registration of the PIONEER HEALTHCARE mark. The
Company and petitioner are currently discussing a settlement whereby the parties
would  agree  that  there is no  likelihood  of  confusion  of their  respective
trademarks  due to the  difference  in the  trademarks,  the  difference  in the
parties'  services,  the  difference  in the  channels of trade of the  parties'
services and the scope of  protection to be accorded  trademarks  using the name
PIONEER.  The Company is unable to express an opinion as to the likely merits of
this matter.

      On October  31,  1994,  the  Company was served with a summons for a Civil
Action in the Superior Court  Department of the Trial Court of the  Commonwealth
of Massachusetts by NovaCare, Inc. ("NovaCare"), an entity which contracted with
the Company in 1992 to provide rehabilitation therapy and related administrative
services to the Company's long-term care facility (the "Action").  The complaint
alleged  that the Company  owed  NovaCare  contractual  damages in the amount of
approximately $587,000, plus interest,  attorney fees, costs of collection,  and
double or triple damages pursuant to a Massachusetts  statute prohibiting unfair
and deceptive trade  practices.  The Company filed a counterclaim  alleging that
NovaCare  breached  the  contract in  question  and that the Company may be owed
damages in excess of the amount sought by NovaCare.

      On February  13, 1996,  the Company  settled the Action by agreeing to pay
NovaCare  an amount  less than its claim.  The  Company  is not paying  NovaCare
accrued interest,  attorney's fees, costs of collection,  or multiple damages. A
portion  of the  settlement  amount  has  already  been paid The  balance of the
settlement amount is payable over twelve (12) months with interest on the unpaid
balance at 9.5%. In the event that the Company defaults on its obligation to pay
the  settlement  amount,  it has agreed to entry of  judgment  against it in the
amount of $457,637.46 (the "Judgment").  The Judgment represents the full unpaid
balance of NovaCare's claim against the Company, including interest,  attorney's
fees, and costs of collection. Any amounts paid by the Company to NovaCare after
February  9, 1996 shall be  deducted  from the  Judgment.  Until the  settlement
amount is paid, NovaCare will continue to hold a mortgage on a day care property
owned by the Company in Saugus, Massachusetts.



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

      No matters were  submitted  to a vote of the  Company's  security  holders
during the fourth quarter of the fiscal year ended June 30, 1996.






DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

      The directors and officers of the Company are as follows:

NAME                           AGE                 POSITION
Bruce A. Shear................ 41  Director, President, &Chief Executive Officer
Robert H. Boswell............. 47  Executive Vice President
Mark Cowell (3)............... 50  Vice President of Communications
Gerald M. Perlow, M.D. (1)(2). 58  Director and Clerk
Donald E. Robar (1)(2)........ 59  Director and Treasurer
Paula C. Wurts................ 47  Controller, Assistant Clerk,  and   Assistant
                                     Treasurer
(1)   Member of Audit  Committee.
(2)   Member of Compensation Committee.
(3)   Mr. Cowell resigned from the Company effective July, 1996.

      All of the directors hold office until the annual meeting of  stockholders
next  following  their  election,  or until  their  successors  are  elected and
qualified. The Company is required, upon request of Americorp Securities,  Inc.,
the  underwriter  of the Company's  initial  public  offering in March 1994 (the
"Underwriter"),  to use its best efforts to elect a designee of the  Underwriter
to the Board of  Directors  for a period of three years from March 3, 1994.  The
underwriter  has advised the Company that it has no current plans to designate a
director.  Officers are elected  annually by the Board of Directors and serve at
the discretion of the Board. There are no family  relationships among any of the
directors or officers of the Company.

      Information  with respect to the business  experience and  affiliations of
the directors and officers of the Company is set forth below.

     BRUCE A. SHEAR has been President,  Chief Executive  Officer and a Director
of the Company  since 1980 and Treasurer of the Company  since  September  1993.
From  1976 to 1980  he  served  as Vice  President,  Financial  Affairs,  of the
Company.  Mr. Shear has served on the Board of Governors  of the  Federation  of
American  Health Systems for over ten years.  Mr. Shear received an M.B.A.  from
Suffolk  University in 1980 and a B.S. in Accounting  and Finance from Marquette
University in 1976.

     ROBERT H. BOSWELL has served as the Executive Vice President of the Company
since  1992.  From  1989  until  Spring  of  1994  Mr.  Boswell  served  as  the
Administrator  of the Company's  Highland  Ridge  Hospital  facility where he is
based.  Mr. Boswell is principally  involved with the Company's  substance abuse
facilities.  From 1981 until 1989, he served as the Associate  Administrator  at
the Prevention  Education  Outpatient  Treatment  Program--the  Cottage Program,
International. Mr. Boswell graduated from Fresno State University in 1975 and
from 1976 until 1978 attended Rice University's doctoral program in philosophy.

     MARK COWELL has served as Vice President of  Communications  of the Company
since 1984 and as  Administrator  of Mount Regis Center since 1989.  Mr.  Cowell
received his B.A. in  Journalism  from  Northeastern  University  in 1969 and is
currently completing courses for an M.B.A. at Virginia Polytechnic University.

     GERALD M. PERLOW,  M.D.  has served as a Director of the Company  since May
1993 and as Clerk since February,  1996. Dr. Perlow is a cardiologist in private
practice in Lynn,  Massachusetts,  and has been Associate  Clinical Professor of
Cardiology at the Tufts University  School of Medicine since 1972. Dr. Perlow is
a Diplomat of the National Board of Medical  Examiners and the American Board of
Internal Medicine (with a subspecialty in  cardiovascular  disease) and a Fellow
of the American  Heart  Association,  the American  College of  Cardiology,  the
American College of Physicians and the Massachusetts  Medical Center.  From 1987
to  1990,  Dr.  Perlow  served  as the  Director,  Division  of  Cardiology,  at
AtlantiCare  Medical Center in Lynn,  Massachusetts.  Dr. Perlow received a B.A.
from  Harvard  College  in 1959 and an M.D.  from  Tufts  University  School  of
Medicine in 1963.

     DONALD E. ROBAR has served as a Director of the Company  since 1985 and has
served as the Treasurer since February,  1996. Dr. Robar has been a professor of
Psychology since 1961, most recently at Colby-Sawyer  College in New London, New
Hampshire.  Dr. Robar received a Ed.D. from the University of  Massachusetts  in
1978,  an M.A.  from Boston  College in 1968 and a B.A.  from the  University of
Massachusetts in 1960.

     PAULA C. WURTS has served as the  Controller  of the Company since 1989, as
Assistant Treasurer since 1993, and as Assistant Clerk since January,  1996. Ms.
Wurts served as the Company's Accounting Manager from 1985 until 1989. Ms. Wurts
received  an  Associate's  degree in  Accounting  from the  University  of South
Carolina in 1980, a B.S. in Accounting from Northeastern  University in 1989 and
passed the examination for Certified Public  Accountants.  She has completed the
requirements  for a Master's  Degree in  Accounting  from  Western  New  England
College.

                                      PART II

ITEM 5.     MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

      The Company's  Units,  Class A Common Stock and Class A Warrants have been
traded on the NASDAQ  National  Market  under the  symbols  "PIHCU,"  "PIHC" and
"PIHCW,"  respectively,  since the Company's  initial public  offering which was
declared  effective on March 3, 1994.  There is no public trading market for the
Company's Class B and Class C Common Stock.  The following table sets forth, for
the  periods  indicated,  the high and low sale price of the  Company's  Class A
Common Stock, as reported by NASDAQ.

1995                                                  HIGH              LOW
      Third Quarter (beginning
        March 3, 1995) . . . . . . . . . .            6 1/4             5 1/8
      Fourth Quarter . . . . . . . . . . .            7 3/8             5 1/8

1996
      First Quarter     . . . . . . . . . . . .       7 3/4             6 1/2
      Second Quarter . . . . . . . . . . .            7 3/8             5 1/2
      Third Quarter . . . . . . . . . . . .           9 5/8             5 1/4
      Fourth Quarter . . . . . . . . . . .            9 3/4             7

1997
      First Quarter (through
      September 13, 1996). . . . . . .    9 3/4                   7

      On September 13, 1996,  the last reported sale price of the Class A Common
Stock was $7.50.  On  September  13, 1996 there were 46 holders of record of the
Company's  Class A Common Stock,  322 holders of record of the Company's Class B
Common Stock and 335 holders of the Company's Class C Common Stock.

DIVIDEND POLICY.

      The Company has never paid any cash  dividends on its Common Stock.  While
there are currently no restrictions  on the Company's  ability to pay dividends,
the Company anticipates that in the future,  earnings,  if any, will be retained
for  use  in  the  business  or  for  other  corporate  purposes,  and it is not
anticipated  that cash  dividends in respect of Common Stock will be paid in the
foreseeable  future.  Any decision as to the future  payment of  dividends  will
depend on the results of operations  and  financial  position of the Company and
such other factors as the Company's Board of Directors, in its discretion, deems
relevant.


ITEM 6.     MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION

GENERAL

      The following  discussion and analysis should be read in conjunction  with
the  consolidated  financial  statements and notes thereto  appearing  elsewhere
herein.

      The Company is a provider of health care services through several chemical
dependency  centers, a long-term care facility,  an acute psychiatric  hospital,
and  effective  fiscal  year  1996  two  outpatient   psychiatric  centers.  The
profitability  of the  Company  is  largely  dependent  on the level of  patient
occupancy at these treatment facilities.  The Company's  administrative expenses
do not  vary  significantly  as a  percentage  of  total  revenue  although  the
percentage tends to decrease  slightly as revenue increases because of the fixed
components of these expenses.

      The healthcare  industry is subject to extensive federal,  state and local
regulation governing,  among other things, licensure and certification,  conduct
of operations, audit and retroactive adjustment of prior government billings and
reimbursement.  In addition, there are ongoing debates and initiatives regarding
the  restructuring  of the  health  care  system  in its  entirety.  While it is
anticipated that a number of the proposed regulatory changes may have a positive
impact on the Company's  business,  there can be no assurance that other changes
may not adversely affect the Company.

      Over the past several years, the Company has been  systematically  phasing
out its day care center  operations due to declining  profitability and its lack
of fit with the Company's health care  operations.  At June 30, 1996 the Company
had remaining net assets related to these operations  amounting to approximately
$56,700  which is a real estate  parcel  located in Saugus,  Massachusetts.  The
Company does not anticipate any significant future losses due to the disposition
of this asset.

RESULTS OF OPERATIONS

YEARS ENDED JUNE 30, 1996 AND 1995

      The  Company  experienced  a loss for  fiscal  year  ended  June 30,  1996
primarily as a result of the increased  expenses  incurred in the opening of the
new beds at  Franvale.  Census  levels at Franvale  did not  increase as soon as
anticipated  to  cover  the  fixed  costs  involved  in the  expanded  facility.
Marketing  efforts since the opening of the new beds are now producing  expected
patient  census and mix.  Census is currently at 90%  occupancy of the 128 total
beds  which is up from 87.1% for the  fiscal  year  ended June 30,  1996 on less
available beds.

      Also  contributing  to the current year's loss was Good Hope Center's loss
of referrals  from the  Department of Child,  Youth and Family  Services  (DCYF)
contract  funded by the state of Rhode  Island.  This created a sharp decline in
adolescent  census.  The  Company is  re-engineering  the program and the center
operations.  In  conjunction  with  the  re-engineering  of  the  facility,  two
unprofitable  outpatient  centers  have been  closed,  some  programs  have been
combined, several positions have been eliminated and new management has been put
in  place.  The  management  team is  focusing  its  attention  on both  expense
reduction and revenue enhancement.

      Net patient care revenue from all facilities  increased 32% to $21,802,758
for the year ended June 30,  1996 from  $16,536,618  for the year ended June 30,
1995..  Net patient  care  revenue  for the  psychiatric  hospital,  Harbor Oaks
Hospital,  was  $6,218,410  for the fiscal year ended June 30, 1996  compared to
3,204,857 for June 30, 1995. Net patient care revenue at the Company's  chemical
dependency  treatment  centers  increased to $9,155,595 from $8,932,864 over the
same  period.  Net patient  revenue at the  Company's  long-term  care  facility
increased to $5,043,922  for fiscal 1996 (20.7%) from  $4,180,471 in fiscal 1995
which is  attributable  to the  increase  in census  due to the  addition  of 37
available beds.

      Total  patient  care  expenses  for  all  facilities  increased  29.8%  to
$12,004,383  for the year ended June 30, 1996 from $9,248,317 for the year ended
June 30, 1995. Patient care expenses for the psychiatric  hospital,  Harbor Oaks
Hospital,  were  $3,098,664  for the fiscal year ended June 30, 1996 compared to
$1,941,528  for fiscal year ended June 30, 1995.  Patient  care  expenses at the
Company's  chemical  dependency  treatment  centers decreased to $4,350,423 from
$4,453,212 for the same period  (approximately  2.3%).  Patient care expenses at
the Company's  long-term  care facility  increased to $4,029,572 for fiscal 1996
from $2,884,425 in fiscal 1995 (approximately 39.7%). The percentage increase in
patient care expenses in the long-term care facility is due to increased  census
and acuity of patient mix and fixed cost increase,  interest,  salaries, related
to the new  addition.  The census  increase  related to the new beds took longer
than anticipated creating a loss for the fiscal year ended June, 1996. Census is
now at the expected  level and rate increases  have been  implemented  effective
September 1, 1996 to offset the higher costs.


LIQUIDITY AND CAPITAL RESOURCES

      During the third fiscal quarter of 1996,  the Company  completed a private
placement of 493,700 Class A Common Stock with  Warrants to purchase  additional
shares of Class A Common Stock at $4.00 a share.  This  resulted in net proceeds
to the Company of approximately $1,524,800.

      Prior to 1992, the Company's primary lender was a bank which failed in May
1992 and was taken over by the FDIC.  As noted  above,  during  fiscal  1994 the
Company  negotiated  the repayment of this debt  resulting in a reduction in the
amount due of approximately $400,000. Of the total negotiated amount to be paid,
$1,100,000  was paid in fiscal 1994 and  $497,500 was paid in fiscal 1996 out of
the proceeds received from HUD financing (see below).

      In September  1994 the Company  consummated  its planned HUD financing for
the  expansion and  refurbishment  of its long-term  care  facility.  Under this
financing the Company  received gross proceeds of $6,822,700 which were expended
as follows:


                  Existing Indebtedness   $2,327,230
                  Construction Contract   $2,879,183
                  Other Costs             $   596,470
                  Finance and Carrying
                  Charges                 $1,019,547

      A significant  factor in the liquidity and cash flow of the Company is the
timely collection of its accounts  receivable.  Accounts receivable from patient
care increased 45% to $9,606,000 at June 30, 1996 from approximately  $6,621,000
at June 30,  1995.  The  increase in accounts  receivable  is net of the sale of
certain receivables to LINC Finance Corporation VIII (LINC).  Without this sale,
the  June  30,  1996  ending  accounts   receivable   balance  would  have  been
approximately   $796,000   higher  and  would  have  reflected  an  increase  of
approximately 40%. This significant  increase in receivables is primarily due to
increase in revenues from new acquisitions  and increased beds at Franvale.  The
Company  continues  to closely  monitor its  accounts  receivable  balances  and
implement  procedures to manage this  receivables  growth and keep it consistent
with growth in revenues.

      During the fiscal year ended 1995,  PHC of  Virginia,  Inc.,  PHC of Rhode
Island,  Inc. and LINC entered  into Sale and Purchase  Agreements,  pursuant to
which LINC will provide funding of up to $950,000 to each of these subsidiaries.
There can be no assurance  that the other  subsidiaries  will enter into similar
agreements or satisfy the conditions necessary to receive funding if pursued.

     During  the  fiscal  year  ended  June  30,  1996,  PHC of Utah,  Inc.  and
HEALTHPARTNERS FUNDING, L.P. entered into a revolving credit agreement, pursuant
to which HealthPartners  Funding,  L.P. will provide funding of up to $1,000,000
to PHC of Utah, Inc. This revolving credit agreement is secured by the assets of
the subsidiary.

      At June 30, 1996 the Company had  approximately  $293,000 in cash and cash
equivalents,  working capital of approximately  $4,871,000 and a working capital
ratio of  approximately  1.9 to 1.  Management  believes  that the  Company  has
adequate cash resources to fund operations for the foreseeable future.  However,
the Company is currently  seeking bank lending  relationships to insure that the
Company  will have the  necessary  capital  to fund  expansion  of its  existing
business in the future and to pursue acquisition opportunities as they arise.

      The Company has made significant progress toward the accomplishment of its
acquisition and expansion  plans by completing its nursing home  refinancing and
the  construction  of a  new  37-bed  addition  and  facility  renovations.  The
completion  of  the  Rhode  Island  acquisition  expanded  its  substance  abuse
facilities  base while the  closing  of the  Company's  unprofitable  California
facility  focuses its efforts on contributing to the  profitability  of its core
substance abuse facilities.

      The Company's first psychiatric  hospital acquisition in September of 1994
marked the Company's entry into this  compatible  business line. The acquisition
of the Company's first outpatient  psychiatric  clinic was completed in November
of 1995. The March, 1996 acquisition of Total Concept also focuses on outpatient
psychiatric  care.  The Company will continue to look into further  expansion in
these areas taking into account the overall enhancement of stockholders' value.


ITEM 7.           FINANCIAL STATEMENTS.

===============================================================================
                                                                AT PAGE
===============================================================================
Index...........................................................   F-1
===============================================================================
Reports of Independent Auditors.................................   F-2
===============================================================================
Consolidated Balance Sheets.....................................   F-3
===============================================================================
Consolidated Statements of Operations...........................   F-4
===============================================================================
Consolidated Statements of Changes
in Stockholders' Equity.........................................   F-5
===============================================================================
Consolidated Statements of Cash Flows...........................   F-6
===============================================================================
Notes to Financial Statements...................................   F-7
===============================================================================



                                     PART III

ITEM 9.     DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS

     Information  required  by  Item  401  and  Item  405 of  Regulation  S-B is
contained in Part I of this report.

COMPLIANCE WITH SECTION 16(A) OF THE EXCHANGE ACT

      Based  on a  review  of  Forms  3 and 4  furnished  to  the  Company,  all
directors,  officers and beneficial owners of more than ten percent of any class
of equity  securities  of the Company  registered  pursuant to Section 12 of the
Securities  Exchange Act (the  "Exchange  Act") filed on a timely basis  reports
required by Section  16(a) of the  Exchange  Act during the most  recent  fiscal
year.


ITEM 10.    EXECUTIVE COMPENSATION.

EMPLOYMENT AGREEMENTS

     The  Company  has not  entered  into  any  employment  agreements  with its
executive officers. The Company has acquired a $1,000,000 key man life insurance
policy on the life of Bruce A. Shear.

EXECUTIVE COMPENSATION

      Two executive  officers of the Company  received  compensation in the 1996
fiscal  year  which  exceeded  $100,000.  The  following  table  sets  forth the
compensation  paid or accrued by the  Company  for  services  rendered  to these
executives in fiscal year 1996:


                      SUMMARY COMPENSATION TABLE

                                            ANNUAL      All Other       
                                         COMPENSATION   Salary
  Bruce A. Shear, President and
      Chief Executive Officer.........    $294,063      $10,818(1)
  
  Robert  H.  Boswell,   
       Executive  Vice President......     $80,667      $24,750(2)
  

(1)   This  amount  represents  (i)  $2,650  contributed  by the  Company to the
      Company's  Executive  Employee Benefit Plan on behalf of Mr. Shear,  (ii))
      $5,146 in premiums paid by the Company with respect to life  insurance for
      the benefit of Mr.  Shear,  and (iii)  $3,022  personal use of Company car
      held by Mr. Shear.

(2)   This amount represents (i) $1,000 bonus, (ii) $3,750 automobile allowance,
      and (iii)  $20,000 net gain from the  exercise  of options and  subsequent
      sale of stock.

COMPENSATION OF DIRECTORS

      Directors who are  employees of the Company  receive no  compensation  for
services as members of the Board. Directors who are not employees of the Company
receive  $2,500  stipend per year and $1,000 for each Board meeting they attend.
In  addition,  directors of the Company are  entitled to receive  certain  stock
option grants under the Company's  Non-Employee  Director Stock Option Plan (the
"Director Plan").

COMPENSATION COMMITTEE


     The  Compensation  Committee  consists of Mr.  Donald Robar and Dr.  Gerald
Perlow.  The  Compensation  Committee met once during fiscal 1996. Mr. Shear did
not participate in discussions  concerning,  or vote to approve,  his salary. In
fiscal year 1996,  none of the  executive  officers or  directors of the Company
served on a board of directors of any other entity.

STOCK PLAN

      The  Company's  Stock Plan was adopted by the Board of Directors on August
26, 1993 and approved by the  stockholders  of the Company on November 30, 1993.
The Stock Plan  provides for the issuance of a maximum of 300,000  shares of the
Class A Common  Stock of the Company  pursuant to the grant of  incentive  stock
options to employees and the grant of  nonqualified  stock options or restricted
stock  to  employees,  directors,  consultants  and  others  whose  efforts  are
important to the success of the Company.

      The Stock Plan is administered  by the Board of Directors.  Subject to the
provisions of the Stock Plan, the Board of Directors has the authority to select
the  optionees or  restricted  stock  recipients  and determine the terms of the
options or restricted stock granted,  including:  (i) the number of shares, (ii)
option exercise  terms,  (iii) the exercise or purchase price (which in the case
of an incentive stock option cannot be less than the market price of the Class A
Common  Stock as of the date of grant),  (iv) type and  duration  of transfer or
other  restrictions  and (v) the time and form of payment for  restricted  stock
upon  exercise  of  options.  Generally,  an option is not  transferable  by the
optionholder  except by will or by the laws of descent and  distribution.  Also,
generally, no option may be exercised more than 60 days following termination of
employment.  However,  in  the  event  that  termination  is  due  to  death  or
disability,  the option is  exercisable  for a period of one year following such
termination.

      In September of 1993,  the Company  issued  options to purchase a total of
57,500  shares of Class A Common  Stock at an exercise  price of $5.00 per share
under the Stock Plan.  Because the holders of two of those options are no longer
employees  of the Company and some options  have been  exercised,  the number of
shares of Class A Common Stock for which these options are  exercisable has been
reduced to 36,250. These options were fully exercisable as of September 9, 1996.

      In June of 1994,  the Company  issued options to purchase a total of 3,000
shares of Class A Common Stock at an exercise price of $6.37 per share under the
Stock Plan. In April of 1995,  the Company issued options to purchase a total of
39,000  shares of Class A Common  Stock at an exercise  price of $5.13 per share
under the Stock  Plan.  As of June 30,  1996,  10,000 of these  options had been
exercised.  These options are all  immediately  exercisable and can be exercised
for a period of five  years  from the grant  date,  provided  that the  optionee
remains an employee of the Company as of the exercise date.

      In March of 1996, the Company issued options to purchase a total of 35,000
shares of Class A Common Stock at an exercise  price ranging from $5.25 to $6.50
under the Stock Plan.  In May of 1996,  the Company  issued  options to purchase
6,000 shares of Class A Common at an exercise price of $7.00. These options were
immediately  exercisable as to 25% of the shares covered thereby.  The remaining
option  shares are  exercisable  at the rate of 25% per year over the next three
years  after the grant date  provided  the  optionee  remains an employee of the
Company as of each exercise date.


EMPLOYEE STOCK PURCHASE PLAN

      On October 18, 1995, the Board of Directors voted to provide employees who
work in excess of 20 hours per week and more than five months per year rights to
elect to  participate  in an Employee  Stock  Purchase  Plan (the "Plan")  which
became effective February 1, 1996. No more than 100,000 shares may be sold under
this Plan.  The price per share shall be the lesser of 85% of fair market  value
on the Offering Date or 85% of the fair market value of a share on the date such
right is exercised.  Currently  there is an offering period under the plan which
began on February 1, 1996 and will end on January 31, 1997. There are twenty-six
employees participating in this plan period.

NON-EMPLOYEE DIRECTOR STOCK PLAN

     The Company's  Non-Employee  Director Stock Plan (the "Director  Plan") was
adopted by the directors on October 18, 1995 and approved by the Stockholders of
the Company on December 15, 1995.  Non-qualified  options to purchase a total of
30,000  shares of Class A Common  Stock are  available  for  issuance  under the
Director Plan.

     The Director Plan is  administered by the Board of Directors or a committee
of the Board.  Under the Director  Plan,  each director of the Company who was a
director at the time of adoption of the Director  Plan and who was not a current
or former employee of the Company  received an option to purchase that number of
shares of Class A Common Stock as equals 500  multiplied by the years of service
of such  director  as of the date of the grant.  At each  annual  meeting of the
Board of Directors of the Company  following the initial grant described  above,
each  nonemployee  director  is  granted  under the  Director  Plan an option to
purchase  2,000 shares of the Class A Common  Stock of the  Company.  The option
exercise  price is the fair market value of the shares of the Company's  Class A
Common stock on the date of grant. The options are  non-transferable  and become
exercisable as follows: 25% immediately and 25% on each of the first, second and
third  anniversaries  of the grant date. If an optionee ceases to be a member of
the  Board of  Directors  other  than for  death or  permanent  disability,  the
unexercised  portion  of  the  options,  to  the  extent  unvested,  immediately
terminate,  and the  unexercised  portion of the options which have vested lapse
180 days after the date the optionee  ceases to serve on the Board. In the event
of death or permanent disability,  all unexercised options vest and the optionee
or his or her legal  representative  has the right to exercise  the option for a
period of 180 days or until the expiration of the option, if sooner.

      On  January  23,  1996,  a total of 5,500  shares  were  issued  under the
Director Plan at an exercise price of $6.63 per share. As of September 13, 1996,
none of these options had been exercised.


ISSUANCE OF RESTRICTED STOCK

      On December 17, 1993,  the Company  issued 11,250 and 19,750 shares of the
Company's Class A Common Stock to certain directors and officers of the Company,
respectively,  at a purchase price of $4.00 per share.  The shares of restricted
stock were issued  pursuant to the Company's  Stock Plan. Each purchaser paid to
the Company  25% of the  purchase  price for his or her shares in cash,  and the
balance with a  non-recourse  note.  The notes are payable  quarterly over three
years commencing June 30, 1994, and bear interest at the rate of 6% per year. To
secure the payment obligation under the non-recourse notes, shares paid for with
these notes have been pledged to the Company. As the principal due under each of
the notes is reduced,  the  appropriate  number of shares are released  from the
pledge.

      On November 1, 1995,  the Company  issued  75,000  shares of the Company's
Class A Common  Stock as part of the  acquisition  of  Harmony  Counseling.  The
Company also issued 12,000 shares of Class A Common Stock in the  acquisition of
Total Concept EAP on March 15, 1996.


ITEM 11.    SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

      The following table sets forth certain information regarding the ownership
of shares of the Company's Class A Common Stock,  Class B Common Stock and Class
C Common  Stock  (the only  classes of capital  stock of the  Company  currently
outstanding) as of September 22, 1996 by (i) each person known by the Company to
beneficially own more than 5% of any class of the Company's  voting  securities,
(ii) each director of the Company, (iii) each of the named executive officers as
defined in 17 CFR  228.402  (a)(2) and (iv) all  directors  and  officers of the
Company as a group.  Unless  otherwise  indicated below, to the knowledge of the
Company,  all persons  listed below have sole voting and  investment  power with
respect  to their  shares of Common  Stock,  except to the extent  authority  is
shared by spouses under  applicable law. In preparing the following  table,  the
Company has relied on the information furnished by the persons listed below.

TITLE OF CLASS Name and Address of   Amount and Nature   Percent of
               BENEFICIAL OWNER      OF BENEFICIAL OWNER CLASS (6)

  Class A      Gerald M. Perlow      15,250 (3)          *
  Common Stock c/o PHC, Inc.
               200 Lake ST, STE 102
               Peabody MA 1960

               Donald E. Robar       7,375 (3)           *
               c/o PHC, Inc.
               200 Lake ST, STE 102
               Peabody MA 01960

               Bruce A. Shear        5,000
               c/o PHC, Inc.
               200 Lake ST, STE 102
               Peabody MA 01960

               All Directors and     74,125 (4)          3.2%
               Officers    as a
               Group (6 persons)

Class B        Bruce A. Shear        681,259 (1)         84.5%
Common         c/o PHC, Inc.
Stock   (7)    200 Lake ST, STE 102
               Peabody MA 01960

Class B        J. Owen Todd         59,280 (5)          7.3%
Common Stock   c/o Todd and Weld
               1 Boston Place
               Boston MA  02108

               William F. Grieco     59,280 (5)          7.3%
               115 Marlborough ST
               Boston MA 02116

               All Directors and     681,259 (1)         84.5%
               Officers    as a
               Group (6 persons)

  Class C      Bruce A. Shear        156,502 (2)         78.3%
  Common Stock c/o PHC, Inc.
               200 Lake ST, STE 102
               Peabody MA 01960

               J. Owen Todd          13,173 (5)          6.6%
               c/o Todd and Weld
               1 Boston Place
               Boston, MA  02108

               William F. Grieco     13,173 (5)          6.6%
               115 Marlborough ST
               Boston MA 02116

               All Directors and     156,502 (2)         78.3%
               Officers    as a
               Group (6 persons) 

* Less than 1%.

 (1)  Includes  56,369 shares of Class B Common Stock pledged to Steven J. Shear
      of 2 Addison Avenue, Lynn,  Massachusetts 01902, Bruce A. Shear's brother,
      to secure the purchase  price  obligation  of Bruce A. Shear in connection
      with his purchase of his brother's  stock in the Company in December 1988.
      In the  absence  of any  default  under  this  obligation,  Bruce A. Shear
      retains  full  voting  power with  respect to these  shares.  Excludes  an
      aggregate  of  59,280  shares of Class B Common  Stock  owned by the Shear
      Family  Trust and the NMI Trust,  of which  Bruce A. Shear is a  remainder
      beneficiary.

(2)   Includes  12,526 shares of Class C Common Stock pledged to Steven J. Shear
      of 2 Addison Avenue, Lynn,  Massachusetts 01902, Bruce A. Shear's brother,
      to secure the purchase  price  obligation  of Bruce A. Shear in connection
      with his purchase of his brother's  stock in the Company in December 1988.
      In the  absence  of any  default  under  this  obligation,  Bruce A. Shear
      retains  full  voting  power with  respect to these  shares.  Excludes  an
      aggregate  of  13,173  shares of Class C Common  Stock  owned by the Shear
      Family Trust and the NMI Trust (the "Trusts"),  of which Bruce A. Shear is
      a remainder beneficiary.

(3)   Includes 11,375 shares issuable  pursuant to currently  exercisable  stock
      options.  Of those  options,  10,000 have an  exercise  price of $5.00 per
      share, and 1,375 have an exercise price of $6.63.

(4)   Includes an  aggregate  of 46,875  shares  issuable  pursuant to currently
      exercisable stock options. Of those options, 20,000 have an exercise price
      of $5.00 per  share,  3,000  have an  exercise  price of $6.37 per  share,
      20,000 have an exercise  price of $5.13 per share,  2,500 have an exercise
      price of $5.25 per share,  and 1,375 have an  exercise  price of $6.63 per
      share.

 (5)  Messrs.  Todd  and  Grieco  are  the  two  trustees  of the  Trusts  which
      collectively hold 72,453 shares of the Company's outstanding Common Stock.
      Gertrude Shear,  Bruce A. Shear's mother,  is the lifetime  beneficiary of
      the Trusts.  In addition to the shares held by the Trusts,  Gertrude Shear
      currently  owns 2.86% of the Company's  outstanding  Class A Common Stock,
      less than 1% of the Company's  outstanding Class B Common Stock and 4.97%
      of the Company's outstanding Class C Common Stock.

(6)   Represents  percentage  of  equity of class,  based on  numbers  of shares
      listed  under  the  column   headed   "Amount  and  Nature  of  Beneficial
      Ownership." Each share of Class A Common Stock is entitled to one vote per
      share and each share of Class B Common Stock is entitled to five votes per
      share on all  matters  on which  stockholders  may vote  (except  that the
      holders of the Class A Common  Stock are  entitled to elect two members of
      the  Company's  board of  directors  and the holders of the Class B Common
      Stock are  entitled to elect all the  remaining  members of the  Company's
      board of directors).  The Class C Common Stock is non-voting.

      Based on the numbers of shares listed under the column headed  "Amount and
      Nature of Beneficial  Ownership," the following persons or groups hold the
      following  percentages  of voting  rights for all  shares of common  stock
      combined:

                   Bruce A. Shear          53.6%
                   J. Owen Todd            4.7%
                   William F. Grieco        0%
                   All   Directors  and
                   Officers  as a Group    54.7%
                   (6 persons)

(7)   Each share of Class B Common Stock is convertible  into one share of Class
      A Common Stock  automatically  upon any sale or transfer thereof or at any
      time at the option of the holder.


ITEM 12.    CERTAIN RELATIONSHIPS AND RELATED PARTY TRANSACTIONS.

RELATED PARTY INDEBTEDNESS

      For approximately  the last ten years,  Bruce A. Shear, a director and the
President,  Chief  Executive  Officer and Treasurer of the Company,  and persons
affiliated and associated  with him have made a series of unsecured loans to the
Company  and  its  subsidiaries  to  enable  them  to  meet  ongoing   financial
commitments. The borrowings generally were entered into when the Company did not
have  financing  available  from  outside  sources  and,  in the  opinion of the
Company,  were entered into at market rates given the financial condition of the
Company and the risks of repayment  at the time the loans were made.  As of June
30, 1996, the Company owed an aggregate of $103,996 to related  parties.  During
the year ended June 30,  1996,  the  Company  paid an  aggregate  of $181,612 to
related parties.

      During  the  period  ended  June 30,  1996,  the  Company  paid Mr.  Shear
approximately $181,612 in principal and accrued interest under various notes. In
connection  with the IPO, Mr.  Shear  contributed  to the Company  approximately
$85,000  of  accrued  and  unpaid  interest  payable  under  various  notes  and
approximately  $15,000 of  accrued  and  unpaid  guarantee  fees owed to him for
20,000 shares of the Company's Class B Common Stock.  The Company paid Mr. Shear
$50,000 out of the proceeds of the IPO in reduction of the  principal  amount of
the notes for the payment of certain tax  obligations  arising from the issuance
of the stock. Upon the consummation of those transactions,  Mr. Shear accepted a
new  promissory  note of the  Company in  exchange  for the notes  plus  accrued
interest for  $110,596.  As of August 31, 1996,  the Company owed Bruce A. Shear
$110,596 on that  promissory  note,  which is dated March 31,  1994,  matures on
December  31,  1998  and  bears  interest  at the rate of 8% per  year,  payable
quarterly in arrears,  and requires  repayments of principal  quarterly in equal
installments  commencing July 1, 1996,  until  maturity.  The current balance of
this note as of June 30, 1996 is $78,996.

      On June 30, 1988,  in connection  with the  acquisition  of Franvale,  the
Company  issued  promissory  notes in the amount of  $1,350,000  and $225,000 to
Continental  Medical  Systems,  Inc.,  the seller of Franvale.  These loans bore
interest  at the rate of 10% per annum and were  payable  on  December  1, 1996.
Additionally,  on June 30,  1992,  the  Company  issued a note in the  amount of
$240,084 to  Continental  Medical  Systems,  payable on  December  1, 1996,  and
bearing  interest at the rate of 10% per annum.  As of  September  8, 1994,  the
aggregate  principal  amount  outstanding  under  these  loans  was paid in full
through the HUD refinancing of the Franvale facility.

      Bruce  A.  Shear  guaranteed  each of the  loans  in  connection  with the
acquisition  of  Franvale  for a  guarantee  fee  payable by the  Company  equal
annually to 1.5% of the outstanding principal amount guaranteed.  In addition, a
3% fee is  payable  by the  Company  on the  accrued  and  unpaid  amount of the
guarantee  fees.  Bruce A. Shear  received no guarantee  fees  pursuant to these
arrangements in the fiscal year ended June 30, 1996 in cash.

      Certain  other  relatives  of Bruce A.  Shear have made loans from time to
time to the Company.  As of June 30, 1994,  the principal  amount of $27,700 was
outstanding on a note payable to Gertrude Shear, Bruce A. Shear's mother,  which
paid  interest  from April 15,  1993 until  April 15, 1994 at the rate of 8% per
annum,  and  thereafter  paid  interest  at the prime  rate  plus 2% per  annum,
adjusted quarterly.  An aggregate principal amount of $13,850 was paid September
10, 1994 and the balance was paid in full on March 10, 1996.

      In addition the Company  owed Tot Care,  Inc.  and Humpty  Dumpty  School,
Inc., two corporations owned by Bruce A. Shear, an aggregate principal amount of
$55,000 as of June 30, 1994.  These loans earned interest at the rate of 15% per
year.  An aggregate  principal  amount of $27,500 was paid on September 10, 1994
and the balance was paid in full on March 10, 1996.

     The Company has also borrowed from certain of its officers and  consultants
other than Bruce Shear and his  relatives.  As of August 31, 1996, the aggregate
principal  amount  owed by the  Company to such  persons was $25,000 as follows:
$5,000 to Mark S. Cowell,  the Company's Vice President of  Communications,  and
his wife, Karen K. Cowell, $10,000 to Himanshu S. Patel, the Medical Director at
Changes,  and Anjana H.  Patel,  and  $10,000 to Mukesh P.  Patel,  the  Medical
Director at Mt. Regis, and Falguni M. Patel. All of these borrowings are payable
on demand.

         The Company has leased  furniture and equipment  from time to time from
Trans  National  Leasing  Corp.,  a  corporation  owned by Leon Shear,  Bruce A.
Shear's uncle.  The Company  currently has sixteen  equipment  leases with Trans
National,   which  in  the  aggregate  provide  for  annual  lease  payments  of
approximately  $70,200.  At the term of each lease,  the lessee has the right to
purchase the subject  equipment for 10% of the total  equipment  purchase price.
The Company intends to honor its existing lease obligations with Trans National,
and in the future to obtain  equipment and furniture  either through purchase or
lease from such companies,  including  Trans  National,  as can provide the best
terms  available  to the Company as  determined  by its  management.  During the
period ended June 30, 1996 the Company paid an aggregate of $114,736 under these
leases.

      The  Company  had  proposed to develop a  short-term  intensive  inpatient
treatment center in Lynn, Massachusetts. The site on which such treatment center
was to be  located is the former  Mt.  Pleasant  Hospital  which is owned by the
Shear Family  Trust and the NMI Trust (the "Shear  Trusts"),  two family  trusts
established by the Shear family. The Company has recently made a decision not to
pursue this project. As a result, the Company has received from the Shear Trusts
a refund of an option deposit payment of $50,000 previously made by the Company,
plus accrued interest  thereon,  and will obtain  reimbursement of approximately
$107,000 in  development  expenses over time.  As of June 30, 1996,  the Company
received $6,000 in payment on this account and is currently receiving payment of
$500 each month.

      On December 17, 1993,  the Company  issued 11,250 and 19,750 shares of the
Company's Class A Common Stock to certain directors and officers,  respectively,
of the Company at a price of $4.00 per share,  pursuant to the  Company's  Stock
Plan.  Each  purchaser  paid to the Company 25% of the purchase price for his or
her shares in cash,  and the balance  with a  non-recourse  note.  The notes are
payable  quarterly  over the three  years  commencing  June 30,  1994,  and bear
interest  at the rate of 6% per year.  The shares  purchased  with  non-recourse
notes have been pledged to the Company to secure the payment obligation.  As the
principal  due under each of the notes is  reduced,  the  appropriate  number of
shares are released from the pledge.

      William F.  Grieco,  as one of the two  trustees of the Shear Family Trust
and the NMI Trust,  of which Gertrude  Shear,  Bruce A. Shear's  mother,  is the
lifetime  beneficiary,  controls 7.0% of the outstanding Class B Common Stock of
the Company,  and 6.6% of the  outstanding  Class C Common Stock of the Company.
Mr. Grieco was a partner of Choate, Hall & Stewart, which provides general legal
representation  to the Company.  During the fiscal year ended June 30, 1996, the
Company incurred legal fees and expenses for services provided by Choate, Hall &
Stewart in an aggregate amount equal to $306,484.92.

      The Company adopted a policy that all transactions between the Company and
its officers, directors and affiliates will be on terms no less favorable to the
Company than could be obtained from unrelated third parties and will be approved
by a majority of the disinterested members of the Company's Board of Directors.

                           PHC, INC. AND SUBSIDIARIES



                                  - I N D E X -


                                                              PAGE
                                                             NUMBER

REPORT OF INDEPENDENT AUDITORS                                 F-2


CONSOLIDATED BALANCE SHEETS                                    F-3


CONSOLIDATED STATEMENTS OF OPERATIONS                          F-4


CONSOLIDATED STATEMENT OF CHANGES
IN STOCKHOLDERS' EQUITY                                        F-5


CONSOLIDATED STATEMENTS OF CASH FLOWS                          F-6


NOTES TO FINANCIAL STATEMENTS                                  F-7

                                       F-1

<PAGE>



                        REPORT OF INDEPENDENT AUDITORS



Board of Directors and Stockholders
PHC, Inc.
Peabody, Massachusetts


      We have audited the accompanying  consolidated balance sheets of PHC, Inc.
and  subsidiaries  as at June  30,  1996  and June  30,  1995,  and the  related
consolidated statements of operations, changes in stockholders' equity, and cash
flows for each of the 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 consolidated  financial  statements  enumerated above
present fairly, in all material respects, the consolidated financial position of
PHC, Inc. and  subsidiaries  at June 30, 1996 and June 30, 1995, and the results
of their  operations  and their  cash  flows for each of the years then ended in
conformity with generally accepted accounting principles.





Cambridge, Massachusetts
September 6, 1996

                                     F-2

<PAGE>


                                PHC, INC. AND SUBSIDIARIES

                                CONSOLIDATED BALANCE SHEETS



<TABLE>
<CAPTION>
     
                                                                                JUNE 30,     
                                                                              -------------
                                                                              
                             A S S E T S                                 1996         1995
                             -----------                                ------       -----

<S>                                                                  <C>          <C>    
   Cash and cash equivalents. . . . . . . . . . . . . . . . . . . . . $   293,515  $. .586,738
   Accounts receivable, net of allowance for bad debts of $1,492,983
     at June 30, 1996 and $815,459 at June 30, 1995 (Notes A and M). .  8,866,065    5,964,279
   Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . .     259,893      174,539
   Other receivables and advances . . . . . . . . . . . . . . . . . . .    66,513       81,889
   Deferred income taxes (Note F) . . . . . . . . . . . . . . . . . .     515,300      251,863
         
        Total current assets. . . . . . . . . . . . . . . . . . . . .  10,001,286    7,059,308

Accounts receivable, noncurrent (Note A) . . . . . . . . . . . . .        740,000      656,734
Loans receivable. . . . . . . . . . . . . . . . . . . . . . . . . . .     113,805       96,343
Property and equipment, net (Notes A and B) . . . . . . . . . . . .     7,884,063    7,086,637
Deferred income taxes (Note F). . . . . . . . . . . . . . . . . . . .     154,700 
Deferred financing costs, net of amortization . . . . . . . . . . . .     702,948 
Goodwill, net of accumulated amortization (Note A). . . . . . . . . .     709,573 
Other assets (Note A) . . . . . . . . . . . . . . . . . . . . . . . .     454,160     352,795
Net assets of operations held for sale (Note J) . . . . . . . . . .        56,682     163,568


          T O T A L . . . . . . . . . . . . . . . . . . . . . . . . . $20,817,217  $15,415,385
                                                                      

                LIABILITIES AND STOCKHOLDERS' EQUITY
                ------------------------------------

Current liabilities:
   Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,127,052  $ 2,282,765
   Notes payable - related parties (Note E) . . . . . . . . . . . . .      56,600       46,598
   Notes payable - bank . . . . . . . . . . . . . . . . . . . . . . .                  100,000
   Current maturities of long-term debt (Note C). . . . . . . . . . .     403,894       61,438
   Current portion of obligations under capital leases (Note D) . . .      88,052       59,212
   Accrued payroll, payroll taxes and benefits. . . . . . . . . . . .     715,515      535,525
   Accrued expenses and other liabilities . . . . . . . . . . . . . .     738,784      567,846
   Deferred revenue . . . . . . . . . . . . . . . . . . . . . . . . .                   55,453

          Total current liabilities . . . . . . . . . . . . . . . . . . 5,129,897    3,708,837

Long-term debt and accounts payable (Note C). . . . . . . . . . . . .   7,754,262   5,682,036
Obligations under capital lease (Note D). . . . . . . . . . . . . . .   1,468,475   1,474,976
Notes payable - related parties (Note E). . . . . . . . . . . . . . . .    47,394     88,996

          Total noncurrent liabilities. . . . . . . . . . . . . . . .   9,270,131    7,246,008

          Total liabilities . . . . . . . . . . . . . . . . . . . . .  14,400,028   10,954,845

Commitments and contingent liabilities (Notes G, H, K, M, N and O)

Stockholders' equity (Notes H and K):
   Preferred stock, $.01 par value; 1,000,000 shares authorized, 
       none issued. . . . . . . .
   Class A common stock, $.01 par value; 10,000,000 shares authorized, 
       2,293,568 and 1,504,662 shares issued in 1996 and 1995 . . . .      22,936       15,047
   Class B common stock, $.01 par value; 2,000,000 shares authorized, 
       812,237 and 898,795 shares issued  in 1996 and  1995, 
       convertible into one  share of Class A common stock  .               8,122        8,988 
   Class C common  stock,  $.01 par value;  200,000  shares
       authorized and 199,816 and 199,966 shares issued in 1996 and 1995   1,998         2,000
   Additional paid-in capital . . . . . . . . . . . . . . . . . . . .   8,078,383    5,554,874
   Notes receivable related to purchase of 31,000 shares of Class A
       common stock                                                       (63,928)     (75,362)
   Accumulated deficit. . . . . . . . . . . . . . . . . . . . . . .    (1,630,322)  (1,045,007)

          Total stockholders' equity. . . . . . . . . . . . . . . .     6,417,189    4,460,540


          T O T A L . . . . . . . . . . . . . . . . . . . . . . . . . $20,817,217  $15,415,385
===================================================================== =========== ============
</TABLE>






                    The accompanying notes are an integral part hereof.

                                            F-3

<PAGE>



                                PHC, INC. AND SUBSIDIARIES

                           CONSOLIDATED STATEMENTS OF OPERATIONS



                                                       YEAR ENDED JUNE 30,
                                                     1996               1995
Revenues:
   Patient care, net (Note A) . . . . . . . .      $21,569,594       $16,408,461
   Other. . . . . . . . . . . . . . . . . . .          233,164           128,157
                                                      --------       -----------

          Total revenue . . . . . . . . . . .       21,802,758        16,536,618
                                                  ------------        ----------

Operating expenses:
   Patient care expenses. . . . . . . . . . .       12,004,383         9,248,317
   Cost of management contracts . . . . . . .          146,407           149,317
   Administrative expenses. . . . . . . . . .        9,694,802         6,223,815
                                                 ------------       -----------

          Total operating expenses. . . . . .      21,845,592         15,621,449
                                                  ------------       -----------

Income (loss) from operations . . . . . . . .         (42,834)           915,169
                                                  ------------       -----------

Other income (expense):
   Interest income. . . . . . . . . . . . . .          14,486             28,870
   Other income . . . . . . . . . . . . . . .         211,292             80,317
   Start-up costs (Note A). . . . . . . . . .        (128,313)
   Interest expense . . . . . . . . . . . . .        (863,484)         (577,544)
   Gain on disposal of center (Note G[2]) . .                             72,756
   Gain (loss) from operations held for sale
     (Note J) . . . . . . . . . . . . . . . .         11,947             (9,789)
                                                  -----------       ------------

          Total other income (expense). . . .       (754,072)          (405,390)
                                                  -----------       ------------

Income (loss) before income taxes . . . . . .        (796,906)           509,779

Income taxes (benefit) (Note F) . . . . . . .        (211,591)           241,108
                                                    ----------       -----------


NET INCOME (LOSS) . . . . . . . . . . . . . .     $  (585,315)        $  268,671
                                                  ===========        ===========


Net income (loss) per share (Note A). . . . .       $(.22)               $.11
                                                    ======               ====


Weighted average number of shares outstanding      2,709,504           2,403,457
                                                  ==========          ========= 
             
                                                  











                    The accompanying notes are an integral part hereof.

                                            F-4

<PAGE>



                                PHC, INC. AND SUBSIDIARIES

                 CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY


<TABLE>
<CAPTION>

                                     Class A             Class B            Class C      Additional   Notes
                                   COMMON STOCK        COMMON STOCK      COMMON STOCK     Paid-in   Receivable Accumulated
                                 SHARES    AMOUNT    SHARES   AMOUNT    SHARES  AMOUNT    CAPITAL   FOR STOCK    DEFICIT      TOTAL
<S>                           <C>          <C>      <C>       <C>      <C>      <C>     <C>        <C>        <C>           <C>

Balance - June 30, 1994 . .     1,483,500   $14,835  920,000    $9,200  200,000 $2,000 $5,554,902  $(93,000) $(1,313,678) $4,174,259

Payment of notes receivable .                                                                        17,638                   17,638

Conversion of shares. . . . .      21,162       212 (21,205)     (212)     (34)              (28)                             (28)

Net income, year ended 
June 30, 1995.                                                                            268,671     268,671
                                     ----  -------- --------   ------- --------  ------- ----------  --------- ------------ --------

Balance - June 30, 1995 . . .   1,504,662    15,047  898,795     8,988  199,966  2,000  5,554,874   (75,362)  (1,045,007)  4,460,540

Payment of notes receivable .                                                                         11,434                  11,434

Conversion of shares. . . . .      86,554       866 (86,558)     (866)    (150)    (2)          2                              - 0 -

Exercise of options . . . . .      22,500       225                                       113,575                            113,800

Issuance of stock for obligations 
  in lieu of cash . . . . . . .     6,600        66                                        36,184                             36,250

Exercise of bridge loan warrants   33,509       335                                       153,617                            153,952

Sale of stock in connection with
   private placement. . . . . .   493,750     4,937                                     1,970,063                          1,975,000

Costs related to private placement                                                      (442,395)                          (442,395)

Exercise of IPO warrants. . . .    21,493       215                                       137,785                            138,000

Issuance of shares with 
       acquisition                 87,000       870                                       392,678                            393,548

Exercise of private placement
   warrants . . . . . . . . .      37,500       375                                       149,625                            150,000

Amount paid for options, not 
  yet issued . . . . . . . .                                                                9,375                              9,375

Compensatory stock options. . .                                                             3,000                              3,000

Net loss, year ended June 
  30, 1996.                                                                            (585,315)   (585,315)
                                     ----  -------- --------   ------- --------  ------- ----------- --------- ------------ --------


BALANCE - JUNE 30, 1996 . .     2,293,568   $22,936  812,237    $8,122  199,816  $1,998  $8,078,383 $(63,928)$(1,630,322) $6,417,189
                               ==========  ======== ========   ======= ========  ======= =========== ========= ============ ========


</TABLE>





                    The accompanying notes are an integral part hereof.

                                            F-5

<PAGE>



                                PHC, INC. AND SUBSIDIARIES

                           CONSOLIDATED STATEMENTS OF CASH FLOWS


<TABLE>
<CAPTION>

                                                                    YEAR ENDED JUNE 30,
                                                                   1996             1995
<S>                                                             <C>              <C>    

Cash flows from operating activities:
   Net income (loss) . . . . . . . . . . . . . . . . . . .       $   (585,315)      $   268,671
   Adjustments to reconcile net income (loss) to net
     cash used in operating activities:
       Deferred tax provision (benefit). . . . . . . . . .           (418,137)          173,137
       Depreciation and amortization . . . . . . . . . . .            554,025           238,547
       (Increase) in accounts receivable . . . . . . . . .         (2,985,052)       (1,786,691)
       Compensatory stock options and stock issued for
         obligations . . . . . . . . . . . . . . . . . . .             39,250
       (Increase) in prepaid expenses and other current
         assets. . . . . . . . . . . . . . . . . . . . . .            (69,978)         (150,933)
       (Increase) decrease in other assets . . . . . . . .           (107,711)          162,570
       Decrease in net assets of operations held for sale.            106,886            32,303
       Increase in accounts payable. . . . . . . . . . . .          1,414,089           314,196
       Increase in accrued expenses and other liabilities.            295,475           258,175
                                                                 ------------       -----------

          Net cash used in operating activities. . . . . .         (1,756,468)         (490,025)
                                                                 ------------      ------------

Cash flows from investing activities:
   Acquisition of property and equipment and intangibles .        (1,557,419)      (3,557,378)
   Loan receivable . . . . . . . . . . . . . . . . . . . .           (17,462)         (91,343)
                                                                 ------------     ------------

          Net cash used in investing activities. . . . . .        (1,574,881)      (3,648,721)
                                                                 ------------     ------------

Cash flows from financing activities:
   Proceeds from exercise of options and warrants  . . . .            576,561          17,610
   Net proceeds from private placement . . . . . . . . . .          1,532,605
   Proceeds from borrowings. . . . . . . . . . . . . . . .          2,043,748       5,149,643
   Payments on debt. . . . . . . . . . . . . . . . . . . .           (402,828)     (2,651,546)
   Deferred Financing Costs . . . . . . . . . . . . . .  .           (711,960)
                                                                 ------------     ------------

          Net cash provided by financing activities. . . .         3,038,126        2,515,707
                                                                 ------------     -----------


NET DECREASE IN CASH AND CASH EQUIVALENTS. . . . . . . . .          (293,223)      (1,623,039)

Beginning balance of cash and cash equivalents . . . . . .           586,738        2,209,777
                                                                 ------------     -----------


ENDING BALANCE OF CASH AND CASH EQUIVALENTS. . . . . . . .       $   293,515      $   586,738
                                                                 ============     ===========


Supplemental cash flow information:
   Cash paid during the year for interest. . . . . . . . .       $   779,898      $   575,000
   Cash paid during the year for income taxes. . . . . . .           187,120           40,200

Supplemental disclosures of noncash investing and financing 
activities:
     Stock issued for acquisition of property and equipment 
       and intangibles. .. .. .. .. .. .. .. .. .. .. .. .            393,548           84,242
     Long-term debt assumed upon acquisition . . . . . . .                              84,242
============================================================= ===============  ===============
     Note payable due for litigation settlement. . . . . .            225,000
============================================================= ===============  ===============
     Capital leases. . . . . . . . . . . . . . . . . . . .             94,699
============================================================= ===============  ===============
</TABLE>










                    The accompanying notes are an integral part hereof.

                                            F-6

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE A) - THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

      [1]   BASIS OF PRESENTATION AND CONSOLIDATION:

            PHC, Inc.  ("PHC")  operates  substance abuse  treatment  centers in
several  locations  in the United  States,  a nursing home in  Massachusetts,  a
psychiatric hospital in Michigan and psychiatric outpatient facilities in Nevada
and  Kansas.  The  consolidated   financial   statements  include  PHC  and  its
subsidiaries, all of which are 100% owned (collectively the "Company"):

     PHC of Utah, Inc. ("PHU"),  PHC of Virginia,  Inc. ("PHV") and PHC of Rhode
Island,  Inc.  ("PHR")  provide  treatment of addictive  disorders  and chemical
dependency.  PHC of Michigan,  Inc. ("PHM") provides inpatient psychiatric care.
PHC of Nevada,  Inc. ("PHN") and PHC of Kansas, Inc. ("PHK") provide psychiatric
treatment on an outpatient basis.  Quality Care Centers of  Massachusetts,  Inc.
("Quality  Care")  operates a  long-term  care  facility  known as the  Franvale
Nursing and Rehabilitation  Center.  STL, Inc. ("STL") operated day care centers
(see  Note  J  -  Operations  Held  For  Sale).  All  significant   intercompany
transactions and balances have been eliminated in consolidation.

            For the year ended June 30, 1996, the Company incurred costs related
to an addition at Quality Care prior to  obtaining a license to admit  patients.
These  costs,  amounting  to  $128,313,  are  included  in other  expense in the
accompanying statement of operations under the caption "Start-up Costs".

      [2]   REVENUES AND ACCOUNTS RECEIVABLE:

            Patient care revenues are recorded at  established  billing rates or
at the amount  realizable under agreements with  third-party  payors,  including
Medicaid and Medicare.  Revenues under  third-party payor agreements are subject
to examination and adjustment, and amounts realizable may change due to periodic
changes in the  regulatory  environment.  Provisions  for estimated  third party
payor  settlements are provided in the period the related services are rendered.
Differences between the amounts accrued and subsequent  settlements are recorded
in operations in the year of settlement.

            A  substantial  portion of the  Company's  revenues at the  Franvale
Nursing and  Rehabilitation  Center is derived from patients  under the Medicaid
and Medicare  programs.  There have been and the Company expects that there will
continue  to  be,  a  number  of  proposals  to  limit   Medicare  and  Medicaid
reimbursement,  as well as reimbursement  from certain private payor sources for
both Franvale and substance abuse treatment center services.  The Company cannot
predict at this time  whether  any of these  proposals  will be  adopted  or, if
adopted and implemented, what effect such proposals would have on the Company.


(continued)


                                        F-7

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE A) - THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
           (continued)

      [2]   REVENUES AND ACCOUNTS RECEIVABLE:  (continued)

            Medicaid  reimbursements  are currently  based on established  rates
depending  on the level of care  provided and are  adjusted  proactively  at the
beginning of each calendar year. Medicare  reimbursements are currently based on
provisional rates that are adjusted retroactively based on annual, calendar cost
reports  filed by the Company  with  Medicare.  The  Company's  cost  reports to
Medicare are  routinely  audited on an annual  basis.  The Company  periodically
reviews its  provisional  billing  rates and  provides  for  estimated  Medicare
adjustments.  The Company believes that adequate  provision has been made in the
financial  statements for any adjustments  that might result from the outcome of
Medicare audits.

            The Company has substantial  receivables from Medicaid and Medicare,
relating to its long-term  care facility  aggregating  approximately  $2,350,000
(including  $415,000  related to  Medicare  adjustments)  at June 30, 1996 which
constitutes a  concentration  of credit risk should these  agencies  defer or be
unable to make reimbursement payments as due.

      [3]  PROPERTY AND EQUIPMENT:

            Property and equipment are stated at cost.  Depreciation is provided
over  the  estimated   useful  lives  of  the  assets  using   accelerated   and
straight-line methods. The estimated useful lives are as follows:

                                               Estimated
                    ASSETS                    USEFUL LIFE

            Buildings. . . . . . . . . .  20 through 39 years
            Furniture and equipment. . .  3 through 10 years
            Motor vehicles . . . . . . .  5 years
            Leasehold improvements . . .  term of lease

      [4]  OTHER ASSETS:

            Other  assets  represent  deposits,   deferred  expenses  and  costs
incurred in the organization of the Companies.  Organization costs are amortized
over a five-year period using the straight-line method.

(continued)


                                        F-8

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE A) - THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
           (continued)

      [5]  GOODWILL, NET OF ACCUMULATED AMORTIZATION:
     

            The excess of the  purchase  price over the fair market value of net
assets  acquired  are  being  amortized  on a  straight-line  basis  over  their
estimated useful lives.

      [6]  EARNINGS PER SHARE:
     

            Net income or loss per share is based on the weighted average number
of shares of common  stock  outstanding  during  each period  excluding  Class C
common shares held in escrow.  Common stock equivalents have been excluded since
they are antidilutive.

      [7]   USE OF ESTIMATES:
  

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

      [8]  CASH AND CASH EQUIVALENTS:

            Cash and cash equivalents are short-term  highly liquid  investments
with original maturities of less than three months.


(NOTE B) - PROPERTY AND EQUIPMENT:

      Property and equipment is comprised as follows:

                                                   JUNE 30,
                                              1996         1995

            Land. . . . . . . . . . . . .  $  251,759   $  239,259
            Buildings . . . . . . . . . .   7,338,838    3,834,799
            Furniture and equipment . . .   1,404,716    1,027,413
            Motor vehicles. . . . . . . .      50,889       42,459
            Leasehold improvements. . . .     301,067      216,633
            Construction (Note D) . . . .     - 0 -      2,753,679
                                           -----------  ----------

                                            9,347,269    8,114,242
            Less accumulated depreciation   1,463,206    1,027,605

                      T o t a l . . . . .  $7,884,063   $7,086,637
                                           ===========  ==========


(continued)


                                        F-9

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE C) - LONG-TERM DEBT:

      At June 30,  1996,  the Company  substantially  completed  an addition and
renovation  to the Quality  Care  facility in which 37 new beds were added.  The
Company  financed  this  addition  and  renovation  through  the  United  States
Department of Housing and Urban Development  ("HUD").  At the final endorsement,
which took place subsequent to year-end in July 1996, an additional  $479,308 of
costs  were  advanced  bringing  the  final  balance  of  the  note  payable  to
$6,781,294.   At  June  30,  1996  deferred   financing  costs  related  to  the
construction  note payable  totalled  $711,960 and are being  amortized over the
life  of  the  note.   Interest  costs   capitalized  in  conjunction  with  the
construction  approximated  $65,250  and  $89,000 at June 30,  1996 and June 30,
1995.

      Long-term debt is summarized as follows:

                                    JUNE 30,
                                                           1996        1995

            Notes payable to various  entities with
               interest  ranging from 8% to 9% 
               requiring monthly payments  aggregating
               approximately  $4,000 and maturing
               through May 2001. . . . . . . . . . . .  $   58,154  $   73,772
            Note payable due in monthly installments
               of $2,000 including imputed interest at
               8% through April 1, 1999, when the
               principal is due . .. .. . . . . . . . .     60,163      78,145
            9% mortgage note due in monthly
               installments of $4,850 through July 1,
               2012, when the remaining principal
               balance is payable. . . . . . . . . . .     505,485     518,224
            Mortgage note payable . . . . . . . . . . .                 23,690
            Note payable due in monthly installments
               of $21,506 including interest at 10.5%
               through November 1, 1999,
               collateralized by all assets of PHN
               and certain receivables . . . . . . . .     735,213
            Construction obligations:
               Construction note payable
                 collateralized by real estate and
                 insured by HUD due in monthly
                 installments of $53,635, including
                 interest at 9.25%, through December
                 2035. . . . . . . . . . . . . . . . .   6,301,986   5,049,643
               Other construction obligations to be
                 added to note payable . . . . . . . .     344,802
            Note payable to a former vendor, payable
               in monthly installments of $19,728
               including interest at 9.5% through
               February 1997 (see Note N). . . . . . .     152,353
                                                        ----------

                      T o t a l. . . . . . . . . . . .   8,158,156   5,743,474

            Less current maturities. . . . . . . . . .     403,894      61,438
                                                        ----------- ----------

                      T o t a l. . . . . . . . . . . .  $7,754,262  $5,682,036
                                                        =========== ==========

(continued)


                                        F-10

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE C) - LONG-TERM DEBT:  (continued)

      Maturities of long-term debt are as follows as at June 30, 1996:

            Year Ending
             JUNE 30,                            AMOUNT

               1997 . . . . . . . . . . . . .  $  403,894
               1998 . . . . . . . . . . . . .     273,424
               1999 . . . . . . . . . . . . .     302,539
               2000 . . . . . . . . . . . . .     157,923
               2001 . . . . . . . . . . . . .      56,977
               Thereafter . . . . . . . . . .   6,618,597
                                               ----------

                         T o t a l. . . . . .  $7,813,354

      In May 1996,  PHU entered into a loan and security  agreement to borrow up
to $1,000,000 under a revolving line of credit. This agreement will be in effect
for a  period  of two  years  with an  option  to  renew  for  one-year  periods
thereafter.  Principal is due upon the  expiration  of the term of the revolver.
Interest  is payable  monthly  at the prime rate plus  2.25%.  The  revolver  is
collateralized  by  substantially  all the assets of PHU. At June 30, 1996 there
were no borrowings under this agreement.


(NOTE D) - CAPITAL LEASE OBLIGATIONS:

      At June 30, 1996,  the Company is obligated  under various  capital leases
for  equipment  and real estate  (see Note L)  providing  for  monthly  payments
aggregating  approximately  $19,000  for  fiscal  1997 and terms  expiring  from
December 1996 through February 2014.

      The carrying value of assets under capital leases is as follows:

                                                   JUNE 30,
                                              1996         1995

            Building. . . . . . . . . . . .  $1,477,800   $1,477,800

            Equipment and improvements. . .     214,754      137,207

            Less accumulated depreciation .    (222,100)    (137,057)

                                             $1,470,454   $1,477,950


(continued)


                                        F-11

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE D) - CAPITAL LEASE OBLIGATIONS:  (continued)

      Future  minimum  lease  payments  under  the  terms of the  capital  lease
agreements are as follows at June 30, 1996:

      Year Ending                            Real
       JUNE 30,               EQUIPMENT    PROPERTY        TOTAL

         1997. . . . . . . .  $ 68,895   $   231,000   $   299,895
         1998. . . . . . . .    56,728       231,000       287,728
         1999. . . . . . . .    33,262       239,000       272,262
         2000. . . . . . . .    15,075       259,248       274,323
         2001. . . . . . . .     3,098       272,208       275,306
         Thereafter. . . . .    - 0 -      4,886,036     4,886,036
                              ---------  ------------  -----------

         Total future
            minimum lease
            payments . . . .   177,058     6,118,492     6,295,550
         Less amount
            representing
            interest . . . .   (29,711)   (4,709,312)   (4,739,023)
                              ---------  ------------  ------------

         Present value of
            future minimum
            lease payments .   147,347     1,409,180     1,556,527
         Less current
            portion. . . . .    53,936        34,116        88,052
                              ---------  ------------  -----------

         Long-term
            obligations
            under capital
            lease. . . . . .  $ 93,411   $ 1,375,064   $ 1,468,475
                              =========  ============  ===========







(continued)


                                        F-12

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE E) - NOTES PAYABLE - RELATED PARTIES:

      Related party debt is summarized as follows:

                                                      JUNE 30,
                                                  1996       1995

            Note payable, president and
               principal stockholder,
               interest at 8%, due in
               installments through
               1998 . . . . . . . . . . . .    $ 78,996   $110,596
            Notes payable, other related
              parties interest at 12% and
              payable on demand. . . . . . . .   24,998     24,998
                                                ---------  --------

                     T o t a l . . . . . . . .   103,994    135,594

           Less current maturities . . . . . .    56,600     46,598
                                                ---------  --------

                    T o t a l . . . . . . . .  $ 47,394   $ 88,996
                                               =========  ========

      Accrued  interest  related to these notes totals $3,652 and $21,950 at
       June 30, 1996 and June 30, 1995, respectively.

      Maturities of related party debt are as follows at June 30, 1996:

            Year Ending
             JUNE 30,                                AMOUNT

               1997. . . . . . . . . . . . . . . .  $ 56,600
               1998. . . . . . . . . . . . . . . .    31,600
               1999. . . . . . . . . . . . . . . .    15,794
                                                    --------

                         T o t a l . . . . . . . .  $103,994

      Related  party  interest on notes  receivable  related to the  purchase of
Class A common stock approximated  $4,295 and $3,000 for the year ended June 30,
1996 and June 30, 1995, respectively.


(NOTE F) - INCOME TAXES:

      For the year ended June 30, 1995 the Company  utilized net operating  loss
carryforwards of approximately $754,000 to reduce taxable income. No significant
state income taxes were paid prior to June 30, 1995.

(continued)


                                        F-13

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE F) - INCOME TAXES:  (continued)

      The  Company  had  the  following  deferred  tax  assets  included  in the
accompanying balance sheets:

                                                        JUNE 30,
                                                   1996       1995

      Temporary differences attributable to:

         Allowance for doubtful accounts . . . .  $510,000   $251,863

         Depreciation. . . . . . . . . . . . . .   154,700

         Other . . . . . . . . . . . . . . . . .     5,300
                                                             
                                                  --------------------

                Total deferred tax asset . . . .   670,000    251,863

         Less current portion. . . . . . . . . .   515,300    251,863
                                                  ---------  --------

                Long-term portion. . . . . . . .  $154,700   $ - 0 -
                                                  =========  =======

      The Company had no deferred tax  liabilities at June 30, 1996 and June 30,
1995.

      Income tax expense for the years ended is as follows:

                                                         JUNE 30,
                                                     1996       1995

            Deferred income taxes (benefit) . . .  $(418,137)  $173,000

            Current income taxes. . . . . . . . .    206,546     68,108
                                                   ----------  --------

                      T o t a l . . . . . . . . .  $(211,591)  $241,108
                                                   ==========  ========



(continued)


                                        F-14

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE F) - INCOME TAXES:  (continued)

      Reconciliations of the statutory U.S. Federal income taxes based on a rate
of 34% to actual income taxes is as follows:

                                                YEAR ENDED JUNE 30,
                                                  1996       1995

Income taxes (benefit) at statutory rate. . .  $(271,000)  $173,000

State income taxes. . . . . . . . . . . . . .     80,850     48,108

Increase due to nondeductible items,
   primarily penalties and travel and
   entertainment expenses . . . . . . . . . .     12,100     20,000

Other . . . . . . . . . . . . . . . . . . . .    (33,541)
                                               ----------

          T o t a l . . . . . . . . . . . . .  $(211,591)  $241,108
                                               ==========  ========


(NOTE G) - COMMITMENTS AND CONTINGENT LIABILITIES:

      [1]   OPERATING LEASES:

            The Company leases office and treatment facilities and furniture and
equipment  under  operating  leases  expiring on various dates through May 2000.
Rent  expense  for the  years  ended  June  30,  1996  and  June  30,  1995  was
approximately  $450,000  and  $386,000,  respectively.   Minimum  future  rental
payments under  noncancelable  operating leases having remaining terms in excess
of one year as of June 30, 1996 are as follows:

            Year Ending
             JUNE 30,                                AMOUNT

               1997 . . . . . . . . . . . . . . .  $  422,791
               1998 . . . . . . . . . . . . . . .     419,490
               1999 . . . . . . . . . . . . . . .     205,380
               2000 . . . . . . . . . . . . . . .      59,235
                                                   ----------

                         Total minimum future
                          rental payments . . .  $1,106,896

(continued)


                                        F-15

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE G) - COMMITMENTS AND CONTINGENT LIABILITIES:  (continued)

      [2]  CENTER CLOSING:

            The  Company  decided to  discontinue  operations  at its  treatment
center in California  because of poor financial  performance  and discharged its
last patient in August 1994.  The results of operations  for the year ended June
30,  1995  reflect  revenues  of  approximately   $90,000  and  a  net  gain  of
approximately $22,000 from this center.


(NOTE H) - STOCK PLANS:

      The Company has three stock plans:  a stock option plan, an employee stock
purchase plan and a nonemployee directors' stock option plan.

      The stock  option plan  provides  for the issuance of a maximum of 300,000
shares of Class A common stock of the Company pursuant to the grant of incentive
stock  options  to  employees  or  nonqualified   stock  options  to  employees,
directors,  consultants and others whose efforts are important to the success of
the Company.  Subject to the provisions of this plan, the compensation committee
has the authority to select the optionees and determine the terms of the options
including:  (i) the number of shares,  (ii)  option  exercise  terms,  (iii) the
exercise or purchase price (which in the case of an incentive  stock option will
not be less than the market  price of the Class A common stock as of the date of
grant),  (iv) type and  duration of transfer or other  restrictions  and (v) the
time and form of payment for restricted stock and upon exercise of options.

      In October 1995, the Company adopted an employee stock purchase plan which
provides  for the  purchase  of Class A common  stock at 85  percent of the fair
market value at specific  dates,  to encourage  stock  ownership by all eligible
employees. At June 30, 1996, 100,000 shares were available for purchase.  During
the year ended 1996, there were no shares purchased under this plan.

      Also in October 1995, the Company adopted a nonemployee  directors'  stock
option  plan  that  provides  for  the  grant  of  nonstatutory   stock  options
automatically  at the time of each  annual  meeting  of the  Board.  During  the
meeting in which this plan was  approved,  options  for 5,500  shares  were
granted  under this plan.  The Company has reserved  30,000  shares for issuance
under this plan.  Each outside  director  shall be granted an option to purchase
2,000  shares  of  Class A  common  stock  at fair  market  value,  vesting  25%
immediately and 25% on each of the first three anniversaries of the grant.


(continued)


                                        F-16

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE H) - STOCK PLAN:  (continued)

      The Company had the following  activity in its stock option plans for 1996
and 1995:

                                        Number of   Option Price
                                         SHARES      PER SHARE
      Option plans:
         Balance - June 30, 1994. . .   60,500    $5.00 - $6.37
         Granted. . . . . . . . . . .   39,000        $5.13
         Cancelled. . . . . . . . . .   (7,500)       $5.00
         Exercised. . . . . . . . . .

         Balance - June 30, 1995. . .   92,000    $5.00 - $6.37
         Granted. . . . . . . . . . .   46,500    $5.25 - $7.00
         Cancelled. . . . . . . . . .   (1,250)       $5.00
         Exercised. . . . . . . . . .  (22,500)   $5.00 - $5.13
                                       --------

         Balance - June 30, 1996. . .  114,750    $5.00 - $7.00
                                       ========

      Options  for  68,625  shares  are  exercisable  as of June 30,  1995 at an
average price of $5.20.

      During fiscal 1994 the Company also issued  restricted stock to certain of
the directors and officers of the Company for the purchase of 31,000 shares at a
purchase  price of $4.00 per share.  The directors and officers were required to
pay 25% of the  purchase  price of their  shares  immediately,  with the balance
being payable  quarterly  over three years together with interest at 6% per year
until paid in full.

(continued)


                                        F-17

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE I) - SEGMENT INFORMATION:

      The  Company's  continuing  operations  are  classified  into two  primary
business segments: substance abuse/psychiatric treatment and long-term care.
                                            YEAR ENDED JUNE 30,
                                             1996          1995
      Revenue:
         Substance abuse/psychiatric
           treatment. . . . . . . . . .  $16,525,672   $12,227,990
         Long-term care . . . . . . . .    5,043,922     4,180,471
         Other. . . . . . . . . . . . .      233,164       128,157
                                         ------------  -----------

                T o t a l . . . . . . .  $21,802,758   $16,536,618
                                         ============  ===========

      Income (loss) from operations:
         Substance abuse/psychiatric
           treatment. . . . . . . . . .  $   818,188   $   649,395
         Long-term care . . . . . . . .     (826,463)      243,335
         Other. . . . . . . . . . . . .      146,407       149,317
         General corporate. . . . . . .     (180,966)     (126,878)
         Other income (expense), net. .     (754,072)     (405,390)
                                         ------------  ------------

      Income (loss) before income
        taxes . . . . . . . . . . . . .  $  (796,906)  $   509,779
                                         ============  ===========

      Depreciation and amortization:
         Substance abuse/psychiatric
            treatment. . . . . . . . . . $   349,437   $   131,109
         Long-term care . . . . . . . .      176,450        78,332
         General corporate. . . . . . .       28,138        29,106
                                         ------------  -----------

                                         $   554,025   $   238,547
                                           ============  ===========

      Capital expenditures:
         Substance abuse/psychiatric
            treatment. . . . . . . . . . $   233,466   $   496,793
         Long-term care . . . . . . . .      982,978     2,953,679
         General corporate. . . . . . .       16,583        36,542
                                         ------------  -----------

                                         $ 1,233,027   $ 3,487,014
                                           ============  ===========

      Identifiable assets:
         Substance abuse/psychiatric
          treatment. . . . . . . . . .   $10,877,197   $ 8,308,656
         Long-term care . . . . . . . .    8,619,133     6,091,763
         General corporate. . . . . . .    1,264,205       851,398
         Net assets of operations held
           for sale . . . . . . . . . .       56,682       163,568
                                         ------------  -----------

                T o t a l . . . . . . .  $20,817,217   $15,415,385
                                         ============  ===========

(continued)


                                        F-18

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE J) - OPERATIONS HELD FOR SALE:

      Over the past several years, the Company has been  systematically  phasing
out its day care center  operations  (STL).  At June 30, 1996 and June 30, 1995,
the  Company  had net  assets  relating  to its day care  centers  amounting  to
approximately $57,000 and $164,000, respectively, which primarily represents the
depreciated  cost of real  estate.  At June 30,  1996 the  Company  had one real
estate parcel remaining which the Company has offered for sale.

      The Company does not anticipate any  significant  future losses due to the
day care center operations or the ultimate sale of the real estate parcels.


(NOTE K) - CERTAIN CAPITAL TRANSACTIONS:

      In addition to the  outstanding  options  under the  Company's  stock plan
(Note I), the Company has the following options and warrants outstanding at June
30, 1996:

                               Number of           Exercise        Expiration
        DESCRIPTION           UNITS/SHARES          PRICE             DATE

Bridge warrants             4,814 units       $4.57 per unit     September 1998

Unit purchase option        146,077 units     $5.99 per unit     March 1999

IPO warrants                1,657,821 shares  $7.50 per share    March 1999

Private placement warrants  703,125 shares    $4.00 per share    January 1999

Bridge warrants             33,696 shares     $7.50 per share    March 1999

Incentive bridge warrants   8,424 shares      $6.00 per share    December 1998

      Each unit  consists of one share of Class A common  stock and a warrant to
purchase one share of Class A common stock at $7.50 per share.

(continued)


                                        F-19

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE K) - CERTAIN CAPITAL TRANSACTIONS:  (continued)

      In  February  1996,  the  Company  issued  in a  private  placement  units
comprised of 6,250 shares of Class A common stock and warrants to purchase 9,375
shares of Class A common stock. A total of 79 units, representing 493,750 shares
of Class A common  stock and 740,625  warrants  were issued in the offering at a
gross purchase price of $1,975,000. Fees and expenses payable in connection with
the  offering  total  $442,395  of fees and  expenses.  Subject to the terms and
conditions of the applicable warrant agreement,  each warrant is exercisable for
one share of Class A common  stock at an  exercise  price of $4.00,  subject  to
adjustment  upon certain  events.  The warrants expire in January 1999. Upon the
issuance of the units  described  above,  certain  additional  shares of Class A
common  stock or  securities  exercisable  therefor  became  issuable  under the
antidilution provisions of certain outstanding securities of the Company.

      Also, in connection with the Company's  initial public  offering,  present
stockholders  have  agreed  to  restrictions  on  approximately  200,000  shares
(designated  Class C common  stock)  whereby some or all of those shares will be
transferred  to the  Company for no  consideration  if certain  future  earnings
targets are not achieved  through June 30, 1997. The earnings  target for fiscal
1996 was net income of $3.0  million or more to have  restrictions  released and
increases to $4.0 million for the year ending June 30, 1997.  When,  and if, the
share restrictions are released,  the Company will incur an expense based on the
fair market value of the shares at the time the restrictions lapse.


(NOTE L) - ACQUISITIONS:

      On September 20, 1994 the Company purchased a 64-bed  healthcare  facility
located in Michigan  ("PHM")  which  provides  psychiatric  and other  specialty
services to patients.  The Company acquired the tangible,  intangible,  and real
property  owned by the seller of the business for  consideration  consisting  of
$759,307 in cash.  The purchase  price was  allocated to the assets  acquired as
follows:

            Land. . . . . . . . . . . . . . . . . .  $ 20,959
            Building. . . . . . . . . . . . . . . .   644,152
            Equipment and other assets. . . . . . .    94,196

                      T o t a l . . . . . . . . . .  $759,307

(continued)


                                        F-20

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE L) - ACQUISITIONS:  (continued)

      On November 1, 1995, the Company purchased an outpatient  facility located
in Nevada ("PHN") which provides psychiatric  services to patients.  The Company
acquired  the  tangible  and  intangible  property  owned by the  seller  of the
business for  consideration  consisting of $631,000 in cash and 75,000 shares of
Class A common stock of PHC,  Inc.  which were valued at $323,000.  The purchase
price was allocated as follows:

            Accounts receivable . . . . . . . . . .  $231,509
            Equipment and other assets. . . . . . .    54,397
            Covenant not to compete . . . . . . . .    10,500
            Goodwill. . . . . . . . . . . . . . . .   671,359
            Accrued benefits payable. . . . . . . .   (13,765)

                                                     $954,000

      On March 29, 1996 PHN entered into a lease  agreement for the real estate.
The  lease  payments,   which  increase  annually,  are  due  in  equal  monthly
installments over a period of four years.

      On March 16, 1996, the Company purchased an outpatient facility located in
Kansas  ("PHK") which  provides  psychiatric  services to patients.  The Company
acquired  the  tangible  and  intangible  property  owned by the  seller  of the
business for  consideration  consisting of 12,000 shares of Class A common stock
of PHC, Inc., valued at $70,548. The purchase price was allocated as follows:

            Equipment and other assets. . . . . . .  $ 20,000
            Covenant not to compete . . . . . . . .    10,000
            Goodwill. . . . . . . . . . . . . . . .    40,548
                                                     --------

                                                     $ 70,548

      In connection with the acquisition, PHK entered into a lease agreement for
the real estate. The lease payments,  which increase annually,  are due in equal
monthly installments over a period of three years.

(continued)


                                        F-21

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS


(NOTE L) - ACQUISITIONS:  (continued)

      Based on unaudited data, the pro forma results of operations as though the
foregoing acquisitions were made at the beginning of the periods indicated below
are as follows.  Management  does not believe  such  results are  indicative  of
future operations.

                                       YEAR ENDED JUNE 30,
                                         (in thousands
                                        except per share
                                             data)
                                         1996       1995

            Revenues. . . . . . . . . .  $22,135    $17,588
            Operating expenses. . . . .   22,126     16,559

            Income from operations. . .        9      1,029
            Other expenses, including
             income taxes . . . . . .      552       (690)
                                       --------   --------

            Net income (loss). .. . .  $  (543)   $   339
                                         ========   =======

            Pro forma income (loss) 
              per share.. .. .. .. ..    $(.20)      $.14


(NOTE M) - SALE OF RECEIVABLES:

      The  Company  has  entered  into a sale  and  purchase  agreement  whereby
third-party  receivables are sold at a discount with recourse. The interest rate
is calculated at 5.5% plus the six-month  LIBOR rate which is 11.3% and 11.5% at
June 30, 1996 and June 30, 1995, respectively. The amount of receivables subject
to recourse at June 30, 1996 totalled  approximately  $805,000 and the agreement
states  that  total  sales of such  outstanding  receivables  are not to  exceed
$4,000,000.  Proceeds from the sale of these receivables totalled  approximately
$3,500,000 and $2,100,000 at June 30, 1996 and June 30, 1995, respectively.  The
purchase fees related to the proceeds above of approximately $73,720 and $30,000
at June 30,  1996 and June 30,  1995,  respectively,  are  included  in interest
expense in the accompanying consolidated statement of operations.  The agreement
expires December 31, 1997.






(continued)


                                        F-22

<PAGE>


                             PHC, INC. AND SUBSIDIARIES

                            NOTES TO FINANCIAL STATEMENTS

(NOTE N) - LITIGATION:

      On October 31, 1994, the Company and a supplier,  NovaCare,  Inc.,  became
parties to a Civil Action in the Superior Court Department of the Trial Court of
the  Commonwealth of  Massachusetts,  NovaCare,  Inc.  ("NovaCare") is an entity
which contracted with the Company in 1992 to provide  rehabilitation therapy and
related administrative services to the Company's long-term care facility. During
the year  ended  June 30,  1996,  the  parties  agreed to settle  all claims and
counterclaims  in the Civil  Action  whereby  no  additional  loss  accrual  was
necessary.  See Note C for payment  terms.  NovaCare has  obtained  (but has not
recorded) a Real Estate  Attachment for a portion of the settlement amount which
may be  employed if PHC does not satisfy  its  obligation  under the  settlement
agreement.


(NOTE O) - SUBSEQUENT EVENT:

     On August  31,  1996 the  Company  purchased  the  assets of an  outpatient
psychiatric  clinic in Michigan,  which was financed  through a loan of $500,000
received  in July  1996.  Annual  revenues  for this  clinic  in the  past  year
approximated $750,000.

                                        F-23

<PAGE>



ITEM 13.    EXHIBITS AND REPORTS ON FORM 8-K.

      (a)   EXHIBITS.

      The  exhibit  numbers in the  following  list  correspond  to the  numbers
assigned to such exhibit in the Exhibit Table of Item 601 of Regulation S-B. The
Company  will furnish to any  stockholder,  upon  written  request,  any exhibit
listed below upon payment by such  stockholder  to the Company at the  Company's
reasonable expense in furnishing such exhibit.

  EXHIBIT      DESCRIPTION
  No.
          +3.1 Restated Articles of Organization of the Registrant, as amended.

           3.2 By-Laws of the Registrant, as amended.

          +4.1 Form of Warrant Agreement.

          +4.2 Specimen certificate representing Class A Common Stock.

          +4.3 Form of  Certificates  representing  redeemable  Class A Warrants
               (form of  certificate  representing  redeemable  Class A Warrants
               included in Exhibit 4.1).

          +4.4 Form of Unit Purchase Option.

       ++++4.5 Warrant  Agreement by and among PHC, Inc.,  American Stock 
               Transfer,and Americorp Securities, Inc.

       ++++4.6 Registration Rights for Exhibit 4.5.

       u +10.1 1993 Stock Purchase and Option Plan of PHC, Inc.

       u +10.2 Form of Stock Option Agreement of PHC, Inc.

      u ++10.3 Form of Restricted  Stock Agreement with list of employees
               and directors who have entered into  agreement and  corresponding
               numbers of shares.

         +10.4 Form of Subscription  Agreement for Bridge financing with list of
               bridge   investors   who  have   entered   into   agreement   and
               corresponding amounts subscribed for.

         +10.5 Form of 8%  Subordinated  Notes of PHC,  Inc.  with  list of  
               bridge investors who have purchased notes and principal 
               amounts thereof.

         +10.6 Form of  Warrant  Agreement  for  Bridge  financing  with list of
               bridge  investors  holding warrant  agreements and  corresponding
               numbers of bridge units for which warrant is exercisable.

         +10.7 Lease  Agreement  between  Blackacre  Realty Trust and PHC, Inc.,
               dated April 30, 1985, with  amendments  dated May 22, 1986, on or
               about March 9, 1988, and May 1, 1992.

          10.9 Lease  Agreement  between David H. Brom and Changes,  dated April
               1, 1995.

        +10.11 Option to Purchase  Agreement  between  PHC,  Inc.  and Quality
               Care Centers of Massachusetts, Inc., dated July 6, 1993.

        +10.12 Lease  Agreement  between  Anna Meta  Leonhard & Claire  Leonhard
               Morse  and PHC,  Inc.,  dated  December  13,  1989;  Approval  of
               Assignment  of lease by PHC,  Inc.,  to PHC of  California,  Inc.
               dated December 13, 1989.

        +10.13 Settlement  Conference  Order,  dated  February  1, 1993,  in the
               matter of AIHS OF  CALIFORNIA,  INC.  V. CLAIRE  LEONHARD  MORSE;
               Letter  from  Jerry  M.  Ackeret  to  Godfrey  J.  Tencer,  dated
               September  24,  1993,  confirming  extension  of the  Settlement;
               Letter from Godfrey J. Tencer to Jerry M. Ackeret,  dated October
               4, 1993,  accepting  extension in letter of  September  24, 1993;
               Letter from Jerry M.  Ackeret to PHC,  Inc.,  dated  February 15,
               1994,  agreeing to  extension  of closing of the  purchase of the
               property to March 8, 1994.

        +10.14 Lease Agreement between Palmer-Wells  Enterprises and AIHS, Inc.
               and Edwin G. Brown, dated September 23, 1983,with Addendum dated 
               March 23,  1989,  and  Renewal of  Addendum  dated  April 7, 
               1992;  Tenant Acceptance Letter to The Mutual Benefit Life 
               Insurance  Company and Palmer-Wells Enterprises,  executed by 
               PHC, Inc. and Edwin G. Brown, dated June 6, 1989.

        +10.15 Sample Equipment Lease with Trans National Leasing Corp.

        +10.16 Note of PHC,  Inc.  in favor of Tot Care,  Inc.,  dated  January
               1, 1991, in the amount of $55,000.

        +10.17 Note of PHC,  Inc. in favor of Humpty  Dumpty  School,  Inc.,  
               dated March 1, 1991, in the amount of $25,000.

        +10.18 Note of PHC,  Inc.  in favor of Bruce A.  Shear,  dated  April 1,
               1993,  in the  amount  of  $152,500;  Subordination  letter  from
               Aquarius  Realty to Malden  Trust  Company as to $50,000 of debt,
               dated 1983,  regarding  debt of PHC, Inc.;  Subordination  letter
               from Bruce A. Shear and Steven J. Shear, individually,  to Malden
               Trust Company as to $80,000 of debt,  dated 1983,  regarding debt
               of PHC, Inc.

        +10.19 Note of PHC, Inc. in favor of Steven J. Shear,  dated April 1, 
               1993, in the amount of $25,000.

        +10.20  Note of PHC,  Inc.  in favor of  Gertrude  Shear,  dated  April
                15, 1993, in the amount of $27,700.

        +10.21 Note of PHC,  Inc. in favor of Mark S.Cowell and Karen K.Cowell,
               dated May 5, 1993, in the amount of $10,000.

        +10.22 Note of PHC, Inc. in favor of Trans National Leasing Corp., dated
               May 17, 1993, in the amount of $50,000.

        +10.26 Advance  Funding  Agreement by and among  Quality Care Centers of
               Massachusetts,   Inc.,   Kelspride   Nursing   Homes,   Inc.  and
               Continental  Medical  Systems,  Inc.,  dated June 30,  1988,  and
               amendment  thereto  dated June 30,  1992;  Note of  Quality  Care
               Centers of  Massachusetts,  Inc. in favor of Continental  Medical
               Systems,  Inc.,  dated June 30, 1992,  in the amount of $240,084;
               Mortgage,  Security  Agreement  and  Assignment  by PHC,  Inc. to
               Continental  Medical  Systems,  Inc.,  dated June 30,  1988,  and
               amendment  thereto  dated June 30,  1992;  Security  Agreement by
               Quality  Care  Centers  of  Massachusetts,  Inc.  to  Continental
               Medical Systems, Inc., dated June 30, 1988, and amendment thereto
               dated  June  30,  1992;   Guaranty  of  PHC,  Inc.  in  favor  of
               Continental  Medical  Systems,  Inc.  dated  June 30,  1988,  and
               amendment  thereto  dated  June 30,  1992;  Guaranty  of Bruce A.
               Shear,  individually,  dated June 30, 1988, and amendment thereto
               dated June 30, 1992 and  Guaranty Fee  Agreement of PHC,  Inc. in
               favor of  Bruce  A.  Shear  in  consideration  of June 30,  1988,
               Guaranty  on behalf of PHC,  Inc.;  Waiver and  Agreement  by and
               among PHC,  Inc.,  Quality Care Centers of  Massachusetts,  Inc.,
               Continental Medical Systems, Inc. and CMS Capital Ventures, Inc.,
               dated October 13, 1993.

        +10.28 Purchase and Sale Agreement by and between Alternative Counseling
               Services,  Inc. and PHC of Virginia,  Inc., dated March 22, 1993;
               Note of PHC of Virginia,  Inc. in favor of Alternative Counseling
               Services,  Inc.,  dated April 1, 1993,  in the amount of $30,000;
               Note of PHC of Virginia,  Inc. in favor of Alternative Counseling
               Services,  Inc.,  dated  April 1, 1993,  in the amount of $15,485
               with Changes Clinic Collections on Purchased  Receivables,  April
               1, 1993 - September 7, 1993.

         10.29 Note of PHC of  Virginia,  Inc.  in favor of  Himanshu S.  Patel
               and Anjana H. Patel, dated April 1, 1995, in the amount of 
               $10,000.

        +10.30 Note of PHC of  Virginia,  Inc.  in favor of  Mukesh  P.  Patel
               and Falguni M. Patel, dated April 1, 1993, in the amount of 
               $10,000.

        +10.31 Mount Regis Center, Limited Partnership Agreement and Certificate
               of Limited Partnership,  dated July 24, 1987, by and among PHC of
               Virginia,  Inc. and limited partners; Form of Letter Agreement of
               limited  partners  dated  October 18, 1993,  with list of Selling
               Limited Partners and Units to be sold.

        +10.32 Contract  for  Purchase  and  Sale of  Real  Estate  by and 
               between Douglas M. Roberts, PHC of Virginia,  Inc. and PHC, Inc.
               dated March 31, 1987, with amendment dated July 28, 1987.

        +10.33 Deed of Trust Note of Mount Regis Center  Limited  Partnership in
               favor of Goulas M. Roberts, dated July 28, 1987, in the amount of
               $560,000, guaranteed by PHC, Inc., with Deed of Trust executed by
               Mount Regis Center, Limited Partnership of even date.

        +10.34 Security  Agreement  Note of PHC of  Virginia,  Inc.  in favor of
               Mount Regis Center,  Inc.,  dated July 28, 1987, in the amount of
               $90,000,  guaranteed by PHC, Inc., with Security Agreement, dated
               July 1987.

        +10.35 Form of  Agreement  amending  Deed of Trust Note (by Mount  Regis
               Center Limited Partnership to Douglas M. Roberts,  dated July 28,
               1987) and Security  Agreement  Note (by PHC of Virginia,  Inc. to
               Mount Regis Center,  Inc.,  dated July 28, 1987,  and assigned by
               Mount Regis to Douglas M. Roberts,  effective  August 1, 1987) by
               and between  Douglas M.  Roberts,  PHC of Virginia,  Inc.,  Mount
               Regis Limited Partnership and PHC, Inc., dated September, 1991.

        +10.37 Note of Quality  Care  Centers of  Massachusetts,  Inc.  in favor
               of Bruce A. Shear, dated April 1, 1993, in the amount of $10,000.

         10.38 Exhibit intentionally omitted.

        +10.42 Note of PHC of  California,  Inc. in favor of Bruce A. Shear,  
               dated April 1, 1993, in the amount of $100,000.

        +10.43 Note of PHC of  California,  Inc.  in favor  of  Marin  Addiction
               Counseling  & Treatment,  Inc.,  dated  January 30, 1990,  in the
               amount  of  $273,163  with  Agreement,   dated  April  26,  1990,
               evidencing  assignment  of note  by  Marin  Addiction  Counseling
               Treatment, Inc. to Circle of Help, Inc.; Asset Purchase Agreement
               by and between Marin Addiction  Counseling & Treatment,  Inc. and
               PHC of California,  Inc.,  dated January 19, 1990;  Waiver Letter
               from Circle of Help, Inc. to PHC, Inc., dated February 15, 1994.

        +10.45 Promissory Note and Corporate  Guarantee of STL, Inc. in favor of
               Joseph and Theodora  Koziol,  dated  November  30,  1992,  in the
               amount of $40,000, Corporate Guarantee by PHC, Inc., with Release
               of All Demands of even date attached.

        +10.50 Letter agreement  between PHC, Inc. and Leonard M. Krulewich,  as
               assignee  of  the  ENOBLE  Corporation,  dated  April  26,  1993,
               relative to the  transfer of  ownership  of the DoN;  Request for
               Transfer of DoN, dated May 28, 1993; Request for Transfer of Site
               of  DoN,   dated  May  28,   1993;   Request  for   Extension  of
               Authorization  Period from June 27,  1993,  dated June 24,  1993;
               Letter   from   counsel   of   AtlantiCare   Medical   Center  to
               Massachusetts Department of Public Health, dated July 13, 1993.

         10.51 Medical  Services  Agreement  between  Mukesh P. Patel and  
               Himanshu Patel and Mount Regis Center, dated August 25, 1995.


        +10.52 Copy of Note of Bruce A. Shear in favor of Steven J. Shear, dated
               December 1988, in the amount of $195,695; Pledge Agreement by and
               between  Bruce A. Shear and Steven J. Shear,  dated  December 15,
               1988; Stock Purchase Agreement by and between Steven J. Shear and
               Bruce A. Shear, dated December 1, 1988.

        +10.53 Management Agreement by and between STL, Inc.and Lillian Furbish,
               dated September 8, 1993.

         10.54 Exhibit intentionally omitted.

        +10.55 Letter Agreement by and between PHC, Inc. and the Utah Group,
               dated November 5, 1993.

        #10.56 Note of PHC, Inc. in favor of Bruce A. Shear,  dated March 31, 
               1994, in the amount of $110,596.

        #10.57 Consent of PHC,  Inc. and PHC of Virginia,  Inc.,  dated June 10,
               1994,  as to  the  transfer  of  partnership  property  to PHC of
               Virginia,  Inc.; Deed by and between Mount Regis Center,  Limited
               Partnership  and PHC of  Virginia,  Inc.,  dated  June 10,  1994;
               Consent to Transfer by Douglas M.  Roberts,  dated June 23, 1994;
               Form of Mount Regis Center,  Limited  Partnership  Assignment and
               Assumption of Limited Partnership Interest, by and between PHC of
               Virginia, Inc. and each assignor dated as of June 30, 1994; Mount
               Regis Center, Limited Partnership  Certificate of Cancellation of
               Limited Partnership, filed June 30, 1994.

        #10.58 Letter from PHC of California,  Inc. to Circle of Help,  Inc., 
               dated September  20,  1994,  confirming  agreement as to payment
               by PHC of California,  Inc. to Circle of Help,  Inc. in the 
               amount of $100,000 as full  satisfaction of promissory note of 
               PHC of California,  Inc. in favor of Marin  Addiction  Counseling
               and Treatment, Inc. in the amount of $273,163  which was assigned
               to Circle of Help,  Inc. on April 26, 1990.

        #10.59 Settlement  Agreement and Mutual General Release,  by and between
               PHC of California,  Inc. and Claire Leonhard Morse,  individually
               and as  Trustee  of the Anna  Leonhard  Trust,  Arnold  Leonhard,
               individually and as Trustee of the Anna Leonhard Trust, and Lloyd
               Leonhard.

        #10.60 Estoppel,  Consent and Subordination Agreement, by and between
               Zions First  National  Bank and Highland  Ridge  Hospital,  
               dated June 30, 1994.

        #10.61 Regulatory  Agreement for Multifamily  Housing  Projects,  by and
               between Quality Care Centers of Massachusetts, Inc. and Secretary
               of  Housing  and Urban  Development,  dated  September  8,  1994;
               Mortgage of Quality Care Centers of Massachusetts,  Inc. in favor
               of Charles River Mortgage, dated September 8, 1994; Mortgage Note
               of  Quality  Care  Centers  of  Massachusetts,  Inc.  in favor of
               Charles  River   Mortgage   Company,   Inc.,  in  the  amount  of
               $6,926,700,  dated September 8, 1994;  Security  Agreement by and
               between Quality Care Centers of  Massachusetts,  Inc. and Charles
               River Mortgage Company,  Inc., dated September 8, 1994;  Standard
               Form Agreement  Between Owner and Architect for Housing Services,
               by and between  Quality Care Centers of  Massachusetts,  Inc. and
               David  H.  Dunlap  Associates,  Inc.,  dated  November  5,  1992;
               Construction  Contract by and  between  Quality  Care  Centers of
               Massachusetts, Inc. and Corcoran Jennison Construction Co., Inc.,
               dated September 8, 1994, and related documents.

        #10.62 First  Amendment to Management  Agreement,  by and between STL, 
               Inc.and Lillian Furbish, dated September 21, 1994.

        *10.63 Asset Purchase  Agreement by and between Good Hope Center,  Inc.
               and the Company, dated as of January 21, 1994.

        #10.64 Lease and Option Agreement,  by and between NMI Realty, Inc. and
               PHC of Rhode Island, Inc., dated March 16, 1994.

        #10.65 Tenant  Estoppel  Certificate of PHC of Rhode Island,  Inc. to
               Fleet National Bank, dated September 13, 1994.

        #10.66 Subordination,  Non-Disturbance  and  Attornment  Agreement,  by
               and among  Fleet  National  Bank,  PHC of  Rhode  Island,  Inc. 
               and NMI Realty, Inc., dated September 13, 1994.

        #10.67 Secured  Promissory  Note of PHC of Rhode  Island,  Inc. in favor
               of Good Hope  Center,  Inc.,  dated  March 16,  1994,  in the 
               amount of $116,000.

        #10.68 Asset Sale  Agreement by and between  Harbor Oaks  Hospital  
               Limited Partnership and the Company, dated June 24, 1994.

        #10.69 Lease Agreement by and between  Conestoga Corp. and PHC, Inc., 
               dated July 11, 1994.

        #10.70 Letter from counsel of PHC, Inc. to  Massachusetts  Department of
               Public Health,  dated August 31, 1994,  requesting,  on behalf of
               the Company  and ENOBLE,  that the  Massachusetts  Department  of
               Public  Health  place  them on the  agenda of the  Public  Health
               Council, with attachments.

       ++10.71 Sale and  Purchase  Agreement  by and between  PHC of Rhode 
               Island, Inc. and LINC Finance Corporation VIII, dated January 20,
               1995.

      +++10.72 Sale and Purchase Agreement by and Between PHC of Virginia,  Inc.
               and LINC Finance Corporation VIII, dated March 6, 1995.

         10.73 Renewal of Lease Addendum  between Palmer Wells  Enterprises  and
               PHC of Utah, Inc., executed February 20, 1995.

    +++++10.74 Employee Stock Purchase Plan

    +++++10.75 Non-Employee Stock Option Plan

         10.76 Loan and Security  Agreement by and between PHC of Nevada,  Inc.
               and Linc Anthem Corp.

         10.77 Secured  Promissory  Note  for  $7,500,000  by  and  between  PHC
               of Nevada, Inc. and Linc Anthem Corp.

         10.78 Loan and Security  Agreement  for  $1,000,000  by and between PHC
               of Utah, Inc. and HealthPartners Funding LP

         10.79 HealthPartners Revolving Credit Note

         10.80 Guaranty of HealthPartners Revolving Credit Note

         10.81 Stock Pledge by and between PHC, Inc. and Linc Anthem Corporation

         10.82 Asset Purchase Agreement by and between  Harmony Counseling, Inc.
               and PHC, Inc.

         10.83 Asset Purchase  Agreement by and between Total Concept  Employee
               Assistance Program, Inc.

              
         +16.1 Letter on Change in Independent Public Accountants.
         
          21.1 List of Subsidiaries.


          99.1 Cautionary Statement for Purposes of the "Safe Harbor" Provisions
               of the Private Securities Litigation Reform Act of 1995


+     Filed  with  the  same  exhibit  number  as an  exhibit  to the  Company's
      Registration Statement on Form SB-2 filed with the Securities and Exchange
      Commission  (Registration  No.  33-71418)  or  an  amendment  thereto  and
      incorporated herein by reference.

++    Filed as an  exhibit to the  Company's  quarterly  report on Form  10-QSB,
      filed with the Securities and Exchange Commission  (Commission File number
      0-23524) on February 14, 1995 and incorporated herein by reference.

+++   Filed as an  exhibit to the  Company's  quarterly  report on Form  10Q-SB,
      filed with the Securities and Exchange Commission  (Commission file number
      0-23524) on May 15, 1995 and incorporated herein by reference.

++++  Filed as an  exhibit to the  Company's  quarterly  report on Form  10Q-SB,
      filed with the Securities and Exchange Commission  (Commission file number
      0-23524) on February 16, 1996 and incorporated herein by reference.

+++++ Filed as an exhibit to the Company's Form 10-C dated February 22, 1996.

*     Filed as an exhibit to the  amendment to the Company's  Current  Report on
      Form 8-K, filed with the Securities Exchange Commission on August 15, 1994
      and incorporated herein by reference.

u     Management contract or compensatory plan or arrangement.



            (b)   REPORTS ON FORM 8-K.

  No reports on Form 8-K were filed by the  Company  during the last  quarter of
the period covered by this report.



<PAGE>



                                  SIGNATURES


            In accordance  with Section 13 or 15(d) of the  Securities  Exchange
Act of 1934, the registrant caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
                                    PHC, INC.




Date: October 4, 1996             By: /S/ BRUCE A. SHEAR
                                       -------------------
                                  Bruce A. Shear, President
                                  and Chief Executive Officer


      In accordance  with 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.


          SIGNATURE                   TITLE(S)                  DATE


/S/ BRUCE A. SHEAR            President, Chief           October  4, 1996
------------------
Bruce A. Shear                Executive  Officer  and 
                              Director     (principal
                              executive officer)

/S/ PAULA C. WURTS                                       October  4, 1996
------------------            
Paula C. Wurts                Controller and Assistant Treasurer
                              (principal    financial
                              and accounting officer)

/S/ GERALD M. PERLOW          Director                    October  4, 1996
---------------------
Gerald M. Perlow                                            



/S/ DONALD E. ROBAR           Director                 October  4, 1996
-------------------
Donald E. Robar